Reading: Estimating the Cost of Capital
3. Market Risk Premium
The second ingredient is the market risk premium, \(MRP\).
This element is more difficult to estimate, as we cannot directly estimate the expected market risk premium. Remember from our discussion of the CAPM, that the market risk premium corresponds to the average future risk premium that the market portfolio is expected to earn over the risk-free rate of return.
Unfortunately, we cannot directly observe the market portfolio, let alone its expected risk:
- In theory, the market portfolio contains all risky assets in the economy, including stocks, bonds, real estate, art, precious metals, gemstones, etc.
- Many of these assets are not traded in a liquid market. Therefore, we often lack reliable historical price information that would allow us to compute past returns, which we could then use as a starting point to forecast future expected returns.
- In reality, academics and professionals therefore use proxies for the market portfolio. Most commonly, we approximate the market portfolio with a broad stock market index (e.g., the S&P 500 or the MSCI World Index) and then measure the risk premium as the difference between the required return on equities and the risk-free rate. The result is the so-called equity risk premium.
- Consequently, the resulting risk premium is a noisy proxy of the market risk premium. We should always keep this in mind when estimating discount rates.
For practical purposes, it can be useful to rely on one of the many online sources that provide estimates of market risk premia around the world. Loosely speaking, these sources can be grouped into model-based estimates and survey-based estimates. A short selection of providers is listed below.
Model-based estimates of market risk premia:
Survey-based estimates of market risk premia:
In particular, the latter survey by Fernandez covers a large number of participants from different countries. According to the survey results, the typical (median) market risk premium used in countries with mature industries and relatively low inflation rates such as the U.S., Germany, the U.K., and Switzerland is 5.0%:
