The Cross-section of Return and Risk: New Evidence from an Emerging Market
Posted: 21 Jun 2019
Date Written: June 10, 2019
The economic theory suggests that expected returns should compensate for the risks undertaken by investors. This implies that investors are rewarded for taking risks while investing in assets with higher risk potentials. Theoretically, if they hold their investments, they receive higher returns, in long run. Over past few decades, this has been examined in the financial economics research extensively. However, some recent research works have suggested otherwise (see, Buffa, et al., 2014 and Agarwalla et al., 2014). In recent decades, low-risk stocks provide higher returns than riskier stocks. This contradicts a well-established market theory of higher risk-higher return. The distorted relationship between risk and return over last few years has been attributed to the factors such as the risk aversion tendency among investors and the steadily growing practices of index investing by fund managers. Motivated by the emerging theory of upended risk-return relationship, we argue that the positive risk-return relationship hypothesis is true to certain level of risk, however, beyond that threshold, the relationship between risk and return breaks down and they behave independently. We argue that for lower and moderate levels of risk, the returns are positively correlated and compensate for incremental risk undertaken by investors, however, when the risks tends to be substantially higher, the return behaves independently irrespective of changing risk levels.
Keywords: Risk-Return Relationship, Asset Pricing, Emerging Market, Indian Stock Market
JEL Classification: D53, G12
Suggested Citation: Suggested Citation