Financial Markets and Institutions (2-downloads)

asset’s expected return relative to that of an alternative asset, holding

everything else unchanged, raises the quantity demanded of the asset.

Risk

The degree of risk or uncertainty of an asset’s returns also affects the demand for the

asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-

Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half of

the time and 5% the other half of the time, making its expected return 10%, while

stock in Feet-on-the-Ground has a fixed return of 10%. Fly-by-Night stock has uncer-

tainty associated with its returns and so has greater risk than stock in Feet-on-the-

Ground, whose return is a sure thing.

To see this more formally, we can use a measure of risk called the standard