Should the expected rate of return of a risky asset be higher than the risk-free rate?...
Should the expected rate of return of a risky asset be higher than the risk-free rate? Please explain.
short and correct answer please
Homework Answers
Yes risky assets should get higher rate of return than risk free assets.
Risk free rate is rate of return expected on securities which has zero risk. Government debt considered as risk free as government won't default. In case of low cash flows government can print money to payback debt.
Theoretically any investment should get minimum rate of return same as risk free rate. Based on the risk associated with the different securities risk premium is added to risk free rate to get the expected rate of return of that particular security.
Example :
To calculate the required rate on equity stock one method is CAPM model
Rate of return on equity = Risk free rate + Beta of stock * (Average market return - Risk free rate)
So by adding (Beta of stock * (Average market return - Risk free rate)) we are adding risk premium to risk free rate as stocks are considered as more risky assets than government bonds.
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