THE PURPOSE OF THIS CHAPTER

If this book were a novel, the risk premium would clearly be one of its central characters, and this chapter would be a pause in the fast-paced plot, where the author takes a breather and regales the reader with illuminating flashbacks about the childhood of the hero. So, this chapter will not change the plot of the book, but will help the reader understand why its main character (the risk premium) behaves the way it does. More specifically, recall that Chapter 11 gave a very ‘constructive’ derivation of the no-arbitrage conditions, which were obtained by building a very tangible risk-less portfolio, invoking no-arbitrage, and reasoning from there what the ability to do so entailed. Chapter 12 then employed a much more abstract (and general) treatment that starts from the ‘virtual’ prices that the representative investor would assign to some special hypothetical securities. Finally, we looked at the condition of no-arbitrage with real (inflation-linked) bonds. In all of this, we have strictly engaged in ketchup economics (see the quote by Summers, 1985 that opens the chapter). Now we want to take a brief look at what the price of ketchup should be, not which price two bottles of ketchup should fetch, given the price of one (or three) bottles.

What does this mean in practice? When it comes to risk premia, we can try to establish what consistency relationships they should obey (this is the one-bottle/two-bottles bit); we can describe them empirically; or we can try to explain them – which means, we can try to explain why there should be a risk premium at all, whether it should be positive or negative, how large it should be, to which quantities it may be related, and why so.