How to Calculate a Market Risk Premium

Market risk premium, or MRP, is a term used often when evaluating investments. It sometimes is used synonymously with "risk premium" and "market premium," and it is the amount of return an investor requires to take on risk. Market risk premiums correspondingly increase as risk levels rise.

A Simple Equation

The basic calculation for determining a market risk premium is: Expected Return - Risk-free Rate = Risk Premium. However, to use the calculation in evaluating investments, you need to understand what all three variables mean to the individual investor.

Expected return is derived from average market rates. The yield on a large group of stocks tracked collectively through an index such as the S&P 500 can denote the expected return when calculating a market risk premium. You also can figure the expected return using the equation: Expected Return = Risk-free rate + Market Risk Premium.

A risk-free rate is the rate an investment would earn if it holds no risk. Since government bonds historically have posed little to no risk, the yield on the three-month Treasury bill often is used as the risk-free rate when calculating a market risk premium.

For simplicity, suppose the risk-free rate is an even 1 percent and the expected return is 10 percent. Since, 10 - 1 = 9, the market risk premium would be 9 percent in this example. Thus, if these were actual figures when an investor is analyzing an investment she would expect a 9 percent premium to invest.

Factors that Affect Risk Premium

One underlying factor that affects market risk premiums is the return on long-term U.S. Treasury bonds since it is generally used as the basis for the risk-free return. In addition, any change in economic conditions that affect the risk-aversion of investors will have an impact on market risk premiums. This includes economic uncertainty that prompts investors to require a larger potential payoff to take on perceived additional risk. Conversely, confidence in the economy can spark investors to accept higher levels of risk. Changes in tax rates, federal monetary policy and huge shifts in inflation affect market risk premiums in both directions, causing increases or decreases depending on whether the changes are considered favorable or unfavorable by investors. For example, when inflation levels rise, investors look for a higher market risk premium to compensate for the decrease in purchasing power.

Investor Preferences

The acceptable market risk premium varies among investors because it involves an individualized yield demanded on investments, to compensate the investor for taking on the risk involved. Thus, what the market risk premium must be for the individual investor depends on his or her level of risk aversion. Younger investors who are decades away from retirement often are willing to take on higher levels of risks than someone nearing or in retirement. This is because younger investors have a longer period to recoup any loss sustained from taking on higher risk.