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Market Risk Premium | Formula | Calculation | Examples - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
of WallStreetmojo trends today we are
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going to learn a concept that is market
risk premium now where does this thing
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exactly
come see when we when we evaluate your
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weighted average cost of capital we
need to evaluate in that that is
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something called cost of equity and
while calculating the cost of equity we
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need something that is called risk
premium right and of that we need market
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risk premium basically so let's try and
evaluate the whole formula and we'll get
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to know what exactly we are trying to
find risk-free rate is the first
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component of the cost of equity as for
the CAPM model that is capital asset
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pricing model risk-free rate is the
basically the return order which you get
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on the Treasury bonds or Treasury bills
or the government bonds and it should be
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in currency in cash flow beta is
basically your sensitivity of the stock
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with that of the market and the degree
to which a company's equity return very
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with the return of the overall market so
beta is basically a you can say
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measure of systemic risk and is a
function of both business as well as the
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financial risk risk premium is basically
the difference between the or risk from
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the market and your is free rate break
because here we are trying to talk
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something that is a what exactly will
the investor get something more than the
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risk-free rate for taking the additional
amount of the risk which is your risk
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premium so let's start and evaluating
how this market risk premium will go
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market risk premium is basically the
additional rate of return over and above
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the RF rate which the investor expects
then they hold on the risk investments
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so this concept is based on the CAPM
model that is capital asset pricing
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model which quantifies the relationship
between the risk and the required return
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in the well-functioning market CAPM
model which is a capital asset pricing
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model is is equal to the risk-free rate
that is your RF plus beta into you have
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get rid of return that is RM less your
RF will give you your cost of equity as
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for the CAPM and formula here basically
the market risk premium market risk
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premium formula is as simple as that
market rate of return that is your RMO
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over here and risk-free rate is your RF
so this whole thing is your market risk
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premium so let's start
what exactly is market risk premium see
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the difference between the expected rate
of return that is your e are from the
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hope from holding an investment and the
risk-free rate that is your RF is called
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as your market risk MRP right now to
understand first we need to go back and
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look at simple concepts we all know
basically that created amount of risk
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will lead to greater return and greater
losses right so why it wouldn't be true
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for investors who have taken a mental
leap from being savers to investors when
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an individual saves the amount in
Treasury bonds so he expects a minimum
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return which as we know as RF he
doesn't want to take more risks so he
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receives the minimum rate but what if
one is ready to invest in a stock
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and only expect more return at least he
would expect more than what he would get
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by investing his money in Treasury bonds
absolutely yes see market risk premium
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formula we know it now very well right
now let's take each of the component of
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the market risk premium formula and try
and analyze them first let's think about
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the expected return that is E are right
now this expected return is totally
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dependent on half investor things and
what is the type of the investments he
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invests in see there are following
options we can consider from the point
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of view of the investor the first type
of investor which is known as these risk
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tolerant investors now when we talk
about risk tolerant investors if the
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investors are players of the market and
understands the ups and the downs and
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are okay with whatever risk they need to
go through then we will call them risk
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tolerant investors see risk tolerant
investors won't expect much from the
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investments and thus the premiums would
be much lesser than the risk-averse
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investors the next thing that we have
lined up is the risk averse investors
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right when we talk about this type of
investor the investors are usually new
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investors we are talking about over here
and they have not invested much in the
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risk investments they have saved over
the money in the fixed deposits or the
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savings in the bank accounts and after
thinking over the prospects of the
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investments they start investing in
stocks and those they expect much more
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return than the risk tolerant investors
so the premium is higher in case of the
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yeah absolutely the premium is really
high in case of the risk-averse
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investors so now the premium also
depends on the type of the investments
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the investors are ready to invest in so
if the investments are too risky
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naturally the expected return would be
much more than the less risky investment
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and thus the premium would also be more
than the less risky investments there
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are also two other aspects that we need
to consider while calculating the
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premium first is the required market
risk premium now this is basically the
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difference between the minimum rate the
investors may expect from any sort of
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investment right and less the risk-free
rate
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right and the second is your historical
market risk premium MRP so this is the
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basically the difference between the
historical market of a particular
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markets over here I'll take I will give
an example like NYSE that is the New
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York Stock Exchange and the de risk-free
rate let's interpret the market risk
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premium market risk premium model is is
an expectancy model because both of the
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component in it expected rate of return
over here we are talking about and the
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risk-free rate are subject to change and
are dependent on volatile market forces
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second to understand it well you need to
have a basis of computing I mean the
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basis you choose should be relevant
aligned with the investments that you
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have done see in normal situation you
all you need to do is to go for the
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historical averages okay to use as the
basis if you invest in NYSE and you want
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to calculate the marketers premium all
you need to do is to find out the past
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records of the stock and you have to
decide to invest in and then find the
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averages then you would get a figure
that could Bank upon here one thing you
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need to remember is that taking
historical figures as the basis you are
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actually assuming that the future would
be exactly like the past which may turn
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out to be floored absolutely so what
would be the right thing or what would
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be the right market risk premium
calculation which would not be flawed
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and would be aligned with the current
market risk condition we need to look
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for the real market premium
that's the catch over you right and here
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the real market risk premium is
basically your red real market MRP our
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MRP is basically one plus your nominal
rate and are divided by one plus your
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inflation rate got it so this is going
to be your formula now in the example
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section we'll understand you know
everything in detail now let's take an
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example let's see that you know there
are two kind of investment investment
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number one and two over here the
expected return er let's say is 10 and
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over here 11 for investor number two and
we have risk-free rate as 4 and 4
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so your market risk premium in this
example we have two investment and we
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have also been paired with the
information for expected return and
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risk-free rate so of this we can find
the premium that is P it will be as
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simple as that
10 - 4 and press ctrl R we'll have 6
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and 7 so now in most of the cases we
need to be pays over assumptions for
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expected return on historical figures
and that means whatever the investment
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expects as a return that would be
decided the or decide the rate of
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premium okay
so let's finally understand the
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limitation of the market risk premium
concept this concept is expectancy model
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that does it can cannot be accurate most
of the time but recorded risk premium is
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much better concept than this if you are
thinking of investing into stocks there
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are many approaches from which we can
calculate this but as of now let's look
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at the limitation of the concept first
this is not the accurate it's not the
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accurate model you can say for
computation depends on the investor that
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means too many variables and too little
basis of a proper computation second
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when market risk premium calculation is
done taking into account the historical
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figures you can say it's assumed that
the future would be similar as the past
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but in most cases that may not be true
third it doesn't take into account the
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inflation rate this is really important
does the real risk premium is much
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better concept than the market premium
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