Can someone please explain me example 8 from reading 46 and q. 17 of the EOC from the same reading? I keep getting them wrong.
Example 8 of reading 46 . An asset risk premium is high when there is a negative relationship between the future payoff and the investors marginal utility from future consumption.
First of all the problems, I did related to this concept are all wrong and I guess because I am not sure how to tackle it and im so sure its much simpler than this.
Here is the thing that I know: we demand high risk premium when we are uncertain about the economy and we save more now to consume more in the future which means we have high marginal utility from future consumption. However, I dont understand the first part. 1. What is the negative relationship about? 2. Future payoff of what? Like what we expect our future income to be? The answer talks about covariance between the payoff and the expected marginal utility from consumption
Question 17. Why is the answer B and not C?
I really cant grasp this whole idea of connecting the risk aversion, intertemporal rate of substitution and the payoff of an asset
With a negative relationship between future payoff and investors marginal utility from future consumption this describes a risky asset:
When investor’s marginal utility from future consumption is high (i.e. bad times) and at the same time, the future payoff of the asset is low (i.e. lower/poor returns) this asset is a bad hedge against bad outcomes.
When investor’s marginal utility from future consumption is low (i.e. good times) and at the same time, the future payoff of the asset is high (i.e. good returns).
So, with such an asset, you would get good returns when times are good and poor returns when times are bad, which means you don’t get any protection/hedge against bad outcomes when times are bad, hence as an investor, you will need a higher risk premium to compensate yourself for investing in such risky asset.
Onda - I’m with you. I don’t understand these concepts - what does future payoff mean? Then there is question 18 (EOC p. 485, 2020 curriculum) that talks about “bad consumption outcomes”. What does “bad consumption outcomes” mean?
Bad consumptions outcomes means that during period like recessions, you shouldnt invest in assets such as stocks. Stocks tend to be relatively risky and during bad periods, there is no guarantee that you will get paid dividends. You should invest something relatively safer and with low risk like t-bills because you have some sort of guarantee of receiving your payments
From my understanding, future payoff is the payoff you get from your investment. Again with period where the economy does well, there is more certainty of receiving your payoff vs period of recession where there is high uncertainty.
Hope this helps. I have been struggling too with the same concept and please correct me if I was wrong
this describes a risky asset: