Finance Lecture:Risk, Return and the Cost of Equity            Brad Simon
Lecture Overview     Risk and Return     Measuring Returns     Volatility     Portfolios     Diversification     Ris...
Motivating the topic: Risk and Return3
Motivating the topic: Risk and Return     The relationship between risk and return is     fundamental to finance theory4
Motivating the topic: Risk and Return     The relationship between risk and return is      fundamental to finance theory ...
Motivating the topic: Risk and Return     The relationship between risk and return is      fundamental to finance theory ...
Motivating the topic: Risk and Return     The relationship between risk and return is      fundamental to finance theory ...
Historical Returns8
Historical Returns                          Ending Price - Beginning   Price      Dividend    Percentage   Return         ...
Historical Returns                           Ending Price - Beginning   Price         Dividend     Percentage   Return    ...
Historical Returns                           Ending     Price     -Beginning     Price         Dividend     Percentage   R...
Historical Returns12
Historical Returns      Percent return = Capital gains yield +      Dividend Yield13
Historical Returns      Percent return = Capital gains yield +      Dividend Yield       Capital gains yield = ($34.90 - ...
Historical Returns      Percent return = Capital gains yield +      Dividend Yield       Capital gains yield = ($34.90 - ...
Historical Returns      Percent return = Capital gains yield +      Dividend Yield       Capital gains yield = ($34.90 - ...
Volatility17
Volatility      High volatility in historical returns are an       indication that future returns will be volatile18
Volatility      High volatility in historical returns are an       indication that future returns will be volatile      ...
Volatility      High volatility in historical returns are an       indication that future returns will be volatile      ...
Volatility      High volatility in historical returns are an       indication that future returns will be volatile      ...
Volatility      High volatility in historical returns are an       indication that future returns will be volatile      ...
Volatility - Example23
Volatility - Example      Example:        Using the following returns, calculate the average         return, the varianc...
Volatility - Example      Example:        Using the following returns, calculate the average         return, the varianc...
Volatility - Example     Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =      4.80%26
Volatility - Example     Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =      4.80%     σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (...
Volatility - Example     Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =      4.80%     σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (...
Volatility - Example     Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =      4.80%     σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (...
Volatility - Application30
Volatility - Application31
Volatility - Application      The volatility of stocks is much higher than the      volatility of bonds and T-bills32
Volatility - Application      The volatility of stocks is much higher than the       volatility of bonds and T-bills     ...
Diversifying risk: Portfolios34
Diversifying risk: Portfolios      In the beginning of the lecture we saw that       higher risks must come with (the pot...
Diversifying risk: Portfolios      In the beginning of the lecture we saw that       higher risks must come with (the pot...
Diversifying risk: Portfolios      In the beginning of the lecture we saw that       higher risks must come with (the pot...
Diversifying risk: Portfolios      In the beginning of the lecture we saw that       higher risks must come with (the pot...
Diversifying risk: Example39
Diversifying risk: Example      In a given year a particular pharmaceutical      company may fail in getting approval of ...
Diversifying risk: Example      In a given year a particular pharmaceutical       company may fail in getting approval of...
Diversifying risk: Example      In a given year a particular pharmaceutical       company may fail in getting approval of...
Diversifying risk: Example      In a given year a particular pharmaceutical       company may fail in getting approval of...
Diversifying risk: Example     (cont‟d)44
Diversifying risk: Example     (cont‟d)      By holding stock in the entire sector of      pharmaceuticals we have elimin...
Diversifying risk: Example     (cont‟d)      By holding stock in the entire sector of       pharmaceuticals we have elimi...
Diversifying risk: Example     (cont‟d)      By holding stock in the entire sector of       pharmaceuticals we have elimi...
Diversifying risk: Example     (cont‟d)      By holding stock in the entire sector of       pharmaceuticals we have elimi...
Diversifying risk: Example     (cont‟d)49
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be      even less risky than a po...
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be       even less risky than a p...
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be       even less risky than a p...
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be       even less risky than a p...
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be       even less risky than a p...
Diversifying risk: Example     (cont‟d)      We would expect this expanded portfolio to be       even less risky than a p...
Diversifying risk: Example     (cont‟d)56
Diversifying risk: Example     (cont‟d)      Firm-specific risk can be diversified away57
Diversifying risk: Example     (cont‟d)      Firm-specific risk can be diversified away      Market-level risk cannot be...
