27 Pages Posted: 12 Oct 2004
Date Written: October 6, 2004
The market risk premium is one of the most important but elusive parameters in finance. It is also called equity premium, market premium and risk premium. The term market risk premium is difficult to understand because it is used to designate three different concepts:
1. Required market risk premium. It is the incremental return of a diversified portfolio (the market) over the risk-free rate (return of treasury bonds) required by an investor. It is needed for calculating the required return to equity (cost of equity).
2. Historical market risk premium. It is the historical differential return of the stock market over treasury bonds.
3. Expected market risk premium. It is the expected differential return of the stock market over treasury bonds.
Many authors and finance practitioners assume that expected market risk premium is equal to the historical market risk premium and to the required market risk premium. The CAPM assumes that the required market risk premium is equal to the expected market risk premium. The three concepts are different. The historical market risk premium is equal for all investors, but the required and the expected market risk premium are different for different investors. We also claim that there is no required market risk premium for the market as a whole: different investors use different required market risk premiums.
Keywords: Required market risk,premium, historical market risk premium, expected market risk premium, risk premium, equity premium, market premium
JEL Classification: G12, G31, M21
Suggested Citation: Suggested Citation
By Ivo Welch