The price of risk

Abstract

The relationship between risk and return is fundamental to financial asset pricing. Many commonly used financial asset pricing models require an annualised risk coefficient. Using the fundamental assumption that consecutive price changes are independent, annualised risk can be easily calculated from the asset risk over shorter time intervals. Recent empirical research however suggests that price changes are not independent, but rather exhibit long-term dependence. This paper will focus on the implications for investors of incorrectly measuring annualised risk. The outcomes of the paper will show that traditional measures of annualised risk are inappropriate when price changes exhibit long-term dependence and will lead the investor to dramatically mis-estimate their real level of risk.