Risk premium and portfolio theory
An alternative view of risk has been derived from extensive work in portfolio theory and capital market theory by Markowitz, Sharpe, and others. These prior works by Markowitz and Sharpe indicated that investors should use an external market measure of risk. Under a specified set of assumptions, all rational, profitmaximizing investors want to hold a completely diversified market portfolio of risky assets, and they borrow or lend to arrive at a risk level that is consistent with their risk preferences. Under these conditions, the relevant risk measure for an individual asset is its comovement with the market portfolio. This comovement, which is measured by an asset’s covariance with the market portfolio, is referred to as an asset’s systematic risk, the portion of an individual asset’s total variance attributable to the variability of the total market portfolio. In addition, individual assets have variance that is unrelated to the market portfolio (that is, it is nonmarket variance) that is due to the asset’s unique features. This nonmarket variance is called unsystematic risk, and it is generally considered unimportant because it is eliminated in a large, diversified portfolio. Therefore, under these assumptions, the risk premium for an individual earning asset is a function of the asset’s systematic risk with the aggregate market portfolio of risky assets. The measure of an asset’s systematic risk is referred to as its beta:
Risk Premium = f (Systematic Market Risk)