What does the market risk premium represent?

The market risk premium represents the additional return that investors expect to receive from a risky investment over the risk-free rate. This concept is fundamental to understanding risk and return in finance; it reflects the compensation that investors demand for taking on the uncertainty associated with riskier assets, such as stocks, compared to safer investments like government bonds. It quantifies the relationship between risk and expected return, illustrating why investors are willing to accept potential losses in exchange for the possibility of higher returns in the market.

Understanding the market risk premium is crucial for portfolio management and asset pricing models, such as the Capital Asset Pricing Model (CAPM), which uses the risk premium to determine expected returns based on the risk level of an asset in relation to the overall market. The market risk premium serves as a key indicator of market sentiment regarding risk and investment opportunities.