Various risk and return models is used to compute the cost of equity but they all...

Various risk and return models is used to compute the cost of equity but they all assume that the marginal investor is well diversified. If you use these models to estimate cost of equity for private or closely held firms, you are likely to under or over estimate the cost of equity. How would you fix the bias?

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Expert Solution

Various models which are used to determine the cost of equity already assumes that investor has properly diversified portfolio and he is completely hedged against any kind of unsystematic risk so his portfolio has been completely diversified and his unsystematic risk is completely eliminated out of portfolio and he is only exposed to the systematic risk and the market risk which can never be diversified so these models are often trying to to calculate the cost of equity based upon systematic risk like Capital Asset pricing model.

I will be trying to ascertain the risk of investment into a security through unsystematic risk factors and I will be trying to ascertain the overall risk in the portfolio by standard deviation as the standard deviation is not only just accounting for systematic this but it is also accounting for the micro risk factor and I will also try to find out the the particular and a specific analysis approach in order to determine the risk related to investment into a security because various securities have a specified risk and those are reflected through unsystematic risk and these risk are to be accounted into the process of investing because in the real life every investor is not well diversified and he is exposed to the firm specific risk, so I will be trying to ascertain the risk of the firm by individual analysis and I will be trying to find the unsystematic risk of the portfolio and I will be trying to factor in the standard deviation as well because standard deviation will be a calculation of the overall risk of the portfolio and it is not only accounting for the systematic response and so we can get over the models like Capital Asset pricing model and arbitrage pricing theory and we will be trying to enhance upon them by inclusion of the unsystematic risk factors.

jeff jeffy answered 2 years ago

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