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The previous chapter introduced the reader to Markowitz mean-variance analysis and the Capital Asset Pricing Model. The cost of capital calculated in Chapter 10 assumes that the cost of equity is derived from the Capital Asset Pricing Model and its corresponding beta, or measure of systematic risk. The Gordon Model, used for equity valuation in Chapter 8, assumes that the stock price will fluctuate randomly about its fair market value. The cost of equity is dependent upon the security beta. In this chapter, we address the issues inherent in a multi-beta, or multiple factor risk model. Accurate characterization of portfolio risk requires an accurate estimate of the covariance matrix of security returns. |
