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Student Question of the Week: Market Risk Premium

Student Question from Alison
Course: Investment Planning

Student Question:

Can you help explain this question better? If the market risk premium were to increase, doesn’t that mean the amount of compensation and investor desires would increase, so the value of stock would need to increase further?

Board Released Question

If the market risk premium were to increase, the value of common stock (everything else being equal) would:

not change because this does not affect stock values.
increase in order to compensate the investor for increased risk.
Increase due to higher risk-free rates.
decrease in order to compensate the investor for increased risk.
decrease due to lower risk-free rates.


Instructor Response:

Hi Alison-

Alison, great question!

Look at it this way.  Let’s say you could purchase one of the following:

  • A U.S. Large cap stock with an average (mean) return of 5% and a standard deviation of 2% or
  • A Small Cap foreign stock with a mean return of 5% and a standard deviation of 6%

You will receive the same mean return yet the return will vary wildly with the small cap stock.

  • Large cap returns, assuming a normal distribution, will fall within 3 standard deviations of the mean return 99% of the time.
    • 99% of the time, returns will range from a loss of 1% to a gain of 11% calculated as 5% +/- 3 standard deviations of 2%.
  • Small cap returns, assuming a normal distribution,  will also fall within 3 standard deviations of the mean return 99% of the time.
    • 99% of the time, returns will range from a loss of 13% to a gain of 23% calculated as 5% +/- 3 standard deviations of 6%.

Why would an investor sign up for the huge increase in variability (investment risk) with the same mean return?  The small cap stock would have to be priced significantly lower than the large cap stock as incentive to take on the added risk.  Let me know how fully this addresses your question if you would.

Bruce