Investing requires a series of formulas and a baseline understanding of the financial markets to receive a successful return. Although it’s not necessary to know every single equation to build your market portfolio, one important calculation to know is the market risk premium formula.
Learn the basics of the premium and how to use it in this blog. Let’s dive in.
The market risk premium is a way to calculate the rate of return on a risky investment. To get this number, investors take the difference between the expected return and the risk-free rate. This formula is used by investors who choose to fill their market portfolio with more precarious investments rather than risk-free assets.
The market risk premium is part of the capital asset pricing model — a finance model that establishes a linear relationship between the required return on a particular investment and the associated risk. This configuration highlights the fact that, while an investment with a high rate of return and low risk is ideal, sometimes more dangerous ventures can lead to bigger returns.
There are two different terms you’ll need to calculate the market risk premium:
There are a few different ways for investors to calculate their level of risk, and therefore the market risk premium. But not all investments will have the same level of vulnerability; it all depends on the types of assets being invested in. In most cases, government bonds and cash equivalents have very little risk, while high-yield debt and equities are much more unsafe.
Here are the four different types of market risk premium:
Sometimes referred to as the hurdle rate of return, this premium is the lowest rate of return that you consider for any investment. Think of it as the benchmark for any financial venture. If an asset’s rate of return is lower than this minimum requirement, then you can consider it not worth investing in as it will most likely cost you more than you’ll gain.
The required market risk premium is the equation that will keep you safe from a bad investment decision, assisting you with earning more money as time passes. Everyone’s situation is different, meaning your minimum return won’t be the same as anyone else’s.
This is a model of the rate of return you’re expecting to make on an investment. Similar to the required market premium, the value of your assets is based on your definition of success and your own idea of anticipated returns.
In this type of market risk premium, there are two different kinds of investors:
This equation is an objective measurement of your return on investment as it looks at the rate of return that your investments have historically created. Rather than base your market risk premium off of what you’re hoping to earn or what you’re afraid to lose, this is a data-driven method for discovering the best investment opportunities.
This formula is different from the other three because it uses the state of the current market within the equation. When you use the real market risk premium, it considers the normal premium rate and the inflation rate of the existing market. This means it’s a beneficial tool if you’re planning on making an investment at the same time as you calculate the premium.
The market risk premium should help you find the acceptable rate of return to expect from your portfolio. Once calculated, the risk premium can be a benchmark number to plan your investments around.
To find the required market risk, expected market risk and historical risk premiums, you can use the following formula:
Calculate the real market risk premium utilizing this equation:
With every person’s investments being unique and the market constantly fluctuating, there’s no gold-standard market risk premium. But it’s important to watch the market and determine if your portfolio is heading in the right direction.
The market risk premium refers to extra return made on risky investments, whereas the equity risk premium is used to refer to stocks and the expected value of stock return that’s above the risk-free rate.
Since 1962, Cathay Bank has helped people all over the globe meet their financial goals and protect assets against vulnerabilities. Our team offers a wide range of financial services, and we’re available to assist your small business with any particular investment or risk management questions you may have.
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This article does not constitute legal, accounting or other professional advice. Although the information contained herein is intended to be accurate, Cathay Bank does not assume liability for loss or damage due to reliance on such information.