Diversifying risk: Naming59
Diversifying risk: Naming      Firm-specific risk is also called:        Asset-specific risk        Diversifiable risk ...
Diversifying risk: Naming      Firm-specific risk is also called:        Asset-specific risk        Diversifiable risk ...
Diversifying risk: Graph62
Diversifying risk: Graph63
Diversifying risk: Conclusions64
Diversifying risk: Conclusions      Investors are only compensated for risks their      bear.65
Diversifying risk: Conclusions      Investors are only compensated for risks their       bear.      Any risks which can ...
Diversifying risk: Conclusions      Investors are only compensated for risks their       bear.      Any risks which can ...
Diversifying risk: Conclusions      Investors are only compensated for risks their       bear.      Any risks which can ...
Optimal Portfolios69
Optimal Portfolios      A portfolio is a collection of assets (stocks, bonds,      real estate, etc.)70
Optimal Portfolios      A portfolio is a collection of assets (stocks, bonds,       real estate, etc.)      Holding diff...
Optimal Portfolios      A portfolio is a collection of assets (stocks, bonds,       real estate, etc.)      Holding diff...
Optimal Portfolios      A portfolio is a collection of assets (stocks, bonds,       real estate, etc.)      Holding diff...
Optimal Portfolios74
Optimal Portfolios75
Optimal Portfolios      The curve drawn through all the efficient portfolios      is known as the “Efficiency Frontier”76
Optimal Portfolios      The curve drawn through all the efficient portfolios       is known as the “Efficiency Frontier” ...
How does diversification work?78
How does diversification work?      Diversification comes when stocks are subject to      different kinds of events such ...
How does diversification work?      Diversification comes when stocks are subject to       different kinds of events such...
Risk Premium81
Risk Premium      We have previously said that the higher the      risk an investment is, the higher the return it      n...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium      We have previously said that the higher the       risk an investment is, the higher the return it      ...
Risk Premium89
Risk Premium      The risk premium is the reward investors require      for taking risk90
Risk Premium      The risk premium is the reward investors require       for taking risk      But the market doesn‟t rew...
Risk Premium      The risk premium is the reward investors require       for taking risk      But the market doesn‟t rew...
Risk Premium      The risk premium is the reward investors require       for taking risk      But the market doesn‟t rew...
Risk Premium - Examples94
Risk Premium - Examples      Below are historical market-level risk premia over      different historical time periods:95
CAPM96
CAPM      We can combine our concepts of optimal      portfolios, the efficiency frontier and risk premium      to create...
CAPM      We can combine our concepts of optimal       portfolios, the efficiency frontier and risk premium       to crea...
CAPM      We can combine our concepts of optimal       portfolios, the efficiency frontier and risk premium       to crea...
CAPM       We can combine our concepts of optimal        portfolios, the efficiency frontier and risk premium        to c...
CAPM101
CAPM       We saw how we can construct an efficiency       frontier comprised of „efficient portfolios.‟102
CAPM       We saw how we can construct an efficiency        frontier comprised of „efficient portfolios.‟       Each por...
CAPM       We saw how we can construct an efficiency        frontier comprised of „efficient portfolios.‟       Each por...
CAPM105
CAPM       The horizontal axis in this example starts at 10%       risk (the standard deviation or volatility)106
CAPM       The horizontal axis in this example starts at 10%        risk (the standard deviation or volatility)       Bu...
CAPM108
CAPM109
CAPM       The top graph is       simply the Efficiency       frontier from the prior       slide.110
CAPM       The top graph is        simply the Efficiency        frontier from the prior        slide.       The bottom g...
CAPM       The top graph is        simply the Efficiency        frontier from the prior        slide.       The bottom g...
CAPM       The top graph is simply        the Efficiency frontier        from the prior slide.       The bottom graph no...
CAPM114
CAPM115
CAPM       By using holding some        combination of the risk-free        asset and an optimal portfolio        we can ...
CAPM       By using holding some        combination of the risk-free        asset and an optimal portfolio        we can ...
CAPM       By using holding some        combination of the risk-free        asset and an optimal portfolio        we can ...
CAPM119
CAPM       Since the investor has only market risk, it would be        desirable to have a measure of risk that measured ...
CAPM       Since the investor has only market risk, it would be        desirable to have a measure of risk that measured ...
CAPM       Since the investor has only market risk, it would be        desirable to have a measure of risk that measured ...
CAPM       Since the investor has only market risk, it would be        desirable to have a measure of risk that measured ...
