More risk → More return!

Risk premium is the additional return, above the risk-free rate, resulting from bearing risk.

  • Also called “excess return”, as it is in excess of the risk-free rate
  • Difference between risky investment return and the risk-free rate
    • T-bills are used as benchmark for risk free asset
      • Simple average return of U.S. common stocks in excess of the T-bill rate during 1928-2010 was 11.31% − 3.70% = 7.61%
      • Simple average return of T bonds in excess of the T-bill rate during 1928-2010 was 5.28% − 3.70% = 1.58%

Risk premium for diversifiable risk zero – investors are not compensated for holding unsystematic risk, since this can be eliminated “for free” by diversifying your portfolio.

  • If the diversifiable risk of stocks were compensated with an additional risk premium, then investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk.
  • By doing so, investors could earn an additional premium without taking on additional risk. This arbitrage opportunity would quickly be exploited.
  • Because investors can eliminate firm-specific risk “for free” by diversifying their portfolios, they will not require or earn a reward or risk premium for holding it.
  • This implies that a stock’s volatility, which is a measure of total risk (that is, systematic risk plus diversifiable risk), is not appropriate for determining the risk premium that investors will earn.
  • There should be no clear relationship between volatility (measured by variance or standard deviation) and average returns for individual securities. Consequently, we need to find a measure of a security’s systematic risk to estimate its expected return.
  • Risk premium of a stock depends on its systematic risk.