Chapter 7
The Pricing of Risky
Financial Assets

CHAPTER OUTLINE
I.
A World of Certainty
II.
Consequences of Uncertainty and Risk Aversion
A. An aside on measuring risk
III. Principles of Diversification
IV. The Risk Premium on Risky Securities

CHAPTER SUMMARY
Any investor who buys a security, which is a claim on future cash flows, expects to be compensated for
two reasons: delaying consumption and bearing risk. Risk arises because the investor is uncertain as to
whether he or she will actually receive the promised future cash flows. Without risk all assets would offer
the same return. Investors appear to be risk averse. They prefer an asset that offers a certain 5 percent
return over another asset that offers an expected return of 5 percent but may actually pay something
different (e.g., a coin flip that pays 10 percent for heads and 0 percent for tails). So, to get risk-averse
investors to purchase securities with uncertain returns, borrowers must offer a higher expected return (e.g.,
a risk-averse investor may prefer a coin flip that pays 12 percent for heads and 0 percent for tails over the
sure 5 percent investment). The increased expected return must be enough to compensate the investor for
the increased risk. How much increase in expected return is enough will depend on the preferences for risk
and expected return of the individual investor.
Risk aversion leads investors to combine securities in a diversified portfolio that will reduce risk for a
given expected return. Risk reduction through diversification is possible because returns on different risky
assets do not always move exactly together. In other words, when some assets in the portfolio are
performing better than expected, others will be performing worse than expected. Their deviations from
expected returns will offset each other and make the returns on the portfolio less volatile (less risky). As a
result, an investor judges the riskiness of a security by how it affects the riskiness of the investor’s
portfolio.

TEACHING
This chapter introduces modern portfolio theory and is important to those wishing to emphasize financial
markets. However, the material is difficult and this chapter may be skipped without loss of continuity.
Stress that under certainty all assets with the same term to maturity should have the same yield. It is worth
emphasizing that risk aversion does not mean always preferring less risk regardless of return. Also
emphasize that risk-averse investors diversify their portfolios. This means that an individual asset may be
risky when considered in isolation, but when combined with other assets can actually reduce the risk of that
portfolio. It may be useful to use a numerical example of two assets with perfectly negatively correlated
18
Chapter 7 The Pricing of Risky Financial Assets  19
returns to show that two risky assets can be combined into a portfolio that is risk free and, therefore, should
offer only the risk-free rate of return.
Useful Internet sites
1.
www.moneychimp.com — This site contains a lot of useful economic and financial information,
including an accessible piece on modern portfolio theory.2.

DISCUSSION QUESTIONS
1.
Is the purchase of a state lottery ticket rational?
Yes, if the marginal benefit of playing the game combined with the extremely low
probability of winning is enough to offset the marginal cost of buying the ticket. Note that
except for the really big jackpots, the expected return from buying a lottery ticket is
negative.
2.
Develop a list of procyclical assets. Under what conditions would it be wise to consider including
several of them in a portfolio?
If their sensitivities to the business cycle differ, then the returns on some will exceed
expectations by more than the returns on others will exceed their expectations. That is, their
returns are not perfectly positively correlated and diversification can reduce risk at a given
expected return. They would also help reduce the risk of a portfolio dominated by
countercyclical assets.
3.
Develop a list of countercyclical assets. Under what conditions would it be wise to consider
including several of them in a portfolio?
See answer to question 2 above.
4.
What kinds of assets would you put in a $100,000 portfolio? What kind of
tradeoff would
you be willing to make between risk and return? How would you diversify?
5.
Are there people who are risk lovers? If so, are they irrational?
There are rational risk lovers; it is a preference.

1.
ANSWERS TO QUESTIONS IN TEXT
Risk aversion means that investors must be compensated for additional risk. Most people are risk
averse because of the diminishing marginal utility of money: the pain caused by a disappointing
outcome outweighs the pleasure of an equal surprisingly good outcome.
2.
If two risky assets have perfect negatively correlated returns, risk can be eliminated. When asset
returns move in opposite directions, the average return is ensured. When one risky asset gives the highest
possible return, the other asset gives the lowest possible return.
3.
The main characteristic of investor behavior that forces riskier assets to pay higher returns is risk
aversion. The only way issuers of riskier securities can entice potential investors is to compensate them for
that greater risk through higher interest payments.
4.
Systematic risk refers to risk that is common to all assets, while nonsystematic risk refers to an
asset’s idiosyncratic risk. For example, most stocks in the New York Stock Exchange rise in value when
the U.S. economy does well and decrease when it does poorly. These price movements are the systematic
portion of the risk of investing in these stocks. In contrast, a crash in the Asian economies may hurt U.S.
banks but help computer manufacturers (cheaper parts). Such stock price movements are nonsystematic.
(These risks are often called systemic and nonsystematic risks.)
5.
Only nonsystematic risk can be eliminated through diversification.
6.
They may have much less risk aversion than the typical investor; the two stocks may be perfectly
negatively correlated; they may find transactions costs of diversification high if they are unaware of
indexed mutual funds.
20  Ritter/Silber/Udell Money, Banking, and Financial Markets, Eleventh Edition

ESSAY QUESTIONS
1.
What is meant by risk aversion? Is everyone risk averse?
It means that investors must be compensated for taking on additional risk. A sure return is
preferred to a gamble with an equal expected return. Portfolio theory assumes that for an
entire portfolio risk aversion holds. Risk aversion is a preference and people’s preferences
differ. People’s preferences likely range from strongly risk averse to strongly risk loving.
Describe how a highly risky individual asset can reduce portfolio risk.
If a risky asset has negative covariance with other assets in the portfolio, risk can be
substantially reduced.
Discuss the difference between systematic and nonsystematic risk. How can each be reduced?
Nonsystematic risk refers to the independent risk of a particular asset. It can be diversified
away by expanding a portfolio. Systematic risk refers
2.
3.