market risk premium

(noun)

the amount by which expected rate of return of the exchange system exceeds the risk-free interest rate

Related Terms

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 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.

  • 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 Capital Asset Pricing Model

    • Systematic risk - also called market risk or non-diversifiable risk - represents the risk present in a security in relation to the economy as a whole.
    • Unsystematic risk - also called idiosyncratic risk or diversifiable risk - represents the risk present in a security that is specific to that investment and unrelated to the overall risk of the market .
    • CAPM states that in market equilibrium, investors are only rewarded for bearing systematic risk - the type of risk that cannot be diversiļ¬ed away.
    • The expected rate of return = the rate of return for a risk-free asset + beta* (the rate of return of the market - the risk-free rate).
    • The return of the market minus the risk-free rate is also known as the risk premium.

  • 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.

  • 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).

  • The "Bond Yield Plus Risk Premium" Approach

    • The risk premium on its equity is 4%.
    • The normal historical equity risk premium for all equities has been just over 6%.
    • In general, an equity's risk premium will be between 5% and 7%.
    • Common methods for estimating the equity risk premium include:
    • Describe the process for the bond yield plus risk premium approach

  • Underwriter

    • Investment bank underwriters help securities issuers lessen their risk in exchange for a premium.
    • IPOs are when a company decides to sell equity on the stock market for the first time .
    • The underwriter offers to take on some of the risk of the offering in exchange for a premium.
    • The issuer knows that it is probably not getting the full market value of the securities, but that's okay because it no longer has the risk of having to find enough buyers to purchase the securities at a desirable price.
    • The details of the process may vary from deal to deal, but the fundamental job of the underwriter(s) is to take some of the issuer's risk in exchange for a premium.