(BQ) Part 2 book “Corporate finance - The core” has contents: Capital markets and the pricing of risk, capital markets and the pricing of risk, investor behavior and capital market efficiency, financial distress, managerial incentives and information, payout policy, and other contents. | Part Risk and Return THE LAW OF ONE PRICE CONNECTION. To apply the Law of One Price correctly requires comparing investment opportunities of equivalent risk. In this part of the book, we explain how to measure and compare risks across investment opportunities. Chapter 10 introduces the key insight that investors only demand a risk premium for risk they cannot costlessly eliminate by diversifying their portfolios. Hence, 4 Chapter 10 Capital Markets and the Pricing of Risk only non-diversifiable market risk will matter when comparing investment opportunities. Intuitively, this insight suggests that an investment’s risk premium will depend on its sensitivity to market risk. In Chapter 11, we quantify these ideas and derive investors’ optimal investment portfolio choices. We then consider the implications of assuming all investors choose their portfolio of risky investments optimally. This assumption leads to the Capital Asset Pricing Model (CAPM), the central model in financial economics that quantifies the notion of “equivalent risk” and thereby provides the relation between risk and return. In Chapter 12, we apply these ideas and consider the practicalities of estimating the cost of capital for a firm and for an individual invest- Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model ment project. Chapter 13 takes a closer look at the behavior of individual, as well as professional, investors. Doing so reveals some strengths and weaknesses of the CAPM, as well as ways we can combine the CAPM with the principle of no arbitrage for a more general model of risk and return. Chapter 12 Estimating the Cost of Capital Chapter 13 Investor Behavior and Capital Market Efficiency 349 349 8/20/16 3:42 PM CHAP TE R 10 Notation pR probability of return R Var (R ) variance of return R SD (R ) standard deviation of return R E [R ] expectation of return R Divt .
