The risk premium of investment is the average return on that investment minus the risk free rate. The US treasury bill (T-bill) is generally used as the risk free rate for calculations in the US, however the theory is that the risk free rate is any investment that involves no risk. Risk premium is the return on an investment that is expected on top of the risk free rate. It’s a concept that states that investors expect to be properly compensated for the amount of risk they take in the form of a risk premium, or additional returns above the rate of return on a risk-free investment .
The risk premium of the market is the average return on the market minus the risk free rate. The return of the market can be the total market return or the S&P 500 or the Dow return for the measured period.
Market Risk Premium = Expected Rate of Return – Risk Free Rate