Market risk premium is calculated by first finding the expected return of an asset or portfolio. The risk-free rate of return is then determined and subtracted from this expected return to arrive at market risk premium.
- Find the expected return of an asset or portfolio
Determine the expected return of an individual asset or portfolio. In some instances, this metric is provided. However, with a more advanced portfolio, this figure is calculated by taking the expected return of each asset in the portfolio and then multiplying it by the weight of the item in that portfolio. The product yields the expected return of the portfolio.
- Determine the risk-free rate of return
The risk-free rate of return must be determined in order to calculate market risk premium. The risk-free rate of return is the market setter off of which other assets are priced. The notion stems from the idea that any amount above the risk-free rate is considered a premium. In most markets, government securities include the risk-free rate of return.
- Subtract the risk-free rate of return from the expected rate of return
To arrive at market risk premium, the risk-free rate of return needs to be subtracted from the expected rate of return. The difference represents the market risk premium. This figure represents the additional risk over the risk-free rate undertaken by an investor.