When are investment projects in the same risk class?

Authors

David Johnstone, University of SydneyFollow

RIS ID

115703

Publication Details

Johnstone, D. (2017). When are investment projects in the same risk class?. Accounting and Finance, 57 (2), 499-510.

Abstract

If two investments have the same pay-off covariance with the market but one has higher expected pay-off, which asset according to the CAPM has most risk? One answer is that as far as risk goes the two assets are the same, because they have the same covariance with the market. The correct answer, pointed out nearly four decades ago by Eugene Fama, but long overlooked, is that investments have the same risk, the same returns beta and the same CAPM discount rate if and only if they have the same ratio of ex ante pay-off covariance to pay-off mean. This insight clarifies much of the conventional wisdom that surrounds capital budgeting and 'risk-adjusted' discount rates, while also displaying the mechanics by which information arrival affects the CAPM cost of capital.