CAPM124
CAPM       Beta measures the co-movement between a stock       and the market portfolio125
CAPM       Beta measures the co-movement between a stock        and the market portfolio       The beta of the overall m...
CAPM       Beta measures the co-movement between a stock        and the market portfolio       The beta of the overall m...
CAPM       Beta measures the co-movement between a stock        and the market portfolio       The beta of the overall m...
CAPM129
CAPM130
CAPM       The CAPM equation allows us to estimate any stock‟s       required return once we have determined the stock‟s ...
CAPM       The CAPM equation allows us to estimate any stock‟s        required return once we have determined the stock‟s...
CAPM       The CAPM equation allows us to estimate any stock‟s        required return once we have determined the stock‟s...
CAPM       The CAPM equation allows us to estimate any stock‟s        required return once we have determined the stock‟s...
CAPM       The CAPM equation allows us to estimate any stock‟s        required return once we have determined the stock‟s...
CAPM136
CAPM       Finding Beta137
CAPM       Finding Beta         The easiest way to find betas is to look them up.         Many companies provide betas:138
CAPM       Finding Beta         The easiest way to find betas is to look them up.         Many companies provide betas: ...
CAPM       Finding Beta         The easiest way to find betas is to look them up.         Many companies provide betas: ...
Caveats141
Caveats       Measures of betas for a given asset can vary       depending on how it is calculated142
Caveats       Measures of betas for a given asset can vary        depending on how it is calculated       The “risk / re...
Caveats       Measures of betas for a given asset can vary        depending on how it is calculated       The “risk / re...
Caveats       Measures of betas for a given asset can vary        depending on how it is calculated       The “risk / re...
Summary146
Summary       We need the expectation of extra reward for       taking on more risk147
Summary       We need the expectation of extra reward for        taking on more risk       An asset‟s risk premium is th...
Summary       We need the expectation of extra reward for        taking on more risk       An asset‟s risk premium is th...
Summary       We need the expectation of extra reward for        taking on more risk       An asset‟s risk premium is th...
Summary       We need the expectation of extra reward for        taking on more risk       An asset‟s risk premium is th...
Summary       We need the expectation of extra reward for        taking on more risk       An asset‟s risk premium is th...
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Finance lecture risk and return

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  1. 1. Finance Lecture:Risk, Return and the Cost of Equity Brad Simon
  2. 2. Lecture Overview  Risk and Return  Measuring Returns  Volatility  Portfolios  Diversification  Risk Premium  CAPM  Summary2
  3. 3. Motivating the topic: Risk and Return3
  4. 4. Motivating the topic: Risk and Return  The relationship between risk and return is fundamental to finance theory4
  5. 5. Motivating the topic: Risk and Return  The relationship between risk and return is fundamental to finance theory  You can invest very safely in a bank or in Treasury bills. Why would you invest in risky stocks and bonds?5
  6. 6. Motivating the topic: Risk and Return  The relationship between risk and return is fundamental to finance theory  You can invest very safely in a bank or in Treasury bills. Why would you invest in risky stocks and bonds? If you want the chance of earning higher returns, it requires that you take on higher risk investments6
  7. 7. Motivating the topic: Risk and Return  The relationship between risk and return is fundamental to finance theory  You can invest very safely in a bank or in Treasury bills. Why would you invest in risky stocks and bonds? If you want the chance of earning higher returns, it requires that you take on higher risk investments  There is a positive relationship between risk and return7
  8. 8. Historical Returns8
  9. 9. Historical Returns Ending Price - Beginning Price Dividend Percentage Return Beginning Price Beginning Price9
  10. 10. Historical Returns Ending Price - Beginning Price Dividend Percentage Return Beginning Price Beginning Price Percentage Return Capital Gains Yield Dividend Yield10
  11. 11. Historical Returns Ending Price -Beginning Price Dividend Percentage Return Beginning Price Beginning Price Percentage Return Capital Gains Yield Dividend Yield  Example: You held 250 shares of Hilton Hotel‟s common stock. The company‟s share price was $24.11 at the beginning of the year. During the year, the company paid a dividend of $0.16 per share, and ended the year at a price of $34.90. What is the dollar return, the percentage return, the capital gains yield, and the dividend yield for Hilton?11
  12. 12. Historical Returns12
  13. 13. Historical Returns  Percent return = Capital gains yield + Dividend Yield13
  14. 14. Historical Returns  Percent return = Capital gains yield + Dividend Yield Capital gains yield = ($34.90 - $24.11)/$24.11 = 44.75%14
