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FRM Part II · FRM Exam Part II · Factor Theory

A fund's consumption-based asset pricing review notes that an asset's payoff is high in recessions, when the stochastic discount factor is high. How should its expected return compared with the risk-free rate be characterised?

Its expected return can be below the risk-free rate. An asset that pays off in recessions, when the discount factor is high, provides insurance against bad times, so investors accept a negative risk premium. Premiums depend on covariance with bad states, not on total risk.

  1. AExpected return below the risk-free rate, since the asset acts as insurance against bad times and investors accept a negative risk premiumCorrect
  2. BExpected return above the risk-free rate, since all risky assets must earn a positive premium
  3. CExpected return equal to the risk-free rate, since the asset has no variance
  4. DExpected return cannot be determined without knowing the asset's idiosyncratic volatility

Explanation

Risk premium is driven by covariance of payoff with the stochastic discount factor. An asset paying off when the discount factor is high hedges bad times, so investors will pay more for it, lowering its expected return, possibly below the risk-free rate (as with put options or gold in some periods). Positive premiums are not required for every risky asset.

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