3

The Implicit Cost of Mezzanine Products

We already concluded in Chapter 1 that in terms of a risk profile, the mezzanine product group fits nicely between the debt product group and the equity area. As this is valid in terms of product characteristics and risk being absorbed by the respective product groups, it makes sense to assume that from a ‘cost of capital’ perspective the product group also sits comfortably in the middle. At least, if we are willing to assume that we live in a risk–return world, and if we are also able to reflect these ideas in a theory which makes these assumptions applicable across the board for the product group, thereby creating uniformity in the way risk is measured. Although there are a number of theories around which claim to do this, we will focus on the one theory which, despite the large number of issues and defaults that have been revealed ever since the theory came to light decades ago, is still the dominant default theory when considering risk in modern finance. It is fair to say that at this point I don't share many of the views and assumptions the theory makes. Where needed I will provide my humble opinion on where the theory's weak spots are. It is fair to say that, when it comes to measuring the risk of an equity security, I am very much in the Buffett camp. I will clarify that later, when focusing on specific aspects of the theory.

3.1 MEASURING RISK

When trying to come up with a theory to measure risk ‘tabula rasa,’ we would probably ...

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