Diversifying the Swedish Market Portfolio

Abstract: According to the Capital Asset Pricing Model (CAPM), the cost of equity estimates are a function of the systematic risk relative to the market portfolio. The market portfolio is a non-observable portfolio containing all investible assets in the world. CAPM is a well-established model in practice. However, most practitioners use an equity-only proxy to calculate the estimated cost of equity. In this thesis, we construct six different market portfolio-proxies that include equities, government bonds, real estate, and corporate bonds, to find how estimates of beta and cost of equity in Swedish financial markets are affected. We run regressions on industry portfolios and find that broader proxies of the market portfolio have substantial effects on estimates. To compare our results from the regressions with investors’ investment choices in practice, we investigate new regulations of Swedish public pension funds. Starting 1st of January 2019, the legislation regarding Swedish public pension funds has been changed to adjust to the characteristics of financial markets today. We conclude that the new legislation is in line with our results. Therefore, broader approximations of the market portfolio should not be ruled out by practitioners when estimating market risk and cost of equity.