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Its obtained by the difference between the predictable return on a market portfolio
and risk-free rate. It can be seen as a role of supply and demand that, when in equilibrium,
excludes the need to pay for the premium. Market risk premium is fundamental on every risk
and return model and at the same time it contributes for estimating costs of equity and capital
in corporate finance and valuation. When the demand arises and the supply doesnt follow,
the price increases and the difference in the price is the premium. Thus it gives the profit
generated when the risk is excluded. This measure equals the slope of the security market line,
which is a capital asset pricing model (CAPM). The security market line is represented by a line
on a graph that shows the systematic risk against the whole return of the market during a
certain period of time.
The concept of market risk premium is broken down into three crucial concepts: the
required, the historical and the expected market risk premium. The required market risk
premium is the return of a portfolio over the risk-free rate required by an investor. Historical
market risk results from the historical differential return of the market over treasury bonds.
Finally, expected market risk is calculated through the expected differential return of the
market over treasury bonds.
Historical market risk can be equal to all investors because the data considered is
based on real values of something that happened in the past. However the expected and the
required market risk will be different for investors considering each ones risk tolerance and
investing styles.
The capital asset pricing model (CAPM) assumes that required and expected market
risk premium are the same. This model defines the required return to equity, through the
following formula:
[ (
is the go to choice, because it is estimated according to the current level of the index. If the
markets, in the aggregate, are overvalued or undervalued, the historical risk premium or the
average implied equity risk premium over long periods are the right approaches to use. When
theres no faith in markets, survey premiums will perform best. Finally its essential to think
about the purpose of the analysis because it may help with the final decision. For equity
research and acquisition valuations and in order to be market neutral, its required the use of
current implied equity risk premium.
This way its possible to come to the conclusion that there is no such good approach
that can be applied for every situation. The features of the markets will define which approach
will cover the analysis better.
Mnica Ferreira
up201500275