MARKET VALUE AND SYSTEMATIC RISK

Abstract

ONE OF THE CENTRAL ISSUES in the theory of finance is the relationship between expected risk and expected return required by individuals investing in assets. The Capital Asset Pricing Model (CAPM)' provides such a theoretical relationship under conditions of market equilibrium. Explicitly, the model states that the expected one-period return for an asset is a linear function of its systematic risk, which is a measure of the responsiveness of the asset's return to changes in the return on the market as a whole. Proposed applications of the CAPM have ranged from strategies for security selection, measurement of investment performance, establishing a structure of managerial fees, to estimating the cost of capital. Such applications usually involve estimating the systematic risk of a firm's equity. Generally, it is assumed that systematic risk is constant over some arbitrary time period and can be estimated using time series data. In the time series testing of the validity of the CAPM to equity securities, though elaborate portfolio construction procedures are used, it is implicitly assumed that systematic risk of equity is constant.2 Yet, there is an increasing amount of empirical evidence by Blume [1971], White [1972], and others indicating that systematic risk of equity is non-stationary. Given the theoretical and practical importance of systematic risk, it is pertinent to enquire about its determinants. In a survey of recent empirical work, Myers [1975] tentatively suggests that systematic risk of equity appears to be related to four variables: financial leverage, earnings variability, growth, and an accounting or cyclical beta, which is a measure of the covariance between swings in the firm's earnings and swings in the general economy. However, most of the empirical studies suffer from the deficiency of lacking any theoretical framework, relying upon intuition for their structural development. To describe the determinants of systematic risk, it is necessary to consider the general question of describing the determinants of market value. Black [1969] drawing upon some unpublished work of Treynor, has argued that the value of an uncertain cash flow depends upon various economic variables, such as the level of