I don’t get why the answer is C.
1 An asset’s risk premium is high when:
A there is no relationship between its future payoff and investors’ marginal utility from future consumption.
B there is a positive relationship between its future payoff and investors’ marginal utility from future consumption. C there is a negative relationship between its future payoff and investors’ marginal utility from future consumption.
This is the explanation:
C is correct. An asset’s risk premium is determined by the relationship between
its future payoff and the marginal value of consumption as given by the covariance between the two quantities. When the covariance is negative—that is, payoffs are low and expected utility from consumption is high—or equivalently, when times are expected to be bad in the future and the value of an extra unit of consumption is high, the risk premium will be high. When the covariance term is zero (there is no relationship), the asset is risk free. When the covariance term is positive, the asset is a hedge and will have a rate of return less than the risk-free rate.
The logic I used is that we ask for a high risk premium when the market conditions are bad. Hence, the future payoff from investing today is uncertain.As such, the marginal utility from consuming today is higher than the marginal utility from consuming in the future. So doesn’t this make the relationship between the future payoff and the the marginal utility from future consumption positively related?