Glossary
Market Risk Premium
The market risk premium is the additional return investors expect to earn from holding a risky market portfolio—like stocks—over a risk-free investment, such as government bonds. It reflects the compensation investors demand for taking on extra risk.
How is the market risk premium calculated?
It’s typically calculated by subtracting the risk-free rate (like a Treasury bond yield) from the expected return of the market:
Market Risk Premium = Expected Market Return − Risk-Free Rate
Why is the market risk premium important?
It helps investors and analysts assess whether the potential return of a risky investment is worth the risk, and it's used in models like the Capital Asset Pricing Model (CAPM).
What’s a typical value for the market risk premium?
Historically, it has ranged from 4% to 6% in the U.S., though estimates vary based on market conditions and assumptions.
Is the market risk premium constant?
No. It changes over time based on investor sentiment, economic outlook, and changes in risk-free rates or market expectations.
How does the market risk premium affect stock valuations?
A higher market risk premium leads to a higher discount rate in valuation models, which typically lowers the estimated value of stocks or projects.
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