Risk Premium Calculator
Estimate the additional return (risk premium) investors demand for taking on higher risk compared to a risk-free investment. Calculates Market Risk Premium (MRP) and Equity Risk Premium (ERP) for individual stocks.
Input Parameters
Understanding Risk Premiums
What is Risk Premium?
Risk premium is the additional return an investor expects for taking on higher risk compared to a risk-free investment (like government bonds). It compensates for uncertainty and potential losses.
Key Formulas
- Market Risk Premium (MRP):
MRP = Expected Market Return - Risk-Free Rate - Equity Risk Premium (ERP) for a Stock:
ERP = β × (Expected Market Return - Risk-Free Rate)
Where β (beta) measures the stock's volatility relative to the market.
How to Interpret Results
- MRP = 5%: The market is expected to return 5% more than risk-free investments.
- ERP = 6% (β=1.2): This stock should return 6% more than risk-free investments due to its higher risk (β > 1).
- Negative ERP (β < 0): Rare cases where stock moves inversely to the market.
Example Calculation
Given: Risk-Free Rate = 3%, Market Return = 8%, β = 1.5
MRP: 8% - 3% = 5%
ERP: 1.5 × 5% = 7.5%
This stock should return ~7.5% above the risk-free rate to compensate for its risk.
Practical Examples
Example 1: Basic Market Risk Premium
Scenario: Calculate MRP using historical U.S. data.
Inputs: Risk-Free Rate = 3%, Expected Market Return = 8%
Calculation: MRP = 8% - 3% = 5%
Interpretation: Investors demand 5% extra return for investing in stocks vs. Treasury bonds.
Example 2: Tech Stock with High Beta
Scenario: A tech stock with β=1.8 during low-rate environment.
Inputs: Risk-Free Rate = 1.5%, Market Return = 7%, β = 1.8
MRP: 7% - 1.5% = 5.5%
ERP: 1.8 × 5.5% = 9.9%
Conclusion: This volatile stock should return ~9.9% above risk-free rate.
Example 3: Defensive Stock (Low Beta)
Scenario: A utility stock with β=0.6 during market uncertainty.
Inputs: Risk-Free Rate = 4%, Market Return = 6%, β = 0.6
MRP: 6% - 4% = 2%
ERP: 0.6 × 2% = 1.2%
Conclusion: This stable stock needs only 1.2% premium over risk-free rate.
Example 4: International Market
Scenario: Emerging markets with higher risk.
Inputs: Risk-Free Rate = 5% (local bonds), Expected Market Return = 12%, β = 1.3
MRP: 12% - 5% = 7%
ERP: 1.3 × 7% = 9.1%
Note: Higher MRP reflects country risk premiums.
Example 5: Negative Beta Stock
Scenario: A gold stock with β=-0.2 (moves inversely to market).
Inputs: Risk-Free Rate = 2%, Market Return = 5%, β = -0.2
MRP: 5% - 2% = 3%
ERP: -0.2 × 3% = -0.6%
Interpretation: Negative ERP suggests this stock may act as a hedge.
Example 6: Recession Period
Scenario: High risk-free rate during inflation.
Inputs: Risk-Free Rate = 6%, Market Return = 9%, β = 1.1
MRP: 9% - 6% = 3%
ERP: 1.1 × 3% = 3.3%
Note: Lower MRP suggests compressed risk premiums.
Example 7: Growth vs Value Stocks
Scenario: Compare high-beta growth stock (β=1.4) vs low-beta value stock (β=0.8).
Inputs: Risk-Free Rate = 2.5%, Market Return = 7%
MRP: 7% - 2.5% = 4.5%
Growth ERP: 1.4 × 4.5% = 6.3%
Value ERP: 0.8 × 4.5% = 3.6%
Conclusion: Growth stocks demand higher premium for volatility.
Example 8: Sector-Specific Beta
Scenario: Airline stock (β=1.7) during economic recovery.
Inputs: Risk-Free Rate = 1%, Market Return = 10%, β = 1.7
MRP: 10% - 1% = 9%
ERP: 1.7 × 9% = 15.3%
Note: Cyclical industries often have high betas.
Example 9: Dividend Stock Analysis
Scenario: Stable dividend stock with β=0.9.
Inputs: Risk-Free Rate = 3%, Market Return = 6.5%, β = 0.9
MRP: 6.5% - 3% = 3.5%
ERP: 0.9 × 3.5% = 3.15%
Use Case: Helps assess if dividend yield compensates for risk.
Example 10: Comparing Two Stocks
Scenario: Stock A (β=1.2) vs Stock B (β=0.7).
Inputs: Risk-Free Rate = 2%, Market Return = 8%
MRP: 8% - 2% = 6%
Stock A ERP: 1.2 × 6% = 7.2%
Stock B ERP: 0.7 × 6% = 4.2%
Analysis: Stock A should theoretically offer 3% higher return.
Frequently Asked Questions
1. What is the difference between MRP and ERP?
Market Risk Premium (MRP) is the excess return expected from the overall market over the risk-free rate. Equity Risk Premium (ERP) is stock-specific, adjusted by its beta (β).
2. Where do I find the risk-free rate?
Use the yield on long-term government bonds (e.g., 10-year U.S. Treasury). For non-U.S. markets, use local sovereign bond yields.
3. How do I estimate expected market return?
Use historical averages (e.g., ~8% for S&P 500) or analyst forecasts. Adjust for current economic conditions if needed.
4. What if my stock has a beta less than 1?
A β < 1 means the stock is less volatile than the market. Its ERP will be lower than the MRP (e.g., β=0.8 → ERP = 0.8 × MRP).
5. Can ERP be negative?
Yes, if β is negative (rare). This implies the stock moves inversely to the market (e.g., some gold stocks).
6. Why is MRP important?
MRP is a key input in valuation models like CAPM and WACC. It reflects the opportunity cost of investing in risky assets.
7. How often should I update these inputs?
Risk-free rates change daily. Beta and market return estimates should be reviewed quarterly or when market conditions shift significantly.
8. What are typical MRP values?
Historically, MRP ranges between 3-6% in developed markets. Emerging markets may have higher premiums (5-10%).
9. Where can I find a stock's beta?
Financial websites like Yahoo Finance, Bloomberg, or your brokerage platform provide beta values.
10. Does high ERP always mean better returns?
Not necessarily. High ERP indicates higher expected returns to compensate for risk, but actual returns may differ.
