Article1983

The Relationship between Risk and Return: Evidence for Life Insurance Stocks

25 citations0/0 files storedJournal of Risk & Insurance

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Financial Risk and Volatility Modeling

Abstract

This paper examines the relationship between realized mean returns and alternative measures of risk for samples of life insurance stocks during the 1961-76 period within the framework of the Capital Asset Pricing Model (CAPM). The results provide some evidence of a significant relationship between mean returns and systematic risk, but they also provide evidence of a significant relationship between mean returns and measures of nonsystematic risk, in contradiction to the principal implication of the CAPM. According to normative financial theory, the rate of return required by shareholders is of critical importance to investment and financing decisions of publicly-held firms. Knowledge of factors that determine required rates of return is needed for rational decision-making. Theorists agree that most investors are risk averse so that required rates of return will be positively related to risk, but there is less than complete agreement on the relevant measure(s) of risk. The Capital Asset Pricing Model (CAPM) of Sharpe [31] and Lintner [ 18] and the zero-beta version of the CAPM developed by Black [ 1] imply that the proper measure of risk for an asset is its market (systematic) risk as measured by beta and that diversifiable (nonsystematic) risk will not affect required rates of return. Thus, the CAPM predicts that realized returns on financial assets should be independent of nonsystematic risk measures, such as return variance, once the influence of beta has been removed. The CAPM has been subject to extensive empirical analysis. Studies by Black, Jensen, and Scholes [2], Fama and MacBeth [9], and Foster [13] suggest that mean realized returns on common stocks are significantly related

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1973Risk, Return, and Equilibrium: Empirical Tests 1976The arbitrage theory of capital asset pricing 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1972Capital Market Equilibrium with Restricted Borrowing 1977A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory 1979Risk measurement when shares are subject to infrequent trading 1972

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