This blog post examines how the risk premium—the reward for accepting risk—changes investor choices and portfolio composition, and how it redefines the balance between profitability and stability.
In economics, the composition of various financial assets held by an individual is called a portfolio. Each asset possesses unique characteristics related to profitability, risk, and liquidity. An investor’s selection of a specific portfolio signifies a comprehensive consideration of these characteristics to determine the investment weighting for each asset. Therefore, diversified investment across multiple financial assets can be interpreted as the result of the portfolio selection process.
The profitability of a financial asset is expressed through its expected rate of return, i.e., the expected return. For example, suppose K Electronics stock is currently trading at 100,000 won per share. Assume there is a one-third probability it will rise to 150,000 won in the next quarter and a two-thirds probability it will fall to 90,000 won. If the stock price rises to 150,000 won, the investor achieves a 50% return; if it falls to 90,000 won, the investor incurs a 10% loss. Calculating based on this, the expected return is 10% through the process of (0.5 × 1/3) + (-0.1 × 2/3). While this expected return serves as the fundamental profitability indicator for the stock, what investors actually care about is the after-tax return, which excludes taxes from the expected return. Under identical conditions, it is natural that assets with higher after-tax returns attract greater demand.
An asset’s risk is closely linked to the volatility of its returns. Even if two stocks, A and B, with identical share prices both have an expected return of 5%, if stock B has greater volatility, it is considered a riskier asset than stock A. Investors generally prefer safer assets when other conditions are equal, so financial products with lower risk are expected to generate greater demand. However, some assets tend to offer higher returns as risk increases. The additional return paid to investors as compensation for accepting this risk is called the risk premium.
The third factor influencing financial product selection is liquidity. Liquidity refers to the ease with which an asset can be converted into cash without significant cost. The ability to quickly recover funds when needed is a crucial consideration for investors. Consequently, highly liquid assets tend to be preferred.
Portfolio selection contributes to mitigating some of the risk arising from price fluctuations by allowing investors to diversify their funds across various financial assets. However, there are practical limitations to fundamentally reducing risk through diversification alone. Derivative financial instruments were designed to overcome these limitations and manage risk more efficiently. Derivatives can be considered an institutional mechanism enabling those seeking to avoid capital losses from asset price fluctuations and those willing to assume that risk in exchange for capital gains to trade the risk itself.
Options are a representative derivative financial product. An option contract is an agreement that grants the right to buy or sell a specific underlying asset at a predetermined price at a future specified point in time or during a specified period. The buyer of the option can exercise this right if buying or selling the underlying asset is advantageous, or forfeit the right if it is disadvantageous. For example, suppose an individual pays an option premium of 500,000 won and enters into an option contract granting the right to purchase up to 100 shares of Company A’s stock at 100,000 won per share in six months. If the stock price falls below 100,000 won six months later, the holder has no obligation to buy the stock at the predetermined price and forfeits the right. The loss incurred in this case is the 500,000 won paid for the option. Conversely, if the stock price exceeds 100,000 won after six months, the option buyer profits by the difference. This is because they can buy at 100,000 won per share and then sell at a higher market price. However, since 500,000 won was already paid when purchasing the option, the stock price must exceed 105,000 won per share for an actual profit to materialize.
Among options, a contract granting the right to buy the underlying asset at a predetermined price at a specific point in time or during a specific period is called a call option. The last day on which this right can be exercised is called the expiration date, and the predetermined purchase price is called the strike price. Holders of call options stand to gain more as the price of the underlying asset rises, so investors anticipating price increases buy call options. In contrast, a contract granting the right to sell the underlying asset at a predetermined price at a specific point in time or within a specified period is called a put option. The holder of a put option stands to gain more as the price of the underlying asset falls significantly in the future. This is because they can buy the underlying asset at a lower market price and then sell it back at the predetermined higher strike price.
Thus, the characteristics and risks of financial assets, along with the development of various financial techniques to manage them, have become essential elements in modern financial markets. When these systems and products are appropriately utilized, investors can pursue returns while controlling risk, and financial markets can function within a more stable structure.
