This paper is written under the assumption that the reader is aware of the basic risk premium evaluation models and theories such as the Modern Portfolio Theory and the Capital Asset Pricing Model. This article explains why there was a need for such evaluation mechanisms and why, in some way shape or form, these models were flawed and hence there was and is a need for a new mechanisms for evaluating risk premiums.
Evolution of models to calculate Risk Premiums
In the realm of corporate finance, investments, and valuations, the central pillar of all estimates is the risk premium associated with an asset class. Over the years, there have been many models that have been used to ...view middle of the document...
To tackle this issue, the investor should invest in multiple firms. That way she is spreading the onus of returns and hence the risk across multiple companies in the airline industry. Now consider the scenario where oil prices surge to very high levels and the airlines are forced to increase ticket prices, lowering the demand for air travel. To tackle this possible turn of events, the investor should invest in multiple industries. But what if those industries too are negatively affected by increased oil prices? To answer this question, let’s look at our first model.
Modern Portfolio Theory
The modern portfolio theory or MPT was developed by Dr. Harry Markowitz in 1952 and it laid the foundation of modern portfolio management. MPT suggests that in order to construct an efficient portfolio, the risk and return parameters of the individual equities should not be considered for addition to or removal from the portfolio in silo. Instead, there should be a relative comparison of the security under consideration with the overall portfolio of the investor. He suggested that it is a security’s covariance with the portfolio that determines the incremental risk of the portfolio and hence the incremental returns. This was is what we call diversification to minimize risk.
Here is the mathematical representation of what MPT posits:
The expected return of a portfolio of N stocks is given by:
E[r] = w1 * r1 + w2 * r2 + … + wN * rN
And the variance of the portfolio is given by:
Varp = Σw2 * σ 2 + Σ wi * wj * σi,j
If N is sufficiently large in this case then the first half of the term will tend towards zero. What this implies to our investor is that by investing in multiple stocks one can reduce the some of the risk. This is called the idiosyncratic risk. Otherwise also known as diversifiable, unique or firm-specific risk. The above equation also shows that the second half of the equation does not become small as the number of stocks in the portfolio increase. Thus, diversification cannot eliminate the systematic, or the undiversifiable or the common risk. Our investor is now equipped with the knowledge of diversification. But can he expect to be a successful investor based on just this knowledge. What if everyone was using the same principles of optimization?
To include a few other factors to answer the problem, let us look at few of the assumptions that the MPT makes:
* Returns on an asset are normally distributed
* All investors are rational in that they tend to minimize risk
* The MPT assumes a frictionless market i.e. there are no transactions costs associated with buying and selling of securities
* It also assumes a perfect market where all investors have all the same information required to make investment decisions
* There is unlimited supply of both funds to buy securities and that of the securities itself
These assumptions fail in the real world. There are always transaction costs, fees and taxes, associated with any...