Academic Theory
Academic theory claims that higher-risk investments should have higher returns over the long-term. Wall Street has a saying that "higher return requires higher risk", not that a risky investment will automatically do better. Some things may just be poor investments (e.g., playing roulette). Further, highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma). Theoretically, a negative beta equity is possible; for example, an inverse ETF should have negative beta to the relevant index. Also, a short position should have opposite beta.
This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the Capital Asset Pricing Model (CAPM). According to the model, the expected return on equity is a function of a firm's equity beta (βE) which, in turn, is a function of both leverage and asset risk (βA):
where:
- KE = firm's cost of equity
- RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury Bonds)
- RM = return on the market portfolio
because:
and
- Firm Value (V) + Cash and Risk-Free Securities = Debt Value (D) + Equity Value (E)
An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e. the Geared Beta.
Read more about this topic: Beta (finance)
Famous quotes containing the words academic and/or theory:
“The poker player learns that sometimes both science and common sense are wrong; that the bumblebee can fly; that, perhaps, one should never trust an expert; that there are more things in heaven and earth than are dreamt of by those with an academic bent.”
—David Mamet (b. 1947)
“The theory [before the twentieth century] ... was that all the jobs in the world belonged by right to men, and that only men were by nature entitled to wages. If a woman earned money, outside domestic service, it was because some misfortune had deprived her of masculine protection.”
—Rheta Childe Dorr (1866–1948)