  15. 15. Historical Returns  Percent return = Capital gains yield + Dividend Yield Capital gains yield = ($34.90 - $24.11)/$24.11 = 44.75% Dividend yield = $0.16/$24.11 = 0.66%15
  16. 16. Historical Returns  Percent return = Capital gains yield + Dividend Yield Capital gains yield = ($34.90 - $24.11)/$24.11 = 44.75% Dividend yield = $0.16/$24.11 = 0.66% Percent return = 44.75% + 0.66% = 45.42%16
  17. 17. Volatility17
  18. 18. Volatility  High volatility in historical returns are an indication that future returns will be volatile18
  19. 19. Volatility  High volatility in historical returns are an indication that future returns will be volatile  One popular way of quantifying volatility is to compute the standard deviation of percentage returns19
  20. 20. Volatility  High volatility in historical returns are an indication that future returns will be volatile  One popular way of quantifying volatility is to compute the standard deviation of percentage returns Standard deviation is a measure of total risk20
  21. 21. Volatility  High volatility in historical returns are an indication that future returns will be volatile  One popular way of quantifying volatility is to compute the standard deviation of percentage returns Standard deviation is a measure of total risk A large standard deviation indicates greater return variability, or high risk21
  22. 22. Volatility  High volatility in historical returns are an indication that future returns will be volatile  One popular way of quantifying volatility is to compute the standard deviation of percentage returns Standard deviation is a measure of total risk A large standard deviation indicates greater return variability, or high risk N 2 (Return t - Average Return) t 1 Standard Deviation N -122
  23. 23. Volatility - Example23
  24. 24. Volatility - Example  Example:  Using the following returns, calculate the average return, the variance, and the standard deviation for Acme stock.24
  25. 25. Volatility - Example  Example:  Using the following returns, calculate the average return, the variance, and the standard deviation for Acme stock. Year Acme 1 10% 2 4 3 -8 4 13 5 525
  26. 26. Volatility - Example Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 = 4.80%26
  27. 27. Volatility - Example Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 = 4.80% σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2 + (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1)27
  28. 28. Volatility - Example Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 = 4.80% σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2 + (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1) σ2Acme = 258.8 / 4 = 64.7028
  29. 29. Volatility - Example Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 = 4.80% σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2 + (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1) σ2Acme = 258.8 / 4 = 64.70 σAcme = (64.70)1/2 = 8.04%29
  30. 30. Volatility - Application30
  31. 31. Volatility - Application31
  32. 32. Volatility - Application  The volatility of stocks is much higher than the volatility of bonds and T-bills32
  33. 33. Volatility - Application  The volatility of stocks is much higher than the volatility of bonds and T-bills  Different periods had differing levels of volatility for the same asset class33
  34. 34. Diversifying risk: Portfolios34
  35. 35. Diversifying risk: Portfolios  In the beginning of the lecture we saw that higher risks must come with (the potential for) higher returns.35
  36. 36. Diversifying risk: Portfolios  In the beginning of the lecture we saw that higher risks must come with (the potential for) higher returns.  More volatile stocks should have, on average, higher returns.36
  37. 37. Diversifying risk: Portfolios  In the beginning of the lecture we saw that higher risks must come with (the potential for) higher returns.  More volatile stocks should have, on average, higher returns.  We can reduce volatility for a given level of return by grouping assets into portfolios37
  38. 38. Diversifying risk: Portfolios  In the beginning of the lecture we saw that higher risks must come with (the potential for) higher returns.  More volatile stocks should have, on average, higher returns.  We can reduce volatility for a given level of return by grouping assets into portfolios  This is known as “diversifying risk”38
  39. 39. Diversifying risk: Example39
  40. 40. Diversifying risk: Example  In a given year a particular pharmaceutical company may fail in getting approval of a new drug, thus causing its stock price to drop.40
  41. 41. Diversifying risk: Example  In a given year a particular pharmaceutical company may fail in getting approval of a new drug, thus causing its stock price to drop.  But it is unlikely that every pharmaceutical company will fail major drug trials in the same year.41
  42. 42. Diversifying risk: Example  In a given year a particular pharmaceutical company may fail in getting approval of a new drug, thus causing its stock price to drop.  But it is unlikely that every pharmaceutical company will fail major drug trials in the same year.  On average, some are likely to be successful while others will fail.42
