Market Risk Premium(MRP) - Essay Example

Market Premium Companies need capital to survive and grow. However capital comes at a cost and investors put up their money only when they see a prospect of both development in share value and stable returns. The market has to offer a tool to evaluate this vis-à-vis the risk involved and this is performed by calculating the Market Premium on the valuation of shares, stocks and debt securities.There are several ways of calculating Market Risk Premium(MRP) but usually the range is between 5-7%.

Normally the US market, and markets in developed countries with similar conditions, is considered the benchmark for MRP calculation but conditions will differ in emerging markets due to the existence of other risk factors like political uncertainty and economic policy shifts. These add to risks and MRP will be higher.The use of MRP helps in determining the cost of funds and will affect the valuations of both equity and debt instruments.It is usual for financial managers and Boards of Directors to be more conservative so that they do not err in costs therefore when they arrive at a hurdle rate, the rate at which investors will start becoming reluctant to invest in their company, and fix a price band that is slightly higher.

Through this they seek to manage costs more prudently to avoid shocks to themselves, but at the same time they cause the investors to shy away from them and loose funding. This is more prevalent in developed markets but in contrast in the emerging markets, due to hidden and accruable values, the investors, both local and overseas are bolder hence the incremental values are higher carrying more MRP. Despite higher taxes, higher volatility and consequently higher MRP on equity this is preferred over debt as the returns are likely to be better.

Another factor for this preference is that unless there is and event like 9/11 or the Enron crisis, historically the socks have always outperformed the debt or bonds. Since the market favours equity, it becomes important to calculate MRP on daily, indeed even several times daily, to present both clear and emerging pictures for the investing public to act upon. On the other hand this also assists the financial managers to plan their fund raising exercises. MRP is also valuable as it offers insights into past movement and likely future scenario except for events that happen to change it abruptly.

At the same time such subtle changes might also shed light on some expected movements that can affect future calculations. Those who are against MRP forward the argument that MRP movement cause reactions that might be sharp in some cases as they cause a cascading affect. This can sometimes be detrimental and erode confidence and capital.The pros and cons apart, the need for MRP is substantiated by the fact that this is based on many variables that come to notice of analysts who attempt to read the possible future of an organisation’s performance and calculate its wellbeing based on these facts.