The market risk premium of an investment stock is the difference between an investment’s expected return and the risk-free rate. Stocks that move more with the market have greater market risk and are consequently expected to have higher risk premiums. Investors can compare these estimates for risk premium and overall return that a stock should have to how the stock is expected to perform in the future.
Estimate the risk-free rate (Rf). This is the rate offered on federal government debt which is expected to have no risk of default. Investors can use the yields of bonds issued by the country where the company that issued the stock is domiciled as an estimate of the risk-free rate. They should use the yield from the bond that has a maturity closest to the anticipated holding period of the stock. U.S. Treasury bond yields are available on finance websites like Yahoo! Finance and Google Finance.
Establish the expected market return (Rm). Different stock markets usually have an average market return that can be obtained from financial websites or market indexes. This is important for determining the market risk premium, which is an important parameter for the risk premium computation. Market risk premiums can be obtained by subtracting the risk-free rate from the average market return.
Calculate the market risk premium by subtracting the risk-free (Rf) rate from the market return (Rm). The expression for the market risk premium is Rm-Rf.
Determine the stock’s beta (β). Beta usually represents the sensitivity of a stock to market changes. The stock’s beta is calculated for you on different financial websites like Google Finance or Yahoo! Finance. These values are based on the past co-movement of the stock’s returns with the overall market’s returns. A stock’s beta may also be calculated from historical price data provided by many of the same financial websites (Yahoo! Finance, Google Finance, etc.). Beta is computed by dividing the co-variance of a security's returns and the returns for the whole market by the variance of the stock’s returns.
Compute the stock’s risk premium by multiplying the stock’s beta (β) and the market risk premium (Rm-Rf). The entire expression for a stock's market risk premium is β x (Rm-Rf)
- The entire expression for the required return for a stock is
- r = Rf + β x (Rm-Rf)
- These calculations come from the Capital Asset Pricing Model (CAPM). Other methods of calculating a risk premium based on factors like a stock's market capitalization and book-to-price ratio have been developed.
- A high risk premium means there is great uncertainty about returns of the stock, but the expected returns are also higher, according to the CAPM model.
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