The First Lesson

Looking at Table 12.3, we see that the average risk premium earned by a typical large-company stock is 13% - 3.9 = 9.1%. This is a significant reward. The fact that it exists

Ross et al.: Fundamentals I V. Risk and Return I 12. Some Lessons from I I © The McGraw-Hill of Corporate Finance, Sixth Capital Market History Companies, 2002

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396 PART FIVE Risk and Return historically is an important observation, and it is the basis for our first lesson: risky assets, on average, earn a risk premium. Put another way, there is a reward for bearing risk.

Why is this so? Why, for example, is the risk premium for small stocks so much larger than the risk premium for large stocks? More generally, what determines the relative sizes of the risk premiums for the different assets? The answers to these questions are at the heart of modern finance, and the next chapter is devoted to them. For now, part of the answer can be found by looking at the historical variability of the returns on these different investments. So, to get started, we now turn our attention to measuring variability in returns.

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