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The Cost and the Benefit of Risk

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In the previous chapter, we developed the tools to calculate and measure risk. We learned about probability distributions , expected values , covariance , and the power of diversification . But we left a critical question unanswered: what is the cost of risk ? We stated that investors are risk-averse and require a risk premium , but we did not quantify it. This chapter tackles that challenge head-on. We will explore how to calculate the cost of risk, examine common mistakes in doing so, and finally, consider the other side of the coin: the potential benefit that risk can bring. 6.1 The Cost of Risk The cost of risk is not a physical cost like a raw material or a wage. It is an opportunity cost. It represents what investors give up, or the extra return they demand, to bear uncertainty. To understand this, imagine two projects: Project A: A risk-free bond that guarantees a return of €100 in one year. Project B: A risky venture with an expected return of €100 in one year, but with a...
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