Market Risk Premium 101

Introduction

When comes to the investment, we might measure the performance of the investment by its nominal return. For example, if the stock you bought in year 1 yields a return 12%, then probably you think this stock is good one to own. On the other hand, if it simply yields a return about 7% in year 2, then you might feel not so good compared to 12% return. However, if further information is revealed that in year 1 the 10-year US treasury bond could give you 8% and in year 2 the 10-year US treasury bond has only 1%, do you still think 12% is better than 7%?
 

High Risk, High Reward

When making the decision in terms of what financial instrument to invest, we are trying to put the money in the one that can give us the best return on investment per risk we take. The main reason why people invest their money in the stock market rather than in the US Treasury bond is because historically it gives us higher return on investment. The reason why we expect to get higher return on investment from stock is because of the fluctuation of the stock price that we might end up losing the principle. With the additional risk we take, extra return is needed to justify investment. It is obvious that if we can get the same return on investment as stock market by investing the money into the US Treasury bond, no one would invest any money into the stock market.
 

Market Risk Premium, the excess return above the risk-free rate

Because of this reason, we are more interested in knowing what’s the excess return above the risk-free rate rather than the nominal return. Take the hypothetical example we mentioned at the beginning, in year 1, the excess return above the risk-free rate would be 12% - 8% = 4%. However, in year 2, the excess return above the risk-free rate would be 7% - 1% = 6%. Actually the stock market performs better in year 2 than in year 1!
 

Estimate the Market Risk Premium

The formula to estimate the market risk premium is simple:
Market Risk Premium = market total return – risk free rate, while market return would be:
(Market Price End – Market Price Beginning + Total Dividend Received) / (Market Price Beginning)
 

Use the Free Data to Calculate the Market Risk Premium Yourself

It would be nice if we can calculate the market risk premium ourselves to get a feel how much excess return do we get in average. Luckily, there are many free data on the internet that we can utilize. Below would be the steps you can follow:^
1. Get SPY ETF historical data: Typically we use S&P 500 index to represent the market. However, it doesn’t have dividend information, so we use SPY, which is the ETF of S&P 500 index to calculate the total market return. You can simply go to Yahoo Finance website to get the data or simply use Stock Historical Data Download to download it for you. Download both monthly quotes and dividend from 1993 to 2012
2. Get ^TNX historical data from Yahoo Finance: the ^TNX historical prices represent the 10-year US Treasury yield. We can use it to represent our risk-free interest rate
3. After putting those data together, we can summarize the result as following:

Year	SPY Begin Price	SPY End Price	Dividend	Total SPY Return	10-Year US Treasury	MRP
1993	31.29	35.24	1.183	16.40%	6.39%	10.01%
1994	35.24	35.51	1.462	4.91%	5.64%	-0.73%
1995	35.51	49.1	1.243	41.77%	7.59%	34.18%
1996	49.1	61.33	0.972	26.89%	5.58%	21.31%
1997	61.33	78.09	1.375	29.57%	6.50%	23.07%
1998	78.09	102.7	1.392	33.30%	5.51%	27.79%
1999	102.7	113.45	1.414	11.84%	4.65%	7.19%
2000	113.45	112.52	1.454	0.46%	6.67%	-6.21%
2001	112.52	93.81	1.032	-15.71%	5.18%	-20.89%
2002	93.81	72.46	1.498	-21.16%	5.03%	-26.19%
2003	72.46	97.11	1.63	36.27%	3.97%	32.30%
2004	97.11	103.05	2.197	8.38%	4.14%	4.24%
2005	103.05	113.15	2.149	11.89%	4.13%	7.76%
2006	113.15	129.93	2.446	16.99%	4.53%	12.46%
2007	129.93	126.46	2.701	-0.59%	4.83%	-5.42%
2008	126.46	78.09	2.721	-36.10%	3.64%	-39.74%
2009	78.09	103.58	2.177	35.43%	2.84%	32.59%
2010	103.58	126.04	1.786	23.41%	3.61%	19.80%
2011	126.04	128.02	2.576	3.61%	3.38%	0.23%
Average						7.04%

From year 1993 to 2011, the market risk premium in average is 7.04%. That means if we invest our money into the stock market during this period instead of 10-year US Treasury bond, the excess return we expect to get is 7.04% annually. However, if we look at the plot, the market risk premium is quite different each year.
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