  43. 43. Diversifying risk: Example  In a given year a particular pharmaceutical company may fail in getting approval of a new drug, thus causing its stock price to drop.  But it is unlikely that every pharmaceutical company will fail major drug trials in the same year.  On average, some are likely to be successful while others will fail.  Therefore, the returns for a portfolio comprised of all drug companies will have much less volatility than that of a single drug company.43
  44. 44. Diversifying risk: Example (cont‟d)44
  45. 45. Diversifying risk: Example (cont‟d)  By holding stock in the entire sector of pharmaceuticals we have eliminated quite a bit of risk as just described.45
  46. 46. Diversifying risk: Example (cont‟d)  By holding stock in the entire sector of pharmaceuticals we have eliminated quite a bit of risk as just described.  But it‟s possible there is sector-level risk that may impact all drug companies.46
  47. 47. Diversifying risk: Example (cont‟d)  By holding stock in the entire sector of pharmaceuticals we have eliminated quite a bit of risk as just described.  But it‟s possible there is sector-level risk that may impact all drug companies.  For example, if the FDA changes its drug- approval policy and requires all new drugs to go through more strict testing we would expect the entire sector – and our portfolio comprised of all pharmaceutical companies – to suffer.47
  48. 48. Diversifying risk: Example (cont‟d)  By holding stock in the entire sector of pharmaceuticals we have eliminated quite a bit of risk as just described.  But it‟s possible there is sector-level risk that may impact all drug companies.  For example, if the FDA changes its drug- approval policy and requires all new drugs to go through more strict testing we would expect the entire sector – and our portfolio comprised of all pharmaceutical companies – to suffer.  But what if we held a portfolio of not just pharmaceuticals but also of computer companies,48 manufacturing companies, service companies
  49. 49. Diversifying risk: Example (cont‟d)49
  50. 50. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.50
  51. 51. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets.51
  52. 52. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets.  Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets52
  53. 53. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets.  Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets  We can then think of risk as having two53 components:
  54. 54. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets.  Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets  We can then think of risk as having two54 components:  Firm-specific risk (or asset-specific risk)
  55. 55. Diversifying risk: Example (cont‟d)  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets.  Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets  We can then think of risk as having two55 components:  Firm-specific risk (or asset-specific risk)
  56. 56. Diversifying risk: Example (cont‟d)56
  57. 57. Diversifying risk: Example (cont‟d)  Firm-specific risk can be diversified away57
  58. 58. Diversifying risk: Example (cont‟d)  Firm-specific risk can be diversified away  Market-level risk cannot be eliminated58
  59. 59. Diversifying risk: Naming59
  60. 60. Diversifying risk: Naming  Firm-specific risk is also called:  Asset-specific risk  Diversifiable risk  Idiosyncratic risk  Unsystematic risk60
  61. 61. Diversifying risk: Naming  Firm-specific risk is also called:  Asset-specific risk  Diversifiable risk  Idiosyncratic risk  Unsystematic risk  Market-level risk is also called:  Systematic Risk  Market risk  Non-diversifiable risk61
  62. 62. Diversifying risk: Graph62
  63. 63. Diversifying risk: Graph63
  64. 64. Diversifying risk: Conclusions64
  65. 65. Diversifying risk: Conclusions  Investors are only compensated for risks their bear.65
  66. 66. Diversifying risk: Conclusions  Investors are only compensated for risks their bear.  Any risks which can be diversified away will not be compensated.66
  67. 67. Diversifying risk: Conclusions  Investors are only compensated for risks their bear.  Any risks which can be diversified away will not be compensated.  We want to understand how to create portfolios which produce the maximum risk diversification.67
  68. 68. Diversifying risk: Conclusions  Investors are only compensated for risks their bear.  Any risks which can be diversified away will not be compensated.  We want to understand how to create portfolios which produce the maximum risk diversification.  We call such portfolios, “optimal portfolios”68
  69. 69. Optimal Portfolios69
  70. 70. Optimal Portfolios  A portfolio is a collection of assets (stocks, bonds, real estate, etc.)70
  71. 71. Optimal Portfolios  A portfolio is a collection of assets (stocks, bonds, real estate, etc.)  Holding different combinations of assets results in different risk and return characteristics.71
  72. 72. Optimal Portfolios  A portfolio is a collection of assets (stocks, bonds, real estate, etc.)  Holding different combinations of assets results in different risk and return characteristics.  We can construct portfolios with “optimal” levels of return for a given level of risk.72
