Address Challenges Markowitz (1952) Faces: A New Measure of Asset Risk

Markowitz (1952) asset risk (MAR) has long been challenged. First, as an impostor of asset risk, volatility captures the noise of asset risk over maturity that improperly reflects asset risk (which has to be measured over a unit of time length to be cumulative since asset holder’s risk approaches zero as the holding time length approaches zero). Second, we argue that asset risk approaches zero as distance approaches zero, and that asset risk drives volatility, but not vice versa, implying that asset risk cannot be diversified away. Third, support to MAR appears to arise from a confusion between asset value and wealth utility: the law of diminishing marginal utility supports that volatility reduces the latter. The above causes explain why CAPM and Fama-French models have long been struggling to price asset volatilities. To address the challenges, we propose that the volatility (variance) of realized (expected) asset value approaches zero as distance approaches zero. We delineate expected asset value (which asset risk impacts without a distribution) and volatility (which does not affect the former while following a lognormal distribution with the risk noise following a normal distribution). Our asset risk for a specific asset excludes the macrorisk in Nie (2024a) that is tied to all assets denominated by the currency. We show that equity price is the present value of a spanning bond, a payment spanning over the predictable lifetime of firm performance, and that an option is an equity bond whose price minus the present value mirrors the overcharge or transaction cost. Our examples show how to compute debt and equity risk. Our asset risk, captured as risk premium, thus solves issues that have long been challenging agency theories, thereby redefining firm misevaluation theory.