Financial Daily from THE HINDU group of publications
Sunday, Sep 18, 2005
Financial Daily from THE HINDU group of publications Sunday, Sep 18, 2005 |
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Investment World
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Stock Markets Columns - Simple Economics Equity risk premium B. Venkatesh
The return on equity is higher because of risk premium. What is this premium? Suppose the one-year government bond returns 5 per cent. The difference of 40 per cent between the equity return and the bond return is the risk premium. Investing in a government bond is risk-free, as the government is unlikely to default on principal and interest payments. Buying stock is, however, risky. That is why we demand a higher return. Suppose you buy shares of ONGC. With the market trading at record levels, the possibility of a decline in the index is high. This means that the risk of investing in ONGC is high, as this stock carries the maximum weight among the Nifty constituents. You will buy the stock only if the return is commensurate with the higher risk. We display such risk-reward behaviour in most of our decisions. Suppose your friend says he will pay you Rs 500 if you pick Ace of Spades from among five cards turned face down. He also gives you the option of taking Rs 100 if you do not want to play the game. The probability of picking the correct card is one-fifth, as there are five cards. The expected value of the game is, hence, just Rs 100 (Rs 500 multiplied by one-fifth), same as the second option. You would rather take the second option, as you are sure to receive the money. Your friend has to better his offer to make you play the game. It is the same with the equity market. You and I will not invest in equity, unless the returns are substantially higher.
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