Operation of the Capital Market Under Entity Specific Pricing

Abstract

ABSTRACTThe paper introduces a setting in which each business in an economy faces considerable uncertainty about the cost of providing its service and therefore needs risk capital to give consumers confidence in its solvency. The paper then explores the operation of the capital market under conditions where businesses charge for this service dependability by setting an entity specific profit margin.This entity specific profit margin is associated with an optimal, arbitrage-free investment portfolio for investors and, as they optimise their portfolios, generates a market equilibrium. Under these conditions it is shown that the entity specific risk premium for investors is the same as the premium for non-diversifiable risk relative to the market portfolio. This reconciles an entity specific approach with the capital asset pricing model, and in this setting would allow the use of the former without having to explicitly take the latter into consideration.A consequence of this is that entity specific pricing and valuation are fair in such an setting and, for example, the fair value accounting of insurance liabilities can be performed on an entity specific basis.