R7.P1.T1.Elton_Topic: Impact_on_CAPM_Price_Affector

[gargi.adhikari]

In reference to R7.P1.T1.Elton_Topic: Impact_on_CAPM_Price_Affector :-
Should it say --> Price Affector will hold Less-of the " Risky-Assets"...? instead of Less of "RiskLess"- Assets..?

Trying to make sure am not understanding it wrong...

 

[David Harper CFA FRM]

Hi @gargi.adhikari No, I think it is correct as shown (please see quote below, emphasis mine). In my paraphrase, this concerns the CAPM assumption that all investors are "price takers" (among the set of conditions for a so-called efficient market). This is the classic assumption that you or myself don't impact the price of an asset (eg, stock) because we buy or sell it (another way to look at this assumption is that endogenous liquidity does not exist). Personally, I think this assumption is not realistic: I think that prices often set "at the margin" by large institutions conducting block trades. Or, think even Warren Buffet: his purchase can move a stock up. So, I might be simplifying the math here but I think this is saying: price makers (the big firms who can push up a stock price by purchasing the stock) will tend to hold more risky assets (i.e., less of the riskless asset) because they have a (slightly) higher view of the future price (they understand it will increase with their purchase), and I *think* the comment that "the market price of risk [ i.e., the equity risk premium, E[R(m) - Rf] is lower than it would be if all investors were price takers" refers to the fact that these investors have an effectively higher risk premium of (E[R(m) - Rf) + (some additional factor) such that non price makers have an effectively lower risk premium. I hope that is helpful!

"NON-PRICE-TAKING BEHAVIOR: Up to now we have assumed that individuals act as price takers in that they ignore the impact of their buying or selling behavior on the equilibrium price of securities and, hence, on their optimal portfolio holdings. The obvious question to ask is what happens if there are one or more investors, such as mutual funds or large pension funds, who believe that their behavior impacts price. The method of analysis used by Lindenberg (1976, 1979) derives equilibrium conditions under all possible demands by the price affector. The price affector selects her portfolio to maximize utility given the equilibrium prices that will result from her action. Assuming that the price affector operates so as to maximize utility, we can then arrive at equilibrium conditions. Lindenberg finds that all investors, including the price taker, hold some combination of the market portfolio and the riskless asset. However, the price affector will hold less of the riskless asset (will be less of a risk avoider) than would be the case if the price affector did not recognize the fact that her actions affected price. By doing so, the price affector increases utility. Because the price affector still holds a combination of the riskless asset and the market portfolio, we still get the simple form of the CAPM, but the market price of risk is lower than it would be if all investors were price takers. Lindenberg (1979) goes on to analyze collective portfolio selection and efficient allocation among groups of investors. He finds that by colluding or merging, individuals or institutions can increase their utility. This analysis provides us with one reason for the existence of large financial institutions."

 

[gargi.adhikari]

@David Harper CFA FRM Got It ! Thanks so much for the clarification..You just cleared my Brain Fog on this one ! Infinite Gratitude to you once again !