Why Systematic Risk Can Earn an Expected Return Premium

Summary

The document explains why investors may expect additional return for holding assets with systematic risk. It corrects the premise that investors cannot avoid this risk: they can choose a risk-free investment or, within the Capital Asset Pricing Model framework, an asset with zero beta. Because investors are generally assumed to dislike risk and have those alternatives, they require an expected return above the risk-free rate to accept systematic exposure.

The explanation frames compensation as a market return premium rather than a payment from a specific party. Its reasoning relies on investor risk aversion, the availability of a risk-free choice, and CAPM's account of beta and expected returns. It offers a conceptual answer, not empirical evidence or a derivation of the size of any premium. The example of a zero-beta asset is model-specific, and the note does not explore how the argument changes under other asset-pricing models or real-world constraints on access to risk-free investments.

Key ideas

• Investors can avoid systematic exposure by selecting a risk-free asset.
• In CAPM, an asset with zero beta is another example of an asset without systematic risk.
• Risk-averse investors generally require expected return above the risk-free rate to hold systematic risk.
• The compensation is described as an expected return premium, not a payment from a named party.

Tags

# Why should investors be compensated for accepting systematic risk?


# Why should investors be compensated for accepting systematic risk?












> Investors should be compensated for accepting systematic risk, as it cannot be diversified.

Why do the investors need to be compensated for accepting systematic risk? Because no one can avoid it and nothing can be done to prevent it. I understand that if not given a suitable return, no investor would accept the systematic risk. But why compensate? And who is going to compensate them?

## Answer by Richard Hardy (score 4, accepted)

https://quant.stackexchange.com/a/77978

Your premise is mistaken. You can avoid systematic risk by investing in a risk-free asset or one that has no systematic risk (e.g. under the CAPM, that would be an asset $i$ with $\beta_i=0$). Since investors are typically risk averse and they have the choice of investing risk free, they will take on systematic risk only if they get some extra compensation for that. The compensation comes in terms of positive expected return in excess of the risk-free rate.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.