Risk Premium and Risk Return in Capital Markets

1. In the capital market line, investors calculate the risk premium associated with a portfolio of specific stocks. The expected return of the portfolio is equal to the risk free interest rate plus a risk premium multiplied by the portfolio's standard deviation. The risk premium is equal to the expected market returns minus the risk-free return divided by the standard deviation of the market. Key to this approach is the emphasis on the market's performance and the risk associated with the market, as well as the portfolio's performance and the risk associated with the portfolio. Individual securities are not taken into account specifically, but the portfolio and market as a whole--and their associated risks--are evaluated, instead.

The security market line, as its name suggests, is concerned with individual securities. In the case of an individual security, risk is associated with how the security varies in relationship to the market as a whole. Here, covariance is used instead of the standard deviation since the risk of an individual security is measured by its contribution to the risk of its associated portfolio. The security market line also uses the covariance of the market, rather than the standard deviation used with the capital market line. Risk is thus measured by the covariance of each security against the market, and the scale is considerably smaller than the scale of the capital market line. A security that has zero correlation to the market is riskless wh

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pursue any capital structure, and capital structures are not permanent. In other words, a company with a low debt-to-equity ratio may decide to take advantage of a down market to issue debt and buy back its own equity, thus increasing its debt-to-equity ratio and possibly boosting the price of the stock. Similarly, a company with a high debt-to-equity ratio might issue stock to pay off some of the debt and reduce its ratio. These restructurings do not affect the assets of the organization and thus the capital structure can be evaluated and changed without affecting other investment decisions. Issuing debt allows a company's current owners to maintain their ownership shares (percentages), but increases the liabilities of the organization. Issuing new equity maintains a steady debt level, but dilutes the ownership pool. The stock market also tends to be wary of companies with high debt-to-equity ratios, so there are other considerations to take into account, as well. There is no one capital structure that is ideal for all firms all of the time. Instead, the ideal capital structure for any company is dependent on both internal and external factors at any point in time. While there is no one optimal structure for all compa

Category: Economics - R