Market Risk Premium: Compensation for Equity Market Exposure

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The market risk premium reflects the difference between equity market returns and the returns which can be made from a risk-free investment. Alpha strategies, including risk premia, aim to beat the market risk premium, sometimes using leverage and derivatives to maximise the outperformance.

Also known as the equity risk premium, this financial indicator shows by how much equity markets outperform (or underperform) treasury bonds. Since investing in equities is inherently more risky than allocating capital to bonds, the market risk premium is usually positive as investors demand a premium, or better returns, for taking on more risk. Equities carry a far greater number of uncertainties than bonds, which yield steady interest payments and return a known principal value.

The term market risk premium can refer to: the historical market risk premium based on returns which have already materialised; the more subjective expected market risk premium, based on return projections; and also the premium required by an investor to allocate capital to equities over bonds.

The equity risk premium in the US, for instance, is measured by subtracting from equity market returns the return of government-issued bonds – usually 90-day treasury bills or 10-year treasury bonds. And many investors consider the US equity risk premium to be useful in other developed economies too, since risk premiums become similar to one another in open markets.

Equity market returns can represented by benchmark indices like the S&P 500, while the risk-free rate is often represented by the best returns currently offered by government bonds.

Some investors may favour a tilt towards broad market exposure (or generating returns from the equity risk premium) by tracking benchmarks like the S&P 500 Index, while others target market-beating returns through alternative factor-basedproprietary indices, often in the form of long-only smart beta strategies.

In order to smooth returns, many smart beta and risk premia strategies can employ an alpha overlay strategy to smooth volatility risk and improve risk-adjusted returns.

The rising equity risk premium

According to the Federal Reserve Bank of New York, the equity risk premium reached abnormally high levels in 2012 and 2013 of about 12%, due to extremely low bond yields. Central banks can use the market risk premium to analyse the state of the economy and general financial stability.

According to some sources, the equity risk premium ranges between 3.5% and 5.5% over the long term, while this has been slightly higher in the wake of the 2007-2008 global economic crisis, partly due to interventions by major central banks and artificially depressed interest rates. This upward shift in the equity risk premium affects investment decisions since the equity risk premium is used to estimate the cost of capital, among other applications.

But the equity risk premium has experienced other periods of material shifts, with one early notable period being the post-World War era where the risk premium rose thanks to greater confidence and appetite for risk.

A more recent period of note was the higher-than-usual equity risk premium experienced after the tech bubble of the late 1990s.

Important to note is that the equity risk premium varies based on how return differences are calculated and on the risk-free rate applied, among other factors.

Also, the subjective forward-looking market risk premium differs from one investor and one methodology to another.

While bond yields are easy to predict, since the expected return on a bond held until it matures is congruent with its current yield, predicting future equity market returns is more difficult. There are a number of different models which investors use to predict equity market returns, meaning market risk premiums differ. Investors can predict expected returns using the dividend discount model and market implied pricing models and supply models, among other methods.

Since the market risk premium is represented by a benchmark such as the S&P 500 Index, it also acts as a yardstick for the performance of individual assets, portfolios and strategies. The volatility of a fund, as measured by beta, is compared to major benchmarks. A beta of 1 indicates that an asset moves in toe with the benchmark. A beta level of less than 1 means the asset is less volatile than the equity market, while a value of more than 1 means its rises and falls will be more exaggerated than the market.

This information helps investors make informed investment decisions based on individual risk profiles and return expectations.

Long-short risk premia strategies, meanwhile, do not measure their performance relative to benchmarks but rather target absolute returns. Unlike smart beta funds, risk premia can make use of short selling, leverage and derivaties in order to boost returns and mitigate against risks.

While the market risk premium represents excess returns on a macro level, an individual stock, fund or strategy also carries a risk premium. capital asset pricing model, the expected return of an investment is the sum of the risk-free rate of return plus this risk premium.