Market Risk Premium

Market Risk Premium — What it Is and How to Use It

What is the market risk premium (MRP)?

The market risk premium is the extra return investors expect for holding a market portfolio instead of a risk-free asset. It is calculated as the difference between the expected return on the market and the risk-free rate:
r_mrp = r_market − r_risk-free

In asset-pricing theory, the MRP is represented by the slope of the security market line (SML) in the Capital Asset Pricing Model (CAPM). It quantifies how much additional return the market demands per unit of systematic risk.

How it works

• Investors demand compensation for taking risk above a risk-free alternative (typically government bonds).
• The historical MRP is the same for all observers looking backward; required or expected MRPs vary by investor depending on risk tolerance and expectations about future returns.
• The MRP links broad market returns to individual assets through each asset’s sensitivity to market movements (beta).

Calculation and example

Basic calculation:
– Market risk premium = Expected market return − Risk-free rate

Example (illustrative):
– If the S&P 500 average annual return = 10.1% and the 10-year U.S. Treasury yield = 4.1%, then:
– MRP = 10.1% − 4.1% = 6.0%

Using CAPM to get an asset’s required return:
– CAPM formula: r_i = r_f + β_i × (r_market − r_f)
– r_i = required return on asset i
– r_f = risk-free rate
– β_i = asset i’s beta
– (r_market − r_f) = market risk premium

This required return is frequently used as the discount rate in discounted cash flow (DCF) valuations.

MRP vs. Equity Risk Premium (ERP)

• Market Risk Premium (MRP): Broadly refers to the excess return for investing across the entire investable market (stocks, bonds, real estate, etc.).
• Equity Risk Premium (ERP): Specifically the excess return for equities (stocks) over the risk-free rate.
  Because equities are a narrower, often riskier subset of investable assets, the ERP commonly exceeds the broader MRP.

Choosing a risk-free rate

• Practitioners commonly use long-term government bond yields as the proxy for the risk-free rate (e.g., the 10-year U.S. Treasury) when estimating long-term returns.
• Shorter-term yields (e.g., 2-year) are sometimes used for short-horizon analyses.

Historical context

• U.S. historical estimates vary widely depending on sample period and method; common ranges cited are roughly 3%–12%.
• Recent decades have often shown MRP values in the mid-single-digit range (for example, around 5–6% over some recent periods).

Key takeaways

• The market risk premium measures the additional return demanded for taking market risk versus a risk-free asset.
• It is central to CAPM and is used to derive required returns for valuation and portfolio construction.
• The MRP depends on the expected market return and the chosen risk-free rate; estimates vary by time period and methodology.
• Distinguish MRP (broad market) from ERP (equities only); ERP is often higher.

Practical use

• Use a defensible choice of market return and risk-free rate, and be explicit about the historical period or forward-looking assumptions used.
• Apply CAPM to translate the MRP into asset-level discount rates via beta for valuation, performance analysis, and capital budgeting.