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A Note on Risk and the Theory of Asset Value

Published online by Cambridge University Press:  19 October 2009

Yoram Peles
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Extract

The purpose of this note is to demonstrate that the explicit introduction of consumption patterns alters the traditional relationship between expected return and variance presented by Markowitz, Tobin, Sharpe, Lintner, and others.

Type
Communications
Information
Journal of Financial and Quantitative Analysis , Volume 6 , Issue 1 , January 1971 , pp. 643 - 647
Copyright
Copyright © School of Business Administration, University of Washington 1971

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References

1 Moreover, the planned consumption itself is not spread evenly through time. There is a kind of indivisibility so that there are several consumption expenditures which are made only once in a while. Vacation is usually taken once in a year. A trip over the sea is taken once in a longer period of time. One's own wedding celebration is, in many cases, made only once in a life time. (With these indivisibilities, it is possible to have segments on the utility-income schedule which have increasing marginal utility of wealth for given periods of time.)

Even if the same level of consumption is preferred whenever there are high costs of transaction, consumption may change with time. For example, in the case of passenger cars, the value of the asset deteriorates with time; therefore, the consumption for the first month of owning the car (namely, the imputed interest plus the decline in the market price) may be higher than that of the last month, before selling it.

2 Buying an insurance policy covering car accidents is an extreme example of hedging. It is buying an asset which has a negative correlation with the return out of the cars. More generally, investors insure specific assets rather than general income.

3 Note the similarity between this analysis and that of the term structure of interest rates. Thus, the conventional theory of the term structure claims that risk aversion leads to a “congenital weakness on the long side of the market [because lenders will prefer to lend short term] which results in a tendency for long rates to exceed short rates.” (Telser, Lester G., “A Critique of Some Recent Empirical Research on the Explanation of the Term Structure of Interest Rates,” Journal of Political Economy, 75 (1967), p. 556).CrossRefGoogle Scholar

4 Part of the risk of changes in prices of raw materials is reduced, since a high correlation between the price of raw materials and the price of the final goods may exist.

There is specialization in risk-reducing due to economies of scale. We may expect the manufacturers rather than each investor to hedge. If inventory holding reduces risk, the holding of inventory will be made by the manufacturers and not by each investor independently.

5 It is so even in a world without transaction costs, therefore, in a world where all the assets yield the same liquidity.

6 Telser, Lester G., “The Supply of Speculative Services in Wheat, Corn, and Soybeans,” Food Research. Institute Studies, Supplement to Volume 7 (1967), p. 174.Google Scholar

7 Telser, , “Critique of Recent Empirical Research,” p. 560.Google Scholar