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My question is a bit more specific as it is indeed well known that investors expect higher returns in times of higher risks/volatility.

However, isn't it counterintuitive to expect the market to achieve higher returns when the economy is slowing down ? For example, if we have a look at the current economic situation, how could someone expect the S&P500 index (let's assume we use it as a proxy for Market Return) to perform better than it did before the coronavirus crisis ?

So, in short, how can you realistically expect higher returns when the economy is in fact crashing down ?

Thanks in advance !

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Risk premium is the excess expected return of the market over that of the risk-free asset. (There is no "(expected) risk premium".)

It is a property of the expected returns of two assets. It is an indication of investor's willingness to bear risk. High risk premium means less risk-bearing capacity in the market, where market participants are in risk-off mode.

Risk premium is not a forecast of future returns of the risky asset. In contrast, something like a P/E ratio (or Shiller's cyclically adjusted CA P/E) is designed to reflect future returns. High P/E means asset is over-priced and lower future returns.

Risk premium can go up when price of risky asset decreases and/or risk-free rate decreases. Both tend to occur when market perceives uncertainty and shifts from a risk-on to risk-off regime. For example, S&P500 price and US Treasury yield (risk-free rate) could go down as capital shift from risky equity to safe US government debt.

This is not restricted to equity markets. Credit spread in the corporate bond market is also a kind of risk premium, for credit risk instead of market risk. The higher perceived default risk of the issuer, the higher is the yield demanded by investors. Corporates whose debt has high yield (junk) rating are perceived to have higher credit risk than those who are low yield (investment grade). During market uncertainty, credit spread widens.

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  • $\begingroup$ Thanks for your reply. However I feel like this does not really answer the question (or maybe I do not get it). As you said in this post the Risk Premium is the difference between the expected return on a market portfolio and the risk-free rate. So if the Risk Premium increases in times of crisis it necessarily implies that the expected return of the market increases (assuming there is no big change for the risk-free rate). And this seems counterintuitive to me, even if I do understand that investors expect higher returns for higher risks. $\endgroup$
    – Robert
    Commented May 18, 2020 at 12:47
  • $\begingroup$ I think I kind of get what you mean. From a DCF valuation perspective the risk premium would indeed increase if the initial investment (price) of a risky asset decreases. However future inflows and thus returns would also decline. As both "effects" work against each other I am not sure how it would eventually result in an increase in the expected market return (above the risk-free rate). $\endgroup$
    – Robert
    Commented May 18, 2020 at 12:56
  • $\begingroup$ "...assuming there is no big change for the risk-free rate..." is incorrect. Risk-free rate is not an exogenous quantity, as already stated. Prices are not exogenous. Treasury yields changes with every trade, just like stock prices. "...even if I do understand that investors expect higher returns for higher risks..."---apparently you don't. It's not "high returns" of the risky asset itself, risk-premium is, by definition, expected excess return. $\endgroup$
    – Michael
    Commented May 18, 2020 at 16:27
  • $\begingroup$ I was indeed assuming that treasury yields were not subject to big changes, forgive my lack of knowledge. I just had a look at the risk-free rate in France for the last 6 months and realised that its recent decrease is not sufficient to match the increase in the implied market risk premium. So it necessarily implies that the expected market return increased as well -- which means that equity prices went down. You mentioned it pretty clearly "Risk premium can go up when price of risky asset decreases and/or risk-free rate decreases" but please correct me if my reasoning is wrong. $\endgroup$
    – Robert
    Commented May 19, 2020 at 13:21
  • $\begingroup$ You keep repeating "expected market return"---risk premium is NOT a forecast of future returns. It's a relationship between two prices (returns)--risky and safe asset. Like any prices, they are determined by demand. Excess demand for safe asset equilibriates to lower price for risky asset. In contrast, something like a P/E ratio (or Shiller's cyclically adjusted P/E) is designed to reflect future returns. High P/E means over-priced/lower returns. Notice P/E is concerned with single firm/asset, in contrast with risk premium. $\endgroup$
    – Michael
    Commented May 19, 2020 at 20:03
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Let's first clarify one concept. Risk premium is the extra expected return that an investor demands (not of the market, here is the key) over the return of risk-free asset (usually government bonds).

Then it becomes clearer that a higher market risk premium during a crisis does not mean the market is expected/able to achieve higher returns. It rather means that the investor during a crisis demands a higher extra expected return. Because it is much riskier to invest during a crisis, it is natural to demand a higher extra expected return.

Hope this clarifies your question.

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