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IAI Actuarial Core Principles · Business Finance · Key principles of finance

In corporate finance, which statement best describes the general relationship between risk and expected return for investments in an efficient capital market?

Investors are rewarded with higher expected returns only for bearing non-diversifiable (systematic) risk. Specific risk can be diversified away at little cost, so markets do not pay a premium for it, and higher risk does not guarantee higher actual returns.

  1. AInvestors are compensated with higher expected returns only for taking on risk that cannot be diversified awayCorrect
  2. BInvestors are compensated for all risk, including risk unique to a single company
  3. CHigher risk investments always produce higher actual returns
  4. DRisk and expected return are unrelated once inflation is considered
  5. Lower risk investments must offer higher expected returns to attract investors

Explanation

In an efficient market, diversifiable (specific) risk can be eliminated cheaply, so it earns no extra reward. Only systematic risk is compensated with higher expected return. Higher risk raises expected return, not guaranteed actual return, so the option about 'always' is wrong.

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