Any return in excess of the risk-free rate promised or paid by a financial investment indicates that there are risks associated with it. Before investing, it is important to understand the risks taken and relate them to the expected return. Whether or not a reward is considered fair depends on the probability and impact of risks materializing and is subjective.
Which investor would not want a free lunch? But unfortunately, there does not exist such a thing as a free lunch in financial markets. Some investors in AAA rated collateralized mortgage obligations have learned this the hard way during the recent financial crisis.
But why then do some financial investments pay a return, either through cash flows or price increases, which is larger than the risk-free rate? The answer is simple:
The return in excess of the risk-free rate paid out by a financial investment compensates the investor for accepting risk
But then, what does risk mean? Consider a corporate bond issued by ABN AMRO Bank in Swiss francs with a time to maturity of 10 years. At the time of writing, such a bond paid a coupon of 1.5% for a price of 97.85, resulting in a yield of 1.74%, 1.60% higher than the prevailing short-term risk-free rate of 0.14% and 0.75% higher than the Swiss treasury rate with the same maturity. But why is that premium not zero? First, there exists the risk that ABN AMRO Bank will not be able to repay the principal of the bond in ten years (or even coupons beforehand) because it goes bankrupt. Second, there exists the risk that interest rates will rise in the future, and thus the investor would be better off investing in those higher yielding bonds. These are the risk that an investor must be willing to bear to get an excess return of 0.75% over the same maturity risk-free rate. The value 0.75% is the return that the market participants consider a fair reward for the risks taken.
The question “what does risk mean?” actually turns into a search for risks and their relationship with expected returns. In general, we distinguish between two types of risk:
- Systematic risks, that is, risks where the market participants, on average, expect a certain return as reward for accepting that risk. Coupon payments of bonds or dividends on equities qualify for such rewards.
- Specific risks, sometimes called diversifiable risks, that is, risks where the expected reward is zero. On average, no excess return can be generated by holding financial investments that only carry specific risk. It is generally possible to remove or reduce specific risks by holding a well-constructed diversified portfolio of financial instruments.
Now you may ask yourself the questions, why should I invest in assets that only carry specific risks? For example, why invest in platinum, an asset that only bears specific risks, the risk being the price dropping (and the potential reward a price increase)? Again, the answer is simple, at least in theory. You invest in platinum if your belief that the probability of the associated risks materializing is lower than the belief of the average of the market participants. Without any additional information or belief, there is no reason to invest in platinum because its price should be an equilibrium price and thus not change systematically in the future. But, if you expect for example car sales to rise, and as such the need for platinum in catalists, you may weigh the probability of a price hike larger than the risk of a price drop. As such, in your personal opinion, the expected reward more than compensates for the potential loss.
Now, what does that mean in general? It means that, for any investment you make, you must answer the following questions:
- What risk am I taking? Do I sufficiently understand that risk and am I able to assess it?
- What reward is the market expecting for taking that risk?
- What is my personal belief with respect to the associated risk materializing? Do I belief the market expected reward is too high or too low? How does my belief change in the context of a portfolio of financial instruments?
Only answering those questions will allow you, from your personal perspective, to pay, in terms of risk, a fair price for the expected performance. And don’t forget, risks happen from time to time.
- There is no such thing as a free lunch. If an instrument is expected to pay an above risk-free return, then there is some risk associated with it.
- Risk is subjective and as such different market participants may have a different opinion on the fair price for risk.
- The price for risk should always be considered in the context of your investment portfolio.