Market Risk Premium

Market Risk Premium is the required return over the Risk-Free Rate, justifying the additional Risk in investing. The Equity Market Risk Premium is specific to a Stock or the Stock Market.

In investing we have choices, a lot of choices. Stocks, Bonds, Funds, ETFs. In Stocks, as an investment is made, as an investor, you must be aware of the Risk Return equation. Or how much extra Return is there potentially available for the extra Risk taken on board. So, let’s start with the “Risk-Free Rate”. Now, there is no such thing as a Risk-Free Investment. Nevertheless, what is termed as the Risk-Free Rate represents the return achieved by investing in Government Bonds. Let’s say a basic benchmark return that can be achieved in an economy. Therefore, if the choice is to invest in Stocks in order to justify the increased risk in investing in Stocks, a higher return or premium return must be achievable.

This would be the Expected Return of an individual Stock or a Stock Portfolio, or if investing in a broad market ETF, the expected return of the overall Stock Market. The Market Risk Premium for Equities or the Equity Market Risk Premium is the difference between the Expected Return for a Stock or the Stock Market minus the Risk-Free Rate. This Risk Premium is always present and cannot be diversified away. At this point, there is a quantitative measure or Quote for the target return required over and above the Risk-Free Rate. This quote cannot live in isolation. It must be justifiable in terms of the Total Expected Forward Return for the Stock or the Stock Market.