Risk and Return
Risk, Risk Aversion, and Risk Premium
Historical Risk Premium
• Historical risk premium
= historical average rate of return
– historical riskless interest rate
• Average Return formula:
t
R t
RA t 1
t
Historical Risk Premium - example
• Suppose average rate of return on Stock A = 5%; on Stock B = 10% and risk-
free interest rate = 4%.
• Calculate historical risk premium’s.
• A: 5% - 4% = 1%
• B: 10% - 4% = 6%
• Note: the greater the risk the greater the required risk premium.
Stable Relationship between Risk and Return
Figure 1-1–(Blackwell, Griffiths & Winters)
Asset Class Average Risk Standard
Return Premium Deviation
U.S. Treasury Bills 3.8% na 3.2%
Long-term Government 5.8% 2.0% 9.4%
Bonds
Long-term Corporate 6.2% 2.4% 8.7%
Bonds
Large-Company Stocks 12.2% 8.4% 20.5%
Small-Company Stocks 16.9% 13.1% 33.1%
The Case of Certainty
• If future value of investment(s) is certain we expect:
• the same rate of return on all assets.
• zero risk premium (as no risk).
Investors would sell the asset with the lowest rate of return and switch their
investment to the asset with the highest rate of return
The Case of Certainty
• Assets with certain return:
• US & UK short-term Treasury Bills
• Referred to as riskless interest rate
• SSIA
The Case of Uncertainty
• When the future is uncertain:
• The higher the volatility the higher expected return.
Investing with Uncertainty
Which Investment to Choose?
Return Outcome Probability
Investment A Investment B Investment C
5.00% 25.00% 50.00% 25.00%
20.00% 50.00% 0.00% 25.00%
35.00% 25.00% 50.00% 50.00%
Expected
Return
Which Investment to Choose?
Expected return = the probability multiplied
by the return summed over all possible
outcome.
3
E r pi ri
i 1
Expected return rule alone does not explain
investor behaviour
Decision-Making Under Uncertainty
• Introducing uncertainty, means that decisions must now
be made in the face of risk.
• The ability to make consistent choices in conditions of
risk implies the existence of a utility function that shows
how much satisfaction a person derives from different
levels of wealth.
U = U(W)
• Utility functions can be specified in any manner. But
consider three simple utility functions. All assume that
more wealth is preferred to less - that is, the marginal
utility of wealth is positive
U
MU( W ) 0
W
Risk Lover Risk Neutral
Risk Averse
Indifference Curves in Risk – Return Space
Risk Averter
Expected Return Risk Lover
Risk Neutral
Risk, s
• Suppose that we establish a gamble between two prospects, a and b. Let the probability
of receiving prospect a be and the probability of b be (1-).
• Question: Will we prefer the actuarial value of the gamble (i.e. its expected outcome)
with certainty - or the gamble itself.
• A person who prefers the gamble is a risk lover; one who is indifferent is risk neutral; and
one who prefers the actuarial value with certainty is a risk averter.
Example: Logarithmic Utility Function
• Assume an individual has a logarithmic utility function,
U(W) = Ln(W)
• The gamble is an 80% chance of a €5 outcome and a 20% chance of a €30 outcome.
• Expected wealth:
E(W) = 0.8(€5) + 0.2 (€30)
= 10
• The utility of the expected wealth can be read directly from the utility function,
• U[E(W)] = Ln (10) = 2.3
• That is, if an individual with a logarithmic utility function could receive €10 with
certainty, it would be provide him with 2.3 units of utility.
Example: Logarithmic Utility Function
• The other possibility is the utility of the gamble - the expected utility of wealth.
E[U(W)] = 0.8 [ U(5)] + 0.2 [U(30)]
= 0.8[Ln(5)] + 0.2 [Ln(30)]
= 0.8 (1.61) + 0.2 (3.40)
= 1.97
If
• U[E(W)] > E[U(W)] Risk aversion, concave utility function
• U[E(W)] = E[U(W)] Risk neutrality, linear utility function
• U{E(W)] < E[U(W)] Risk loving, convex utility function
E[U(W)]=1.97
7.17
U = lnW
eu = elnW
eu = W
U[E(W)]=2.3
E[U(W)]=1.97
7.17 10
Example: Logarithmic Utility Function
• Risk Premium: the maximum amount of wealth an individual would be willing to give up in order to
avoid the gamble.
• If he takes the gamble it is only worth 1.97 units of utility to him, or equally stated, a wealth of
€7.17 (=e1.97). Therefore, he is willing to pay up to €2.83 in order to avoid the gamble. This is
known as the Markowitz risk premium.
• Risk premium is equal to the difference between an individual’s expected wealth, given the gamble,
and the level of wealth that individual would accept with certainty if the gamble is removed, i.e. his
certainty equivalent wealth.
Risk Premium = expected wealth - certainty equivalent wealth
Markowitz Example 1
• You have a logarithmic utility function U(W)=Ln(W), and your current level of wealth is
€5,000. Suppose you are exposed to a situation that results in a 50/50 chance of winning
or losing €1,000.
a. If you can buy insurance that completely removes the risk for a fee of €125, will you buy it
or take the gamble?
b. Suppose you accept the gamble outlined in (a) and lose, then your wealth is reduced to
€4,000. If you are faced with the same gamble and have the same offer of insurance as
before, will you buy the insurance the second time round?
Markowitz Example 2
• You have a power utility function U(W)=-W-1, and your current
level of wealth is €100,000. Suppose you are exposed to a situation
that results in a 50/50 chance of winning or losing €10. What is the
Markowitz risk premium required by the individual faced with
this risk?
