ABSTRACT
§ 2-1. In Chapter 1, we identified some of the pitfalls that can arise from the incorrect calculation and averaging of the returns that accrue on shares, bonds, portfolios and other financial instruments. Historical returns are often used to provide guidance about the likely magnitude of future returns on a given security or financial instrument and of the current prices that ought to be paid for them. Moreover, historical returns are also used to assess the risks that are likely to arise from particular investments. Our purpose in this chapter is to summarize the relationships that exist between the returns that arise on particular investments and the risks that must be taken to achieve them. We also determine what implications these relationships will have for the pricing of risky assets. We begin our analysis in the next section with a consideration of how the risks associated with investments shape the returns that we can expect from them. We then go on to demonstrate how assets are priced so as to be compatible with the risks and returns that arise from them.
