Discussion and 1 reply

 

Respond to one of the following topic to present to your peers in a professional analysis using a minimum of 350 words.

 

 

• Describe the market risk premium and the risk free rate and analyze how these are determined and applied in financial calculations (e.g. CAPM).

 

Your critical response should have a minimum of two sources published in the last 12 months which should be used to support the content within the postings, proper in-text citations.  Your responses should be professionally written and correctly formatted references should be prepared consistent with the APA. The list of references should be physically positioned at the end of the postings.

Post by classmate

 

The market risk premium and the risk-free rate are crucial parts within financial calculations especially within models like Capital Asset Pricing Model. The market risk premium is the additional return that investors can expect to gain from having a risky market portfolio, compared to having assets that are risk-free (CFI Team, 2024). It represents the reward that investors essentially are looking for from taking on that extra risk within the market. This is usually determined by either a historical or forward-looking approach. The historical approach is the average of the difference between the returns of the market and the risk free rate over a long period of time. It can be seen as an educated estimate for what investors can expect for the near future. The forward-looking approach uses the current market prices, earnings forecasts, and dividends to estimate the expected returns on the market. The difference from the expected return and the current risk-free rate is the market risk premium.

The risk-free rate is the return on an investment with zero risk. This is the return an investor would expect to get from an investment that is totally risk-free over a period of time (Vipond, 2024). Although it is assumed that any investment has a certain degree of risk, but some have more risk than others. This is usually determined by government bonds and short & long-term rates. Government bonds are usually used as a risk-free rate over a long-term period. Short- & long-term rates have different maturities of government bonds depending on what they are being used for. For example, if it’s a ten year treasury bond rate, then it will most likely be used for long-term.

Both the market risk premium and the risk-free rate can vary with the current market conditions. If the economy is in an unsteady rate, like during the Covid-19 pandemic than investors might need a higher market risk premium. Investor’s feelings and economic indicators can heavily influence risk-free rate and the market risk premium as well. Some of these factors are unpredictable so it is better for the investor to be prepared than suffer any consequences in the future. Overall, it is important to understand and be able to have an accurate estimate for the market risk premium and the risk-free rate so that investors can better understand what to expect. This will help them make better informed decisions that fit with their financial goals they are trying to achieve.