Question

Suppose the CAPM holds. You know that the average investor has a degree of risk aversion of 2.9. The current risk free rate is 0.017, the inflation is estimated at 0.027, and the volatility of the market is 0.162. What is the market risk premium?

Answer 1

To Calculate Market Risk Premium we can consider below method; -

Market Risk Premium = Expected Rate of Return – Risk-Free Rate

Firstly we need to identify Expected Rate of Return, in question we have standard deviation (Nothing but Total Risk) and we have beta (Market risk). If beta is 1 means if market moves 1% stock also moves 1%. If beta is less than 1 means if market moves 1% stock moves less than one percentage.

Here in question Beta is 0.162 that means this stock is less risky.

And standard deviation provided is 2.9

We can use below formula to identify Expected rate of return:

Expected rate of return: = Risk Free rate of Return +

+ ( Market Risk Premium * Beta of stock )

= 1.7% + (2.9*.0.162)

=1.7% + 0.4698

=2.1698

When you consider inflation of 2.7%, risk free rate will be 1.75%. Then calculation will be like below.

Same formula:

=1.75%+ (2.9*0.162)

=1.75%+.4698

=2.2198

Then Market risk premium will Be:-

Using the first formula: Expected Rate of Return – Risk-Free Rate

=2.2198 - 1.75

=0.4698