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All investors need to balance risk with the expected return on their investments. Market risk premium is a way to measure the risk of a market or equity investment when compared to an investment with a guaranteed, or risk-free, return. The market risk premium of an investment is expressed as the difference between the expected return on the equity investment and the return on the risk-free investment.
This difference is also called the security market line (SML) slope. The SML is a graph that plots the market risk of a particular investment in relation to the return of the market at a certain time. It shows all risky securities investments. Investors can easily see where an investment falls on the graph to determine the amount of risk in relation to the expected return.
The formula for calculating this market risk is part of the capital asset pricing model (CAPM). The CAPM includes the idea that investors need to be compensated for both the time value of money and the risk of the investment. The time value is represented by the risk-free return portion of the formula. Under the CAPM model, if the risk premium does not meet or beat the investor's required return to compensate for the additional risk, the investor should pass on the investment.
To calculate the current market risk premium, investors take the current risk-free investment return — usually U.S. Treasury bonds — and compare that return to the estimated return of the risky investment. For example, suppose that the current bond return is two percent, and the estimated return of the risky market investment is eight percent. The market risk premium of the risky investment would be the difference between the two yields, or six percent. The investor can then decide if the additional six percent return is worth the added risk.
Investors also use different types of market risk benchmarks to determine risk. These include the historical market risk premium, and the expected market risk premium. The historical market risk premium compares the historical return of the stock market compared to U.S. Treasury bonds. The expected market risk premium compares the estimated future returns of the stock market compared to U.S. Treasury bond returns.
These calculations assist the investor in determining the level of risk versus a risk-free investment. They do not guarantee the rate of return or any return at all. Investors generally use risk estimates as part of an overall investment strategy.