What Is Market Risk Premium?

The market risk premium (MRP) is the difference between the expected return on a market portfolio and the risk-free rate.

The market risk premium is equal to the slope of the security market line (SML), a graphical representation of the capital asset pricing model (CAPM). CAPM measures the required rate of return on equity investments, and it is an important element of modern portfolio theory (MPT) and discounted cash flows (DCF) valuation.

Understanding the Market Risk Premium

Market risk premium describes the relationship between returns from an asset portfolio and treasury bond yields. The risk premium reflects the required returns, historical returns, and expected returns. The historical market risk premium will be the same for all investors. The required and expected market premiums, however, will differ from investor to investor based on risk tolerance and investing styles.

Investors require compensation for risk and opportunity costs. The risk-free rate is a theoretical interest rate that is paid by an investment with zero risks. Long-term yields on U.S. Treasuries have traditionally been used as a proxy for the risk-free rate because of the low default risk and have had relatively low yields as a result of this assumed reliability.

Equity market returns are based on expected returns on a broad benchmark index such as the Standard & Poor's 500 index of the Dow Jones Industrial Average (DJIA). Real equity returns fluctuate with the operational performance of the underlying business.

Historical return rates have fluctuated as the economy matures and endures cycles, but conventional knowledge has generally estimated a long-term potential of approximately 8% annually.

Calculation and Application

The market risk premium can be calculated by subtracting the risk-free rate from the expected equity market return, providing a quantitative measure of the extra return demanded by market participants for the increased risk.

Once calculated, the equity risk premium can be used in important calculations such as CAPM. Between 1926 and 2014, the S&P 500 exhibited a 10.5% compounded annual rate of return, while the 30-day Treasury bill compounded at 5.1%. This indicates a market risk premium of 5.4%, based on these parameters.

The required rate of return for an individual asset can be calculated by multiplying the asset's beta coefficient by the market coefficient, then adding back the risk-free rate. This is often used as the discount rate in discounted cash flow, a popular valuation model.

The Bottom Line

The market risk premium—measured as the slope of the security market line (SML)—is the difference between the expected return on a market portfolio and the risk-free rate. It provides a quantitative measure of the extra return demanded by market participants for an increased risk.