Risk and Return in General: Theory and Evidence

Abstract

To the degree risk is not diversifiable, someone must hold it, and standard utility theory suggests those who do hold it should be compensated via a risk premium relative to risk-free alternatives. Yet it is striking that a first approximation to risk via volatility or beta against the market return generates no positive risk premiums. Consider that assets such as houses have characteristics that require compensation, such as crime or bad schools, and these factors are abstract in a sense, yet their effects eminently measurable and consistent with intuition (Black 1999;Tita, Petras and Greenbaum 2006). Risk, meanwhile, has devolved into the financial

Agency‐Based Asset Pricing and the Beta Anomaly

“…The relative utility argument is taken one step further by Falkenstein (), who assumes that relative utility preferences do not only apply to delegated portfolio managers, but universally . In other words, he assumes that investors exclusively derive utility from their level of return compared to other investors, rather than from their absolute level of return, which is equivalent to characterizing investors as being envious instead of greedy.…”

“…() report the existence of a beta anomaly for US corporate bonds (sorted on maturity) and Frazzini and Pedersen (2011) document beta anomalies for US Treasuries, US corporate bonds (sorted on maturity or on rating) and futures markets (considering equity index, bond index and commodity futures). Falkenstein () provides no less than twenty empirical examples of higher risk not being associated with higher returns in all major asset classes, as well as some more exotic ones.…”

“…A popular explanation for the low‐beta anomaly is benchmark‐driven investing, or, more specifically, the agency effects that arise from delegated portfolio management; see, e.g., Blitz and van Vliet (), Falkenstein () and Baker et al . ().…”

“…(). Falkenstein () proposes a model in which risk is not only unpriced in the cross‐section of stock returns, but unpriced in general. His approach is based on the assumption that investors primarily derive utility not from absolute returns, but from the level of return compared to that of other investors.…”

Sub-Additive Recursive "Matching" Noise and Biases in Risk-Weighted Index Calculation Methods in Incomplete Markets With Partially Observable Multi-Attribute Preferences

“…Falkenstein [30] suggests a utility function that measures risk within the context of relative wealth and implies that this is an outcome of investors' preference for…”