Asset Returns and Economic Risk

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 D o financial markets offer higher rewards in the form of average returns for holding risks related to recessions and financial distress in addition to the risks from overall market movements? The answer to this question is related to the way financial economists understand the investment world. Fifteen years ago, financial researchers and practitioners thought that the capital asset pricing model (CAPM) provided a reasonable explanation of why different assets, portfolios, funds, and strategies earn different returns. According to the CAPM, the extra return earned by any risky asset comes from bearing market risk only. There is now considerable evidence against the CAPM, suggesting that variables other than the rate of return on a market portfolio proxy command significant risk premia. The intertemporal CAPM (I-CAPM) theory (Merton 1973) suggests that the premium on any risky asset is related to the market risk premium as well as to the risk premia on these additional variables. In this context, economic risk premia represent the compensation for holding assets that are exposed to prespecified sources of economic risk. Merton does not explicitly identify these additional sources of risk but shows that variables affecting a representative investor’s risk-return trade-off should also command significant risk premia. Hence, the proper selection of additional risk factors has become one of the most challenging tasks in modern finance. Asset Returns and Economic Risk