Market Risk Premium - What is the Definition? How to calculate - Subjectmoney.com

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The Market Risk Premium is the rate of return that the market earns over the Risk Free Rate (generally the 1-year T-Bill). There is a historical market risk premium and an expected market risk premium. The historical market risk premium is the same for all investors since it is calculated using historical facts. The expected market risk premium however can differ between investors. One investor may have an optimistic outlook applying a higher expected market return to the formula than another investor who may have a pessimistic outlook.


To apply this, lets assume that we expect the S&P 500 to return 9% over the next year and the 1 year Treasury Bill's yield to maturity is 2%. To figure out the market risk premium we would simply subtract the risk free rate of 2% from the expected return on the S&P 500 of 9%. 9%-2%=7% so the expected market risk premium would be 7%.

The market risk premium is an important concept because is is a component of the popular Capital Asset Pricing Model (CAPM) which is a formula used to determine the expected return of a companies stock for investors and the cost of equity for corporate managers. Since the market risk premium is an important component of pricing equity securities, investors with superior forecasting methods are the investors who will more accurately be able to determine whether a stock is mispriced by the market.

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