Market Risk Premium (MRP)

The market risk premium is the additional return investors expect to earn from holding a diversified market portfolio instead of a risk-free asset. It compensates investors for taking on systematic (non-diversifiable) risk.

Formula:

$$\text{MRP}=E(R_m)-R_f$$

Where:

• $E(R_m)$ = Expected return of the market portfolio
• $R_f$ = Risk-free rate

Estimation: Commonly estimated using historical averages of market returns minus Risk-Free Rates.

Used in CAPM to determine the required return on an asset:

$$E(R_i)=R_f+{\beta }_i(\text{MRP})$$