How is the market risk premium (MRP) calculated?

The market risk premium (MRP) is a critical concept in finance, representing the additional return that investors expect to earn from holding a market portfolio compared to a risk-free asset. The formula for calculating the MRP is determined as the expected return on the market (E(Rm)) minus the risk-free rate (Rf).

This calculation essentially captures the reward for taking on the additional risk associated with investing in the overall market rather than in a risk-free asset, such as government bonds. If the expected return on the market is higher than the risk-free rate, the MRP will be positive, indicating that investors expect to be compensated for the risk of equity investment. This difference helps investors assess whether the potential returns justify the added risk they are taking on.

In other choices, the addition of E(Rm) and Rf or combinations that might suggest subtraction in inverse scenario do not correctly reflect this relationship, which is simply about determining how much more return one can expect from the market as opposed to a safe investment. Thus, B is the accurate representation of how to compute the market risk premium.