Another way of seeing that A offers a superior return for its level of risk is to note that the slope of our line for Asset B is:


Thus, Asset B has a reward-to-risk ratio of 6.67 percent, which is less than the 7.5 percent offered by Asset A.

The Fundamental Result The situation we have described for Assets A and B could not persist in a well-organized, active market, because investors would be attracted to Asset A and away from Asset B. As a result, Asset A's price would rise and Asset B's price would fall. Because prices and returns move in opposite directions, A's expected return would decline and B's would rise.

This buying and selling would continue until the two assets plotted on exactly the same line, which means they would offer the same reward for bearing risk. In other words, in an active, competitive market, we must have the situation that:

This is the fundamental relationship between risk and return.

Our basic argument can be extended to more than just two assets. In fact, no matter how many assets we had, we would always reach the same conclusion:

The reward-to-risk ratio must be the same for all the assets in the market.

Portfolio Expected Returns and Betas for Both Assets

0 0

Post a comment