Market Premium

Market risk is the day-to-day potential for an investor to experience losses from fluctuations in securities prices. It is the portion of an asset's risk that cannot be diversified away. The volatility in a stock measures how much market risk it faces.



Market risk premium is the excess return that an individual stock or the stock market provides over a risk-free rate. This excess return is considered as a compensation to the investors for taking on the comparatively higher risk of the equity market. The premium vary from stock to stock, higher the risk, higher would be the premium.

The premium factor is determined by the risk-return tradeoff, depending on the type of investing approach an investor has. The higher safer approach offers you lower returns.

Valuation Theories and Market Risk Premiums
The various stock valuation methods are used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis is one of them, which is used for projecting the future free cash flow and then discounting them (considering the market risk premium rate) to arrive at a net present value. This present value depicts the potential of an investment, if this value is higher than the current cost of the investment, then you should go for this investment/stock.

Here is an example of present value of future cash flows: Suppose, the current rate of inflation is 6%, which means the value of your money would halve in every ~12 years. If you are expecting an asset to give you an income of $30 a year in 12 years time, than the income flow should be worth $15 today, in light of inflation at 6% for the period. So, the discounted value of the future cash flow of $30 is $15 to you at present.

An important component in DCF is the risk-free rate, which is directly related to the key interest rates. Key interest rates are the baseline for risk-free rates.

Relationship between the two is as follows:
- An increase in the key interest rate leads to a rise in the risk-free rate, which ultimately, decreases the market risk premium.
- A decrease in the key interest rate leads to a fall in the risk-free rate, which, ultimately, increases the market risk premium.

To determine the present value, we need to determine the appropriate discount rate with the help of CAPM (Capital Asset Pricing Model). CAPM identify a risk-free-rate for money and also identify a market risk premium.

In CAPM, discount rate considers three things:
1. A risk-free-rate for money (typically, Govt.' T-Bills)
2. The time value of money, as the investors are paying today for anticipated cash flow in future years. For this wait, investors must be compensated.
3. The market risk premium that reflects the extra return investors demand because they want to be compensated for the risk they have taken in case the cash flow do not materialize. Also, examine the debt to equity ratio of the company, higher the ratio, the greater will be the risk associated with the return on equity and the higher will be the discount rate used to value that return.