How much is that risky asset worth?

Alex Verkhivker | Sep 27, 2016

Sections Finance

Valuing a future payoff requires understanding market perceptions, future economic conditions, and the nature of risk. The task for investors: assess the risks involved and the potential rewards.

Economists agree that financial markets tend to compensate investors for exposing themselves to market uncertainty. New York University’s Jaroslav Borovička and University of Chicago’s Lars Peter Hansen, who won a Nobel Memorial Prize in Economic Sciences in 2013, have devised a framework to understand better how much an investor should pay for a given risk over alternative investment horizons.

Economic models typically assume investors have rational expectations of the future based on historical financial data. The problem with such models, the researchers write, is that it is unclear precisely what information investors use to make forecasts, and how much confidence investors have in the information they do use.

The return that financial assets produce ought to reflect “risk prices”—the compensation investors stand to gain from investing in a risky asset. The prices will depend on the investment horizon, the market opportunities, and the exposures to risk. Borovička and Hansen use these insights in developing a framework for characterizing the pricing dynamics pertinent for financial-market payoffs.

Unexpected or unpredictable events that impinge on the macroeconomy—or economic shocks, as economists refer to them—cannot be managed with diversification. The researchers’ framework isolates factors that contribute to the market-based risk prices of exposure to this macroeconomic uncertainty. In particular, investors face uncertainty about long-term economic growth prospects, plus their appetite for risk rises and falls over time. The research incorporates these factors and shows how the risk prices resulting from macroeconomic shocks differ depending on the degree of market uncertainty and the investment horizon. It features the interplay of investors’ uncertainty and their tolerance for risk.

The impact of investors’ difficulty with forecasting also varies over time, as investors receive new evidence and revise their expectations based on emerging perspectives. Borovička and Hansen use random processes to capture this term structure of economic uncertainty and the investor compensations. Their approach provides an added piece to understanding the links between financial markets and investment uncertainty. The takeaway for investors, even the most experienced ones: much is still left to chance. Real knowledge requires knowing the extent of one’s ignorance.