[Anonymous]

Hi everyone, I had a question regarding terminology involved in the CAPM equation. If given the term “Market Risk” would you assume it meant Market Rate or Market Risk Premium or something else? I saw a question somewhere where it gave a a value for “Market Risk” and I solved the equation for cost of retained earnings defining it each way, and both were answer choices. Am I overthinking? Is Market Risk the same thing as Market Risk Premium? I have never heard it referred to that way. Please help clarify

kre= rfr + beta*(market rate – risk free premium)

or, alternatively

kre = rfr + beta*(Market Risk Premium)

kre = cost of retained earnings

rfr – risk free rate

km = market rate

PMR = market risk premium = (market rate- risk free rate)

[Minimorty]

Market Risk = Market Rate

It is just the average rate of return for the entire market between two points in time.

Market Risk Premium = Market Rate – Risk Free Rate

When you hear the word “premium” you have to think to yourself “premium to what?” in this instance, it's the additional rate of return the market gives you in excess of the risk free rate.

[Anonymous]

This is confusing…i thought i was sold on it being market risk premium bc I think of the market rate being the rate at which the market is charging not necessarily the risk, only when you subtract out the risk-free rate can you measure risk. I see your point too though.. :/

[Minimorty]

What do you mean “the rate at which the market is charging”? We are talking about equity, not debt. So the cost of equity is the return that an investor demands. The “premium” is the amount the investor requires in excess of the risk free rate.

[Anonymous]

Sorry “charging” wasn't the word I should have used, I should have said “I think of Market Rate as the return on the market but that doesn't measure risk until you subtract out the risk free rate.” I can't remember where I saw the question and I have been searching through my materials but have had no luck. In any case, my previous google searches were “Market Risk vs. Market Rate” or “Market Risk Premium vs. Market Rate.”

However, when I look up “Market Risk”…it is defined as beta!?

“Market risk is measured by beta, which is another measure of investment risk that is based on the volatility of returns. In contrast to standard deviation, beta measures volatility relative to a relevant baseline rather than to the mean of the asset that is being evaluated. Beta is the appropriate measure of an asset's contribution to your portfolio's risk, as it measures only systematic risk, i.e., market risk.”

I thought the problem had given a value for Market Risk, a separate value for beta, and a risk free rate….and all we were supposed to do was solve for cost of retained earnings…but maybe I was mistaken? I'm so confused as to whether I am just reading way too much into it. I take my exam tomorrow so perhaps I am psyching myself out.

Please comment if you have any insight!

[Author]

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