The Risk-Adjusted Return Theory

Abstract

In this paper, a new theory is developed to quantify the relation between risks and a return required by an investor. This theory is built on the principle that a required return is a product of a risk an investor is expected to take and the return per unit of the risk required by the investor. It is formulated separate from the equilibrium and arbitrage principles. The theory is grounded on the Modern Portfolio Theory and the Behavioral Decision Theory. It can be applied in random variable spaces and is more instructive, having a broader use than the Capital Asset Pricing Model and Arbitrage Pricing Theory. An investor's optimal risk budgeting can be lucidly implemented with this new theory.

Keywords: CAPM, APT, MPT, Risk-adjusted Return, Risk Budgeting, Asset Pricing Moedl, semivariance, downside risk, asymmetric risk

JEL Classification: C51, G11, G12, D81