ACCA Financial Management (F9) Certification Practice Exam

What defines the market risk premium?

1. Expected return minus risk-free rate

2. Beta of a security

3. Average cost of capital

4. Difference between market returns

The correct answer is: Expected return minus risk-free rate

The market risk premium is defined as the expected return of the market over the risk-free rate. It serves as a measure of the additional return that investors anticipate earning for taking on the risk associated with investing in the market as a whole, compared to a risk-free investment such as government bonds. To break it down further, the expected return reflects the overall anticipated gains from investing in the market, while the risk-free rate is the return expected from a completely safe investment. By subtracting the risk-free rate from the expected market return, you obtain the market risk premium. This concept is vital because it helps investors assess whether the potential reward of an investment is worth the inherent risks. The other options do not accurately define the market risk premium. The beta of a security relates to the sensitivity of that security's returns to market returns but does not quantify the market risk premium itself. The average cost of capital refers to the overall cost of financing a company's operations, incorporating debt and equity without specifically addressing the risk premium. The difference between market returns isn't a precise definition and lacks the context of comparing it specifically to the risk-free rate.