Principles of Corporate Finance Brealey and Myers u
Principles of Corporate Finance Brealey and Myers u Sixth Edition Risk and Return Slides by Matthew Will Irwin/Mc. Graw Hill Chapter 8 ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 2 Topics Covered w Markowitz Portfolio Theory w Risk and Return Relationship w Testing the CAPM w CAPM Alternatives Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 3 Markowitz Portfolio Theory w Combining stocks into portfolios can reduce standard deviation below the level obtained from a simple weighted average calculation. w Correlation coefficients make this possible. w The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 4 Markowitz Portfolio Theory Price changes vs. Normal distribution # of Days (frequency) Microsoft - Daily % change 1986 -1997 Daily % Change Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 5 Markowitz Portfolio Theory Price changes vs. Normal distribution # of Days (frequency) Microsoft - Daily % change 1986 -1997 Daily % Change Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 6 Markowitz Portfolio Theory Standard Deviation VS. Expected Return % probability Investment C % return Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 7 Markowitz Portfolio Theory Standard Deviation VS. Expected Return % probability Investment D % return Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 8 Markowitz Portfolio Theory u Expected Returns and Standard Deviations vary given different weighted combinations of the stocks. Expected Return (%) Mc. Donald’s 45% Mc. Donald’s Bristol-Myers Squibb Standard Deviation Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 9 Efficient Frontier • Each half egg shell represents the possible weighted combinations for two stocks. • The composite of all stock sets constitutes the efficient frontier. Expected Return (%) Standard Deviation Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 10 Efficient Frontier • Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier. Expected Return (%) T ing w o rr Bo ing d n Le rf S Standard Deviation Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 11 Efficient Frontier Example Stocks ABC Corp Big Corp s 28 42 Correlation Coefficient =. 4 % of Portfolio Avg Return 60% 15% 40% 21% Standard Deviation = weighted avg = 33. 6 Standard Deviation = Portfolio = 28. 1 Return = weighted avg = Portfolio = 17. 4% Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 12 Efficient Frontier Example Stocks ABC Corp Big Corp s 28 42 Correlation Coefficient =. 4 % of Portfolio Avg Return 60% 15% 40% 21% Standard Deviation = weighted avg = 33. 6 Standard Deviation = Portfolio = 28. 1 Return = weighted avg = Portfolio = 17. 4% Let’s Add stock New Corp to the portfolio Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 13 Efficient Frontier Example Stocks Portfolio New Corp s 28. 1 30 Correlation Coefficient =. 3 % of Portfolio Avg Return 50% 17. 4% 50% 19% NEW Standard Deviation = weighted avg = 31. 80 NEW Standard Deviation = Portfolio = 23. 43 NEW Return = weighted avg = Portfolio = 18. 20% Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 14 Efficient Frontier Example Stocks Portfolio New Corp s 28. 1 30 Correlation Coefficient =. 3 % of Portfolio Avg Return 50% 17. 4% 50% 19% NEW Standard Deviation = weighted avg = 31. 80 NEW Standard Deviation = Portfolio = 23. 43 NEW Return = weighted avg = Portfolio = 18. 20% NOTE: Higher return & Lower risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 15 Efficient Frontier Example Stocks Portfolio New Corp s 28. 1 30 Correlation Coefficient =. 3 % of Portfolio Avg Return 50% 17. 4% 50% 19% NEW Standard Deviation = weighted avg = 31. 80 NEW Standard Deviation = Portfolio = 23. 43 NEW Return = weighted avg = Portfolio = 18. 20% NOTE: Higher return & Lower risk How did we do that? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 16 Efficient Frontier Example Stocks Portfolio New Corp s 28. 1 30 Correlation Coefficient =. 3 % of Portfolio Avg Return 50% 17. 4% 50% 19% NEW Standard Deviation = weighted avg = 31. 80 NEW Standard Deviation = Portfolio = 23. 43 NEW Return = weighted avg = Portfolio = 18. 20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 17 Efficient Frontier Return B A Risk (measured as s) Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 18 Efficient Frontier Return B AB A Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 19 Efficient Frontier Return AB A N B Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 20 Efficient Frontier Return ABN AB A N B Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 21 Efficient Frontier Goal is to move up and left. Return WHY? ABN AB A N B Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 22 Efficient Frontier Return Low Risk High Return Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 23 Efficient Frontier Return Low Risk High Return Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 24 Efficient Frontier Return Low Risk High Return Low Risk Low Return Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 25 Efficient Frontier Return Low Risk High Return Low Risk High Risk Low Return Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 26 Efficient Frontier Return Low Risk High Return Low Risk High Risk Low Return Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 27 Efficient Frontier Return ABN AB A N B Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 28 Security Market Line Return . Efficient Portfolio Risk Free Return = rf Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 29 Security Market Line Return Market Return = rm Efficient Portfolio Risk Free Return . = rf Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 30 Security Market Line Return Market Return = rm Efficient Portfolio Risk Free Return . = rf Risk Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 31 Security Market Line Return Market Return = rm . Efficient Portfolio Risk Free Return = rf 1. 0 Irwin/Mc. Graw Hill BETA ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 32 Security Market Line Return Market Return = rm Security Market Line (SML) Risk Free Return = rf 1. 0 Irwin/Mc. Graw Hill BETA ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 33 Security Market Line Return SML rf 1. 0 BETA SML Equation = rf + B ( rm - rf ) Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 34 Capital Asset Pricing Model R = rf + B ( rm - rf ) CAPM Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 35 Testing the CAPM Beta vs. Average Risk Premium Avg Risk Premium 1931 -65 SML 30 20 Investors 10 Market Portfolio 0 1. 0 Irwin/Mc. Graw Hill Portfolio Beta ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 36 Testing the CAPM Beta vs. Average Risk Premium Avg Risk Premium 1966 -91 30 20 SML Investors 10 Market Portfolio 0 1. 0 Irwin/Mc. Graw Hill Portfolio Beta ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 37 Testing the CAPM Company Size vs. Average Return (%) Company size Smallest Irwin/Mc. Graw Hill Largest ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 38 Testing the CAPM Book-Market vs. Average Return (%) Book-Market Ratio Highest Irwin/Mc. Graw Hill Lowest ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 39 Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth = market portfolio Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 40 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain. Wealth = market portfolio Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 41 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain. Standard CAPM Wealth = market portfolio Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 42 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain. Wealth = market portfolio Irwin/Mc. Graw Hill Stocks (and other risky assets) Standard CAPM Consumption ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 43 Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain. Standard Wealth CAPM Consumption is uncertain Wealth = market portfolio Irwin/Mc. Graw Hill Consumption ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 44 Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain. Standard Wealth CAPM Consumption is uncertain Wealth = market portfolio Irwin/Mc. Graw Hill Consumption ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 45 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - rf = Bfactor 1(rfactor 1 Irwin/Mc. Graw Hill - rf) + Bf 2(rf 2 - rf) + … ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 46 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - rf = Bfactor 1(rfactor 1 Return Irwin/Mc. Graw Hill - rf) + Bf 2(rf 2 - rf) + … = a + bfactor 1(rfactor 1) + bf 2(rf 2) + … ©The Mc. Graw-Hill Companies, Inc. , 2000
8 - 47 Arbitrage Pricing Theory Estimated risk premiums for taking on risk factors (1978 -1990) Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
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