Question

Explain in 200 words or less: What are reasonable guesstimates for the market risk premium and why?

Answer 1

Market risk premium is the difference between the expected return on a market portfolio and the risk free rate. The risk free rate can easily be obtained from the rate offered by the current Treasury bill (T-bill) or the long term government bond yield. Reasonable guesstimates for the market risk premium can be obtained from slope of the security market line (SML). SML is nothing but a graphical representation of the CAPM model – capital asset pricing model.

Reasonable guesstimates for the market risk premium can be obtained by determining the relationship between returns from an equity market portfolio and the Treasury bond yields. The guesstimates can be obtained on a reasonable basis by considering the required returns, historical returns and expected returns.

The expected future returns from world equities are 4.5% to 5.5%. Returns from the minimal risk asset is predicted at 0.50% and so market risk premium will be in the range 4.5%-0.5% to 5.5% to 0.5% = 4% to 5%.

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