INVESTMENT ANALYSIS
PAST QUESTION AND ANSWER
For comments,
observations, questions and answers, email theotherwomaninmarriage@gmail.com
QUESTION:
What does it mean to assume that all
investors have homogenous expectation? Why is the assumption necessary to capital
market theory?
ANSWER:
Investors have
homogenous expectations, meaning that investors share identical expectations
with regard to the relevant decision period, the necessary decision inputs,
their form and size. Thus, investors are
presumed to have identical expectations regarding expected returns, variances
of expected returns and covariance of all pairs of securities.
As can be seen by
examining these assumptions, the CAPM reduces the situation to an extreme
case. Everyone has the information and
agree about the future prospects for securities. Implicitly this means that investors analyze
and process information in the same way.
The markets for securities are perfect markets, meaning that there are
no frictions to impede investing. Potential impediments such as finite divisibility,
taxes, transaction costs and different risk-free borrowing and lending rates
have been assumed away. This approach allows
the focus to change from how an individual should invest to what would happen
to security prices if everyone invested in a similar manner. Examining the collective behaviour of all
investors in the market place enables one to develop the resulting equilibrium
relationship between each security’s risk and return.
No comments:
Post a Comment