[PEN-L:12021] Re: Re: equity premium

[James Devine <jdevine@xxxxxxxxxxxxxxx>]

Doug wrote:>That's a very fine distinction [between volatility and
utility preferences for avoiding volatility]. Can you explain how it matters?<

Chuck Higgins responds: >A fine distinction is indeed needed.

>For the CAPM and equities in general, the premium is determined by Market
premium and the coefficient of the security's return which is
non-diversifiable with the market return. [a stock with a high "beta" (high
correlation with the rest of the market) has a high risk premium.]

>For options, the option pricing model predominantly prices the assymetric
component of the expected "in the money" payoff.

>However, utility theory generally holds that an additional premium is
added to the expected return generally increasing with additional uncertainty.

>The point being is that these three premium mechanisms may not (probably
would not) price a risky security identically.

>My conjecture is that the third mechanism may add (more or less) an
additional premium requiring an additional return.<

I don't quite get all of this, so it's gratifying that Chuck adds:

>As to the second comment [about] driving people away driving the return
higher is some ways profoundly and exactly right.  That once culled, the
remaining players (the choir convinced) willingly accept the risk and drive
prices higher.<

Maybe this stuff is too technical for pen-l...



in pen-l solidarity,

Jim Devine   jdevine@xxxxxxxxxxxxxxx
http://clawww.lmu.edu/fall%201997/ECON/jdevine.html
Econ. Dept., Loyola Marymount Univ.
7900 Loyola Blvd., Los Angeles, CA 90045-8410 USA
310/338-2948 (daytime, during workweek); FAX: 310/338-1950
"Segui il tuo corso, e lascia dir le genti." (Go your own way
and let people talk.) -- K. Marx, paraphrasing Dante A.