THE DEMAND FOR RISKY ASSETS: Some Extensions

TLDR: In this paper, the same analytical framework is used to obtain new results on the effect of inflation on the market price of risk, and it turns out that by using nominal values for returns, the market prices of risk under inflation is increased by positive covariance between the rate of inflation and the market rate of return, and decreased by negative covariance.

Abstract: Publisher Summary This chapter discusses some extensions on the demand for risky assets. The research on capital asset pricing has until very recently been devoted almost exclusively to the interrelationships of the risk premiums among different risky assets rather than to the determinants of the market price of risk. Such research has also generally relied on theoretical preconceptions to determine the appropriate utility functions of individual investors upon which both the market price of risk and the pricing of individual risky assets depend. The chapter discusses the highlights of the theoretical and empirical analysis and their conclusions. Then, the same analytical framework is used to obtain new results on the effect of inflation on the market price of risk. It turns out that by using nominal values for returns, the market price of risk under inflation is increased by positive covariance between the rate of inflation and the market rate of return, and decreased by negative covariance. However, statistically as the actual covariance has been very small since the latter part of the 19th century, at least in the USA, the measured market price of risk is not affected appreciably by the adjustment for inflation.