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If a financial asset has an expected return that is greater than what is necessary to...

If a financial asset has an expected return that is greater than what is necessary to compensate for its risk, what will bring the return back in line with equilibrium?

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Answer #1

If the expected return generated by a financial asset is greater than what is required for compensating the asset's risk, the demand for the financial asset will start rising exponentially such that the initial cost incurred to take a position in the financial asset (the price of the financial asset) will increase. This in turn will depress the expected returns generated by the financial asset. This process will continue till the excess return being generated by the asset ceases to exist and the asset's price becomes commensurate with the asset's risk-return profile. This entire process is known as arbitrage.

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