How is the expected market return determined when calculating market risk premium?


In some cases, brokerage firms provide an expected market rate of return based on an investor’s portfolio composition, risk tolerance and investing style. Depending on the factors accounted for in the calculation, individual estimates of the expected market return rate can vary widely.

For those who do not use a portfolio manager, the annual return rates of the major indexes provide a reasonable estimate of future market performance. For most calculations, the expected market return rate is based on the historic return rate of an index such as the S&P 500, the Dow Jones Industrial Average, or DJIA, or the Nasdaq.

Market Risk Premium

The expected market return is an important concept in risk management, because it is used to determine the market risk premium. The market risk premium, in turn, is part of the capital asset pricing model, (CAPM) formula. This formula is used by investors, brokers and financial managers to estimate the reasonable expected rate of return on a given investment.

The market risk premium represents the percentage of total returns attributable to the volatility of the stock market, and is calculated by taking the difference between the expected market return and the risk-free rate. The risk-free rate is the current rate of return on government-issued Treasury bills (T-bills). Though no investment is truly risk-free, government bonds and bills are considered almost fail-proof since they are backed by the U.S. government, which is unlikely to default on financial obligations.

For example, if the S&P 500 generated a 7% return rate last year, this rate can be used as the expected rate of return for any investments made in companies represented in that index. If the current return rate for short-term T-bills is 5%, the market risk premium is 7% – 5%, or 2%. However, the returns on individuals stocks may be considerably higher or lower depending on their volatility relative to the market.

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