Chapter 7 Introduction to Risk Return and The

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Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Mc. Graw-Hill/Irwin

Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Mc. Graw-Hill/Irwin Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved

Topics Covered Ø Over a Century of Capital Market History Ø Measuring Portfolio Risk

Topics Covered Ø Over a Century of Capital Market History Ø Measuring Portfolio Risk Ø Calculating Portfolio Risk Ø Beta and Unique Risk Ø Diversification & Value Additivity Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 2

The Value of an Investment of $1 in 1900 Mc. Graw-Hill/Irwin Copyright © 2006

The Value of an Investment of $1 in 1900 Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 3

The Value of an Investment of $1 in 1900 Real Returns Mc. Graw-Hill/Irwin Copyright

The Value of an Investment of $1 in 1900 Real Returns Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 4

7 - 5 Average Market Risk Premia (by country) Risk premium, % Country Mc.

7 - 5 Average Market Risk Premia (by country) Risk premium, % Country Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved

Rates of Return 1900 -2003 Percentage Return Stock Market Index Returns Year Source: Ibbotson

Rates of Return 1900 -2003 Percentage Return Stock Market Index Returns Year Source: Ibbotson Associates Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 6

7 - 7 Measuring Risk Histogram of Annual Stock Market Returns # of Years

7 - 7 Measuring Risk Histogram of Annual Stock Market Returns # of Years Return % Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved

Measuring Risk Variance - Average value of squared deviations from mean. A measure of

Measuring Risk Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation - Average value of squared deviations from mean. A measure of volatility. Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 8

Measuring Risk Coin Toss Game-calculating variance and standard deviation Mc. Graw-Hill/Irwin Copyright © 2006

Measuring Risk Coin Toss Game-calculating variance and standard deviation Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 9

Measuring Risk Diversification - Strategy designed to reduce risk by spreading the portfolio across

Measuring Risk Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk. ” Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk. ” Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 10

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 11

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 12

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All

Measuring Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 13

Portfolio Risk The variance of a two stock portfolio is the sum of these

Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 14

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is: Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 15

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18. 2% and 27. 3%, respectively. Assume a correlation coefficient of 1. 0 and calculate the portfolio variance. Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 16

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and

Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18. 2% and 27. 3%, respectively. Assume a correlation coefficient of 1. 0 and calculate the portfolio variance. Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 17

Portfolio Risk In real life, the correlation coefficient is 0. 4 Suppose you invest

Portfolio Risk In real life, the correlation coefficient is 0. 4 Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18. 2% and 27. 3%, respectively. Assume a correlation coefficient of 0. 4 and calculate the portfolio variance. Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 18

Portfolio Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All

Portfolio Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 19

7 - 20 Portfolio Risk The shaded boxes contain variance terms; the remainder contain

7 - 20 Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 STOCK To calculate portfolio variance add up the boxes 4 5 6 N 1 2 3 4 5 6 N STOCK Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved

7 - 21 Beta and Unique Risk 1. Total risk = diversifiable risk +

7 - 21 Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes Expected stock return beta +10% - 10% +10% -10% Copyright 1996 by The Mc. Graw-Hill Companies, Inc Mc. Graw-Hill/Irwin Expected market return Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved

Beta and Unique Risk Market Portfolio - Portfolio of all assets in the economy.

Beta and Unique Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio. Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 22

Beta and Unique Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies,

Beta and Unique Risk Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 23

Beta and Unique Risk Covariance with the market Variance of the market Mc. Graw-Hill/Irwin

Beta and Unique Risk Covariance with the market Variance of the market Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 24

Web Resources Click to access web sites Internet connection required www. globalfindata. com www.

Web Resources Click to access web sites Internet connection required www. globalfindata. com www. econ. yale. edu/~shiller Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved 7 - 25