Question

what is the fundamental relationship between risk and return in well functioning markets?

Answer 1

Risk and return in well-functioning market are highly correlated. In a well-functioning, the return is nothing but reward for an investor for bearing risk.

As we keep increasing risk factor for an investor the return also keeps increasing. As per CAPM or Capital Asset Pricing Model the beta is risk measure which is multiplier for the investors for bearing the risk. Higher beta represents the higher riskiness of the security.

Hence, as risk increases the return on security also increases to compensate the investor for bearing risk. The enhanced return for bearing risk is also called risk premium. For earning this risk premium investor takes extra risk.