13 - the case of treasury bonds, all would be lost. To...

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What is meant by the term risk premium ? Why must riskier assets offer a risk premium? A risk premium is the amount of return one needs to realize before taking a chance with an unsecured investment versus a guaranteed investment. This is a very important factor investors consider when choosing how best to allocate their limited resources. Of course, in many cases, this risk premium is theoretical. Very few may actually have a set risk premium in their minds, or at least refer to it in those terms. This risk premium can also be described as the return one expects to make on the market security, versus what kind of return they can make on a more risk-free investment. In the case of a risk-free investment, this usually means an interest rate paid on something like US Treasury bonds or some other sort of guaranteed investment. Of course, even these investments are not guaranteed completely. If there was a catastrophic failure of the financial institution or federal government in
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Unformatted text preview: the case of treasury bonds, all would be lost. To understand why riskier investments offer a premium, it is necessary to make some assumptions describing the preferences and behavior of investors. Most financial models begin with the assumption that investors are risk averse. Risk aversion does not imply that investors always shun risk. Instead, risk aversion means that investors require compensation for taking risk. The years 2000- 2001 witnessed a decline in the value of most international stock indexes, while bonds generally posted above-average returns. Yet many investors persist in holding stocks in their investment portfolios. These investors presumably anticipate that stocks will continue to earn higher average returns than bonds, providing compensation for the higher risks associated with equity securities....
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This note was uploaded on 10/15/2011 for the course FIN 550 taught by Professor Smith during the Spring '11 term at Berklee.

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