A risky asset offers high positive returns during business downturns. A colleague argues that the nominal required rate of return on the asset may be less than the nominal risk-free rate. Is the colleague correct?
Yes.
No, the return must be higher than the nominal risk-free rate.
No, the relationship between the asset’s nominal return and the nominal risk-free rate is indeterminate.
I don’t quite understand why A is correct. My arguing is like this: for the risky asset offers high positive returns during business downturns, the required rate of return must be more than the nominal risk-free rate so the future cash flow will be discounted with a larger number to get a higher interest return.
A is correct. For the required return to be less than the risk-free rate, the asset’s risk premium would need to be negative. Because the asset supplies relatively high returns in economic conditions in which the marginal utility of consumption is relatively high, the covariance term in Equation 6 is positive and the asset thus bears a negative risk premium.
I still dont get it after i read it. It explains why the required return is lower than the risk free rate. But is it contradictory to say that the required return is less than the risk free rate but it has a positive high return in the economic downturn?