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Market Risk Premium

Its obtained by the difference between the predictable return on a market portfolio
and risk-free rate. It can be seen as a role of supply and demand that, when in equilibrium,
excludes the need to pay for the premium. Market risk premium is fundamental on every risk
and return model and at the same time it contributes for estimating costs of equity and capital
in corporate finance and valuation. When the demand arises and the supply doesnt follow,
the price increases and the difference in the price is the premium. Thus it gives the profit
generated when the risk is excluded. This measure equals the slope of the security market line,
which is a capital asset pricing model (CAPM). The security market line is represented by a line
on a graph that shows the systematic risk against the whole return of the market during a
certain period of time.
The concept of market risk premium is broken down into three crucial concepts: the
required, the historical and the expected market risk premium. The required market risk
premium is the return of a portfolio over the risk-free rate required by an investor. Historical
market risk results from the historical differential return of the market over treasury bonds.
Finally, expected market risk is calculated through the expected differential return of the
market over treasury bonds.
Historical market risk can be equal to all investors because the data considered is
based on real values of something that happened in the past. However the expected and the
required market risk will be different for investors considering each ones risk tolerance and
investing styles.
The capital asset pricing model (CAPM) assumes that required and expected market
risk premium are the same. This model defines the required return to equity, through the
following formula:
= + [( ) ]
Rf rate of return of risk-free investments (treasury bonds)
- beta of the security
E(Rm) expected market return
[E(Rm) - Rf] expected market risk premium

Porto, October 11th, 2015

According to the model, investors should be compensated through time value of


money and risk. Risk free assets are the ones from the government which allows for the
determination of the risk-free rate.
The main sources of historical data are based on stock market prices and dividends to
get the equity market return. Risk-free rates are obtained through historical returns data on
treasury bills (short-term debt obligation - < 1 year) or bonds (log-term debt obligation - > 1
year).
It must be stated that market risk premium varies overtime and across markets. The
historical results depend on time periods and the method chosen for computing the average
rate of returns. To predict a future market risk premium, its essential to understand the future
investors behavior, the efficiency of the local equity market, the degree of global equity
market integration and segmentation and the amount of fear or greed on the market
considered.
The risk premium depends on how investors perceive changes in inflation, higher or
lower corporate and personal tax rates, government stability and capital controls, central
banks policies and domestic currency fluctuations relative to foreign currencies.
In markets that are starting its process of development (emerging markets), the
forecast of market risk premium could be a tricky thing to do, because there is no much
historical data to rely on. Its not correct to depend only on historical data to predict the future
because history doesnt replicate itself overtime. This is mainly due to the volatility of stocks
relative to their average value.
There are three other approaches that allow the determination of market premium
risk: survey subsets of investors and managers, historical premium and implied premiums.
Survey premiums are made to get an idea about future expectations on equity returns. The
historical premium consists of relying on past data about the returns earned on equities
relative to riskless investments. Implied premiums are premiums which are predicted based on
market rates or prices on traded assets today.
Considering these approaches the decision now is to decide which one is the best. The
final decision is influenced by different factors. First theres the predictive power, the ability to
provide estimations closer to realized premiums. The approach with the best one should be
enhanced. The beliefs about the market are another important factor in this field of study. If
the markets are expected to be efficient in the aggregate, the current implied equity premium
Porto, October 11th, 2015

is the go to choice, because it is estimated according to the current level of the index. If the
markets, in the aggregate, are overvalued or undervalued, the historical risk premium or the
average implied equity risk premium over long periods are the right approaches to use. When
theres no faith in markets, survey premiums will perform best. Finally its essential to think
about the purpose of the analysis because it may help with the final decision. For equity
research and acquisition valuations and in order to be market neutral, its required the use of
current implied equity risk premium.
This way its possible to come to the conclusion that there is no such good approach
that can be applied for every situation. The features of the markets will define which approach
will cover the analysis better.

Porto, October 11th, 2015