Market Risk Premium

Market risk premium - Additional return expected for bearing the risk of investing in the market.
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Market Risk Premium
OPEN ACCOUNT
3 mins read
26-November-2024

The market risk premium in India is the difference between the expected rate of return and the risk-free rate. The market risk premium (MRP) showcases the additional returns expected by an investor for putting various investments at a higher risk in the portfolio. It is an integral part of the Capital Asset Pricing Model (CAPM), which helps calculate return on investments for various assets.

Understanding market risk premium

When you consider investing, you have to choose between numerous investment instruments. However, every investment has its unique features, especially an expected rate of return. For some investments, such as government-backed bonds, the rate of return is risk-free, as the government pays regular predetermined interest. Here, if you invest, there will be no risk, but the potential for higher returns will be limited.

On the other hand, if you choose market-linked investments such as equities and buying shares, they may offer higher returns than bonds but come at a higher risk. Here, the interest or the rate of return will not be risk-free, and you will be taking a risk to earn higher returns than investment instruments that offer risk-free interest. This concept of taking on more risk for a premium (earning more than risk-free interest) is called the market risk premium.

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Types of market risk premium

Now that you have understood the market risk meaning and how it blends in with the market risk premium in India, here are the types of market risk premiums:

  • Historical market risk premium
    It is the expected additional rate of return calculated by analysing an investment instrument's past performance. This premium is similar for every investment, as the past performance is universal.
  • Required market risk premium
    This describes the minimum return rate that investors want to earn by taking on more risk than risk-free return investment instruments. Investors avoid investing if this rate is too low, as taking a risk without higher return potential makes no sense.
  • Expected market risk premium
    This is the rate of return that investors expect when investing in risky instruments. It varies depending on each investor's distinctive investment goals and risk appetite.

What does market risk premium impact most?

The market risk premium in India is slightly different from that in other countries, as investors are more risk-averse. However, the market premium mostly impacts the risk level that an investor would be willing to take. For example, if you are choosing between two investment instruments, you can look at the market risk premium for both of them to decide if the additional returns align with your risk appetite.

The market risk premium also impacts investors' choices when choosing investment instruments to invest their capital. For example, if you are just starting in the investment market, you will be willing to take on more risk to multiply your investment amount quickly. Here, you will prefer investment instruments with a higher market risk premium.

However, after you have already invested in investment instruments with a higher market premium, you will want to take on a lower risk to ensure your portfolio can square off potential losses. In this case, you will look for investment instruments with a lower market risk premium.

How to calculate the market risk premium?

Calculating market risk premiums is easy. All you have to know is the rate of return for the various types of market risk premiums (any type that you find the most suitable) and the risk-free rate of investment instruments (mostly government bonds). The formula is:

Market risk premium = Expected rate of return – risk-free rate

For example, suppose you are considering investing in a government bond with a coupon rate (interest rate) of 6% and a mutual fund scheme that offers 12% as historical returns. In that case, you can find the market premium by subtracting the mutual fund’s historical rate of return from the bond’s interest rate.

So, 12%-6% = 6%

It means that if you invest in the mutual fund scheme, the higher risk can give you 6% more returns than investing in the government bond.

Also read: Share market timing

What is the difference between risk premium and market risk premium?

Although both concepts describe the additional returns you can get if you invest in investment instruments that do not have a risk-free interest, they differ in their targeted investment instruments. The risk premium, also known as equity risk premium, describes the additional return potential for stocks invested within the share market. On the other hand, market risk premium in India describes such additional returns for every investment instrument available in the securities market.

Conclusion

Market premium (market risk premium) refers to the difference between the expected rate of returns from risky investment instruments and the risk-free rate from relatively risk-free investment instruments. It is one of the most effective metrics for investors to analyse an investment instrument, understand if its risky nature is worth the return potential, and create trading strategies such as breakout trading. You can take any relatively risk-free investment instrument and compare its interest rate with the expected historical and required rate of return to make better-informed investment decisions.

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Frequently asked questions

What is market risk premium formula?

The market risk premium is determined by subtracting the risk-free rate from the expected return on the equity market. This calculation provides a quantitative measure of the additional return required by investors to compensate for the higher risk associated with the market.

What is the risk premium in the stock market?
The risk premium in the stock market, also called equity risk premium, is the additional returns investors can earn by investing in risky investments compared to investments that offer risk-free interest.
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