Question

We learned that if the market interest rate for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain

(a) how a decrease in risk aversion would affect stocks' prices and earned rates of return;

(b) how this would affect risk premiums as measured by the historical differences between returns on stocks and returns on bonds; and

(c) what the implications of this would be for the use of historical risk premiums when applying the CAPM equation.

Answer 1

Decrease in risk aversion:-

a).When investor risk aversion starts decreasing; his expected return on equity will be less. This is psychological/behavioral aspect.

b).It will be an optimistic scenario. Hence liquidity starts pouring in stock. Thus prices of stocks soar.

c).Practical or more recent Risk premium, again a behavioral attribute, will fall down due to optimism. This will be less than risk premium calculated in CAPM pricing model.

d).CAPM calculates expected return on equity, by historical risk premiums. Hence Expected return on equity, on paper, will be high.

Whereas, due to high optimism, expected return on equity on ground or in short term will be less.