Market Risk Premium - Definition, Formula and Calculation

What is Market Risk Premium:

The ‘Market Risk Premium’ is considered as an excess return over the stocks purchased by the individuals or the whole market that are associated with risk-free rate. Considering this as compensation, such aspect is being practiced in stock-exchange a market which helps business industrialists and investors in making the right decision to avoid high risk coming out of the equity market.

Market Risk Premium detail

Each stock depicts different risk involved for the investor to evaluate the size of the premium, which varies from one another. Therefore, higher risk involved in the investment calls out for a higher amount of premium for the investor. It should be in our best interest that ‘Market Risk Premium’ is also referred to as ‘Equity Premium’.

How To Calculate Market Risk Premium?

Let’s catch some of the most effective insights about calculating the market risk premium with simplest formula of market risk premium. The procedure starts with evaluating the rough amount which we would get from our return on stocks.

It should be in our best interest that finance experts assume that calculating the future return on stocks is possibly the most difficult job which takes time and real diplomacy to select some accurate values. The second step pushes us to analyze the risk-free rate because many investors expect that coupon payment and their principles are settled on semi-annual terms.

Market Risk Premium = Rm - Rf

Here we should have to know what are Rm and Rf in market risk premium formula.

Rm = Market Rate of Return, Rf = Risk Free Rate of Return

How Market Risk Premium Helps?

Market risk premium helps in engaging the most high-profile investors in the stock market, since ‘market risk premium’ is all about risk-return trade off which technically helps in getting associated with investments with higher risk rate. Compared to government bonds, the investments made in the stocks exhibit an opposite trend as there’s no such assurance of the profit or if the company shuts down overnight.

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