Toward a Theory of Market Value of Risky Assets

This chapter addresses the theory of market value that incorporates risk, considering a highly idealized model of a capital market in which it is relatively easy to see how risk premiums implicit in present share prices are related to the portfolio decisions of individual investors. Investors may differ, depending on their capital and attitudes toward risk, in the absolute amount of the dominant combination of risky investments they undertake, but if their (probabilistic) forecasts of future value agree, then the proportionate composition of the risky assets must be the same. Unless he hoards cash, the investor will receive a return on his capital at the risk-free lending rate no matter how he invests his money, plus a risk premium, the expected value of which depends only on the risk premium for the respective investments and the position he elects to hold in each. The risk-premium concept is thus a useful one for talking about the portfolio problem under the assumptions, since, together with the uncertainty associated with a given investment, it is the relevant investment parameter.

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