rlt (Xi + ~iRI,t + 'Ilt,t (1) where r., represents the total return of a company's security; at measures the return arising from specific company effects; RI.t represents the return of a broadly based pool of assets characteristic of general business, and 'll,t is a random variable with zero mean and zero intertemporal and intercompany covariance. When the assumptions of the capital asset pricing model are fulfilled a company's risk premium, i.e. its expected return less the pure rate of interest, is proportional to the risk premium of the market as a whole. ~ is the factor of proportionality for it can be shown that: 2 (2) where E is the expectations operator and the R's represent returns. The subscript i denotes the ith company; I, the general index of business conditions; and f, a "safe" security so that R, represents the pure rate of interest." If a firm changes its financial and operating decisions and the market estimates that these actions will affect the corporation's return and risk characteristics, ~ can be expected to change. ~ therefore provides a link between corporate behavior and the market for corporate shares. It follows that an understanding of the determinants
The Journal of Finance – Wiley
Published: May 1, 1973
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