The Cost of Capital (Read slides) Flashcards
What does giving different weights to available assets allow investors to do?
Build portfolios with different risk/return profile
What does a perfect investment world look like? (The assumptions)
- People trade actively in the market (marginal investors)
- Investors are risk-averse and well diversified
- Diversification has no cost
- Investors have homogenous expectations
Who are marginal investors? (2)
Are wholesaler investors who hold large shares within many companies.
Actively trade these shares so they can affect the price of these shares through trading.
What is the ultimate goal for investors?
Make investments with the best risk-return trade-off
What shape is the efficient frontier for assets?
Looks like the ln graph but doesn’t cross the risk axis and plateaus higher.
Y-axis= return
X-axis= risk
What does free diversification and diversified investors mean for risk in a perfect world?
Only systematic risk is present
Are marginal investors price makers or price takers?
Price makers
What is the main argument as to why only marginal investors are in the majority of markets?
Assume that a diversified investor and a non-diversified investor are both looking at Disney. The latter looks at the stock and sees all risk. The former looks at it and sees only the non-diversifiable risk. If they agree on the expected earnings and cash flows, the former will be willing to pay a higher price. Thus, the latter will get driven out of the market
What is meant by homogenous expectations?
Everyone has the same view/assessment of the risk and return for an asset so has the same efficient frontier of risky assets
There exists a ‘certain’ risky asset, when combined with a risk-free asset, that…
…offers the highest return for an level of risk
What does this combination of a risk free asset and certain risky asset look like on the risk and return diagram?
Look at slides for this slide
What does the risk of a well-diversified portfolio depend on?
the market risk of the securities included in the portfolio
What is the risk of any asset/security? Therefore, what is there?
The risk that it adds to the market portfolio
Correlation between the asset and market portfolio
What is a market portfolio?
A theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market
What does the equilibrium security return depend on? What does is the implication of this?
The asset’s systematic return (not its total risk- standard deviation)
The riskiest stock with the highest standard deviation (total risk) does not necessarily have the largest expected return.