market risk premium

Examples of market risk premium in the following topics:

• Defining the Security Market Line

  • The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.
  • The security market line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities.
  • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.
  • The idea of a security market line follows from the ideas asserted in the last section, which is that investors are naturally risk averse, and a premium is expected to offset the volatility of a risky investment.
  • The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

• The Relationship Between Risk and Return and the Security Market Line

  • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
  • Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market.
  • The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset's overall sensitivity to market fluctuations or its beta.
  • The market risk premium is determined from the slope of the SML.
  • The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm)− Rf.

• The Cost of Common Equity

  • -- Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.
  • The CAPM shows that the cost of equity is equal to the risk free rate plus a premium expected for risk.
  • This premium is sensitized to movements in relevant markets using the beta coefficient.
  • Another approach to calculating the cost of common stock is to add a risk premium to the cost of debt.
  • Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.

• Differences Between Required Return and the Cost of Capital

  • Instead of taking into account all types of securities issued by a firm, an investor acquires the appropriate required return by taking the risk-free rate and adding an investment specific risk premium.
  • The risk premium can be established by understanding business risk and financial risk.
  • Financial risk is the risk of changes to earnings from the use of increased debt.
  • Consequently, the risk premium consists of business risk + financial risk.
  • It adds the risk-free rate to the risk premium of the market adjusted to an investment's beta.

• Impact of Diversification on Risk and Return: Systematic Risk

  • Systematic risk is intrinsic to the market, and thusly diversification has no effect on its presence in investments.
  • Recall that previously we talked about the security market line and the implication that investors require more compensation for extra risk.
  • Now, imagine that these 50 corporations are all given a lesser credit rating because of the risk of their overall market segment.
  • This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
  • Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.

• Default Risk and Bond Price

  • Risk premium is always positive.
  • We set the same equilibrium price and quantity for both markets in Figure 1, which means both markets have identical risks.
  • As the default risk increases, then the risk premium increases too.
  • During recessions, when some businesses bankrupt, the default risk increases, increasing the risk premium.
  • Impact of a risk premium on the bond markets

• The Term Structure

  • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
  • Shortcomings of the expectations theory is that it neglects the risks inherent in investing in bonds, namely interest rate risk and reinvestment rate risk.
  • This is called the term premium or the liquidity premium.
  • This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
  • Long-term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long-term.

• Expected Risk and Risk Premium

  • Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.
  • Systemic risk is the risk associated with an entire financial system or entire market.
  • This type of risk is inherent in all marketable securities and cannot be diversified away.
  • The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate.
  • The risk premium, along with the risk-free rate and the asset's Beta, is used as an input in popular asset valuation techniques, such as the Capital Asset Pricing Model.

• Risk Adjusting the Discount Rate

  • Individuals and firms use methods for adjusting discount rates for risk, include adding risk premiums, Sharpe Ratios, rNPV, and Monte Carlo evaluation.
  • The risks taken into account in modeling are typically grouped into credit risk, liquidity risk, market risk, and operational risk categories.
  • Market risk is the risk of losses in positions arising from movements in market prices.
  • The most common method of adjusting a discount rate for risk is by starting with a risk-free rate and adding a risk premium.
  • The Sharpe Ratio is a measure of risk premium per unit of deviation in an investment asset.

• Drivers of Market Interest Rates

  • Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
  • This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
  • The greater the risk is, the higher the market interest rate will get.
  • There is a market for investments which ultimately includes the money market, bond market, stock market, and currency market as well as retail financial institutions like banks.
  • Treasury Bills), rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default, lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).