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Market Equilibrium. Define the tenu "marginal investor" and explain how this concept is used
in financial assets and markets analysis. Discuss whether the Enroa WorldCom scandals (which
involved fraud or serious misrepresentations by company executives, accountants, security
analysts, lawyers, and bankers) might either narrow or widen differences between different
investors' views of individual stocks' values.
Solution
MARGINAL INVESTOR : Risk is an integral part of valuation. When we try to value a
company or equity, we use the cost of capital or the cost of equity as the discount rate. For equity
investors, the cost of equity is the expected return they need to make in the long term to
compensate the risk that they have taken by investing in the equity of the firm.
However, if there are thousands of investors in a firm, whom should we listen to determine the
cost of equity? It’s always the marginal investors. To qualify as the marginal investor, he
needs to satisfy two criteria – 1. He should own significant portion of the equity 2. He should
trade on that equity. If an investor owns 1000 shares of Novartis, he will have no impact on the
stock price and neither if he owns millions of shares and never trades.
It is assumed that the marginal investors set the prices and hence their assessment of risk should
define how we should think about the risk. If the marginal investors are diversified, the only risk
they care about is the market risk i.e. the risk that they cannot diversify. If they are not
diversified, they will care about all the risks in the company.

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