Question

You set up a firm to advise the unemployed on the best way to use their time to earn money. Your firm issues shares on the stock market. In equilibrium, will your shares be expected to earn a higher or lower return than the stock market average ? Why?

Short answer

In equilibrium, your shares should earn a higher return than the stock market average because they likely present a higher risk.

Step-by-step solution

Understand the Concept of Risk and Return

In finance, the expected return of a security is linked to its risk level. Higher risk usually demands a higher expected return. When evaluating different stocks, especially for a new business like your firm, it's essential to consider where it falls on the risk-return spectrum compared to the market average.

Assess the Risk Level of Your Firm

Your firm advises the unemployed on earning money, which may be a niche or unconventional sector. Niche industries often carry higher risk due to factors such as market size, economic conditions, and feasibility of success. This positions your firm potentially at a higher risk than the average stock, affecting expected returns.

Consider Market Equilibrium

In market equilibrium, all available information is reflected in the stock prices, and investors require a return commensurate with the risk. Since your firm likely has higher risk, under efficient market conditions, the shares would need to offer a higher expected return to attract investors.

Compare with Stock Market Average

Typically, firms that are riskier than average need to provide higher expected returns to compensate investors for taking on more risk. Thus, if your firm is indeed riskier, it should be expected to earn a higher return than the average stock, according to equilibrium principles.

Key concepts

Stock Market Equilibrium

Stock market equilibrium occurs when the supply of securities matches the demand at a given price level. In this state, the prices of stocks accurately reflect all available information about a company’s risk and expected return. There is no incentive for buyers or sellers to enter or exit the market as everyone has the same information, leading to stable prices.

For a new company entering the market, like your firm advising the unemployed, understanding equilibrium is vital. If the market perceives your firm as riskier due to its niche focus, it will need to offer higher returns to reach equilibrium. Investors expect to be compensated for the additional risk they take. This way, in equilibrium, the expected returns would align with the perceived risks, ensuring the stock price is stable.

Achieving equilibrium involves aligning your stock offerings so they reflect the firm's risk and return prospects accurately. It can be thought of as balancing a scale where the weight of risk is matched with the reward of expected returns. When this balance is achieved, your stock can compete effectively within the market.

Risk Assessment

Risk assessment is crucial for determining the potential success of your firm's shares in the stock market. It involves analyzing various factors that could affect your business's performance, like market size, economic trends, and industry competition.

Since your firm is in a niche sector, it may face a higher degree of uncertainty compared to well-established companies. This higher risk needs careful assessment because it influences how investors perceive your stock. A comprehensive risk assessment can include:

• Evaluating the market demand for your advisory services
• Studying economic conditions that may impact your clients
• Understanding regulatory changes that could affect the sector

These factors collectively determine the risk level, which directly influences the expected return for investors. A riskier firm typically needs to offer more attractive returns to persuade investors to accept the higher uncertainty.

Expected Return Analysis

Expected return analysis evaluates how much profit or return an investor anticipates receiving from an investment, such as stocks issued by your firm. It is directly connected to the risk level an investor is willing to accept.

To calculate the expected return, investors often look at historical data, compare similarly positioned firms, or analyze future prospects. These components help them estimate the potential return in monetary terms for bearing the associated risk.

• High expected returns generally correlate with high risk.
• The calculation involves factors like dividends, capital gains, and market conditions.
• Investors will require returns that match the risk inherent in buying your shares.

When your firm offers shares with higher perceived risk, the expected return analysis will reflect this risk by predicting a higher return compared to safer investments. Thus, by understanding expected return analysis, you can better structure your firm’s offerings to meet investor expectations, ensuring it remains attractive under equilibrium conditions.