Final answer:
The market risk premium is the excess return investors expect for bearing the risk of the stock market over a risk-free asset. It is a crucial concept in financial investment, where investors account for risk when calculating expected returns. An example is an investor demanding a 15% return, accounting for the risk premium above the risk-free rate.
Step-by-step explanation:
The market risk premium is defined as the difference between the expected rate of return on a market portfolio and the risk-free rate. It represents the additional return investors expect for taking on the higher risk of investing in the stock market compared to risk-free assets. A financial investor takes into consideration both the opportunity cost of capital and the risk premium when choosing an appropriate interest rate to evaluate future payments. For example, if an investor requires a 15% interest rate due to the perceived risks associated with an investment, this rate includes both the expected return on alternate investments and the additional compensation for risk, which is the risk premium. Thus, if the risk-free rate is 5%, and the investor expects to earn 15% from a particular stock, the market risk premium would be 15% - 5% = 10%.