what is meant by an investment risk premium? what is a market risk premium? course hero

Market risk premium is the difference between the forecasted return on a portfolio of investments and the risk-free rate. Since Treasuries are considered the risk-free rate, the market risk premium for a portfolio is the variance between the returns on the portfolio and the chosen Treasury yield.

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What is the difference between a risk premium and market risk premium?

Dec 13, 2021 · A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return. An asset's risk premium is a form of compensation for investors.

What is the equity risk premium Quizlet?

Market risk premium is a way to measure the risk of a market or equity investment when compared to an investment with a guaranteed, or risk-free, return. The market risk premium of an investment is expressed as the difference between the expected return on the equity investment and the return on the risk-free investment .

Does the size of the risk premium depend on the portfolio?

Oct 22, 2019 · The market risk premium is the additional return that's expected on an index or portfolio of investments above the given risk-free rate.

What is'equity risk premium'?

Oct 23, 2020 · An equity risk premium is an excess return earned by an investor when they invest in the stock market over a risk-free rate. This return compensates investors for …

What is market risk premium?

The market risk premium is the additional return that's expected on an index or portfolio of investments above the given risk-free rate. On the other hand, an equity risk premium pertains only to stocks and represents the expected return of a stock above the risk-free rate. Equity-risk premiums are usually higher than standard market-risk premiums.

What is the risk associated with investing?

Investments have varying degrees of risk associated with them. If an investor buys a stock, for example, there's a risk that the stock price could decline, which opens up the possibility of the investor incurring a loss when the position is sold.

Is a Treasury bond risk free?

However, U.S. Treasury bonds are typically considered risk-free returns if the bond is held to maturity. In other words, since Treasuries are backed by the U.S. government, their yields or interest rates are considered risk-free.

Is equity riskier than bonds?

Equity-risk premiums are usually higher than standard market-risk premiums. Typically, equities are considered riskier than bonds, but less risky than commodities and currencies.

What is risk premium?

The risk premium is the extra return above the risk-free rate investors receive as compensation for investing in risky assets. The risk premium is comprised of five main risks: business risk, financial risk, liquidity risk, exchange-rate risk, and country-specific risk. Business risk refers to the uncertainty of a company's future cash flows, ...

What is financial risk?

Financial risk is the risk associated with a company's ability to manage the financing of its operations. Essentially, financial risk is the company's ability to pay its debt obligations. The more obligations a company has, the greater the financial risk and the more compensation is needed for investors. Companies that are financed ...

What is business risk?

Business risk is the risk associated with the uncertainty of a company's future cash flows, which are affected by the operations of the company and the environment in which it operates. It is the variation in cash flow from one period to another that causes greater uncertainty and leads to the need for a greater risk premium for investors.

What is liquidity risk?

Liquidity risk is the risk associated with the uncertainty of exiting an investment, both in terms of timeliness and cost. The ability to exit an investment quickly and with minimal cost greatly depends on the type of security being held.

What is exchange rate risk?

Exchange-rate risk is the risk associated with investments denominated in a currency other than the domestic currency of the investor. For example, an American holding an investment denominated in Canadian dollars is subject to exchange-rate, or foreign-exchange, risk. The greater the historical amount of variation between the two currencies, the greater the amount of compensation will be required by investors. Investments between currencies that are pegged to one another have little to no exchange-rate risk, while currencies that tend to fluctuate a lot require more compensation.

What is country specific risk?

Country-specific risk is the risk associated with the political and economic uncertainty of the foreign country in which an investment is made. These risks can include major policy changes, overthrown governments, economic collapses, and war. Countries such as the United States and Canada are seen as having very low country-specific risk because of their relatively stable nature. Other countries, such as Russia, are thought to pose a greater risk to investors. The higher the country-specific risk, the greater the risk premium investors will require.

Why do companies take on debt?

Companies take on debt to increase their financial leverage; using outside money to finance operations is attractive because of its low cost. The greater the financial leverage, the greater the chance that the company will be unable to pay off its debts, leading to financial harm for investors.

What is equity risk premium?

The term equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio.

How to calculate risk premium?

To calculate the equity risk premium, we can begin with the capital asset pricing model (CAPM), which is usually written as Ra = Rf + βa (Rm - Rf), where: 1 R a = expected return on investment in a or an equity investment of some kind 2 R f = risk-free rate of return 3 β a = beta of a 4 R m = expected return of the market

Is the stock market a risk?

Stocks are generally considered high-risk investments. Investing in the stock market comes with certain risks, but it also has the potential for big rewards. So, as a rule, investors are compensated with higher premiums when they invest in the stock market.

Who is Michael Boyle?

Michael Boyle is an experienced financial professional with more than 9 years working with financial planning, derivatives, equities, fixed income, project management, and analytics. Article Reviewed on October 23, 2020. Learn about our Financial Review Board.