Question

Explain why all assets should be priced based on risk.(give academic support , more than 150 words)

Answer 1

This is a very subjective question. I have put together mu thoughts below. Please go through the same, apply your thoughts as well and then prepare your answer.

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An investment in any asset is always evaluated on the basis of return and risks it offers. “Risk” and “return” are frequently used terms in the field of corporate finance.

A return is what your asset at any point of time gives back to you at a later time. The simplest way to calculate a return is what you receive till investment horizon over and above what you invested. So, if an investment of value V₀ in any asset grows to V_t at the end of investment horizon with intermediate payments in between then

A risk is a probability of unfavorable outcome. All investments are subjected to risks. And all such risks can be broadly classified into two types:

• Systematic risks:
  • Risks inherent inside a system; common to all the entities inside the system; prevalent in every asset traded in the market;
  • These are risks associated with the economic, political, sociological and other macro-level changes.
  • They affect the entire market as a whole;
  • Undiversifiable and cannot be controlled or eliminated merely by diversifying one's portfolio.
  • Also called, market risk, undiversifiable risk, volatility
  • Examples: Interest rate changes, inflation, recessions, wars.
• Unsystematic risks:
  • Risks specific to an entity, company or instrument; independent to external changes in economy or politics
  • Factors such as management capability, consumer preferences, labor, etc. contribute to unsystematic risks.
  • Controllable; can be considerably reduced by sufficiently diversifying one's portfolio through hedging or right asset allocation strategy
  • Diversifiable risk
  • Example: Business risks, financial risks

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. Hence risk and return will go hand in hand. They should not be seen in isolation. It should not be difficult for us to see that a riskier investment should offer higher return to attract an investor. Hence we can conclude that:

1. An investment with higher expected risk should offer higher expected return and vice versa
2. Given same level of expected risk in two investment opportunities, their expected returns should be equal and vice versa otherwise there will be risk return arbitrage