Question

1. Explain why the reward-to-risk ratio must be equal for all securities if the financial markets are efficient.

Answer 1

In efficient financial markets, the prices of all securities reflect all available information, and all securities are "correctly" priced. In other words, it is not possible for any investor to "beat the market", or earn a return higher than the market return. This is because any mispricing of securities is immediately arbitraged away, and no anomalies exist in the prices of securities.

Hence, the reward-to-risk ratio must be equal for all securities if financial markets are efficient. If the reward-to-risk ratio is higher or lower than the overall market ratio for any security, the price of that security would immediately adjust until it is equal to the reward-to-risk ratio of the overall market.