Risk, Return and the Demand for Assets
The theory of asset demand says how much of an asset people want depends on wealth, its expected return relative to alternatives, its risk, and its liquidity. Risk-averse investors require a higher expected return to hold a riskier asset, which is the risk premium.
Why it matters
Given two assets with the same expected return, people prefer the safer one, so the riskier asset must offer more return to attract buyers. Spreading wealth across assets that do not move together cuts the diversifiable part of risk without lowering expected return, though it cannot remove market-wide risk.
Worked examples
Two bonds offer the same expected return, but one is far more volatile. Which trades at a higher price, and why?
The safer bond. Risk-averse investors pay more for it, so it has a higher price and a lower yield, while the riskier bond must offer a higher yield, a risk premium, to attract buyers.
Common mistakes
- ✗A higher expected return always means a better asset. It usually comes with higher risk, and a risk-averse investor weighs both.
- ✗Diversification means buying more of your favourite asset. It means spreading across assets that do not move together, which is what lowers risk.
Revision bullets
- •Asset demand: wealth, expected return, risk, liquidity
- •Riskier assets need a higher expected return, the risk premium
- •Diversification lowers diversifiable (unsystematic) risk
Quick check
Why does a riskier asset generally have to offer a higher expected return?
Connected topics
Sources
- Mishkin (2018), Ch. 5Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The theory of asset demand: wealth, expected return, risk, and liquidity.