  73. 73. Optimal Portfolios  A portfolio is a collection of assets (stocks, bonds, real estate, etc.)  Holding different combinations of assets results in different risk and return characteristics.  We can construct portfolios with “optimal” levels of return for a given level of risk.  We call such portfolios, “efficient portfolios”73
  74. 74. Optimal Portfolios74
  75. 75. Optimal Portfolios75
  76. 76. Optimal Portfolios  The curve drawn through all the efficient portfolios is known as the “Efficiency Frontier”76
  77. 77. Optimal Portfolios  The curve drawn through all the efficient portfolios is known as the “Efficiency Frontier”  We will come back to this later.77
  78. 78. How does diversification work?78
  79. 79. How does diversification work?  Diversification comes when stocks are subject to different kinds of events such that their returns differ over time, i.e. the stock‟s returns are not perfectly correlated. Their price movements often counteract each other79
  80. 80. How does diversification work?  Diversification comes when stocks are subject to different kinds of events such that their returns differ over time, i.e. the stock‟s returns are not perfectly correlated. Their price movements often counteract each other  By contrast, if two stocks are perfectly positively correlated, diversification has no effect on risk.80
  81. 81. Risk Premium81
  82. 82. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.82
  83. 83. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:83
  84. 84. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:  An investment in a risk-free US Treasury bill offers a low return with no risk84
  85. 85. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:  An investment in a risk-free US Treasury bill offers a low return with no risk  Investors who take on risk expect a higher return compared to this risk-free opportunity, therefore:85
  86. 86. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:  An investment in a risk-free US Treasury bill offers a low return with no risk  Investors who take on risk expect a higher return compared to this risk-free opportunity, therefore: Required Return = Risk-free Rate + Risk Premium86
  87. 87. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:  An investment in a risk-free US Treasury bill offers a low return with no risk  Investors who take on risk expect a higher return compared to this risk-free opportunity, therefore: Required Return = Risk-free Rate + Risk Premium87  The risk-free rate equals the real interest rate and expected
  88. 88. Risk Premium  We have previously said that the higher the risk an investment is, the higher the return it needs to offer.  We can re-state this concept in the following way:  An investment in a risk-free US Treasury bill offers a low return with no risk  Investors who take on risk expect a higher return compared to this risk-free opportunity, therefore: Required Return = Risk-free Rate + Risk Premium  The risk-free rate equals the real interest rate and expected inflation88  Typically considered the return on U.S. government
  89. 89. Risk Premium89
  90. 90. Risk Premium  The risk premium is the reward investors require for taking risk90
  91. 91. Risk Premium  The risk premium is the reward investors require for taking risk  But the market doesn‟t reward all risks91
  92. 92. Risk Premium  The risk premium is the reward investors require for taking risk  But the market doesn‟t reward all risks  Since the firm-specific portion of risk can be diversified away, an efficient market will not reward investors for taking this risk92
  93. 93. Risk Premium  The risk premium is the reward investors require for taking risk  But the market doesn‟t reward all risks  Since the firm-specific portion of risk can be diversified away, an efficient market will not reward investors for taking this risk  The market rewards only the remaining risk after the firm-specific risk is diversified away: the market risk93
  94. 94. Risk Premium - Examples94
  95. 95. Risk Premium - Examples  Below are historical market-level risk premia over different historical time periods:95
  96. 96. CAPM96
  97. 97. CAPM  We can combine our concepts of optimal portfolios, the efficiency frontier and risk premium to create a theory seeking to relate an asset‟s risk characteristics to its required risk premium (i.e. it‟s return)97
  98. 98. CAPM  We can combine our concepts of optimal portfolios, the efficiency frontier and risk premium to create a theory seeking to relate an asset‟s risk characteristics to its required risk premium (i.e. it‟s return)  Such a theory is called an “asset pricing theory”98
  99. 99. CAPM  We can combine our concepts of optimal portfolios, the efficiency frontier and risk premium to create a theory seeking to relate an asset‟s risk characteristics to its required risk premium (i.e. it‟s return)  Such a theory is called an “asset pricing theory”  The most famous asset pricing theory is the Capital Asset Pricing Model (or CAPM)99
  100. 100. CAPM  We can combine our concepts of optimal portfolios, the efficiency frontier and risk premium to create a theory seeking to relate an asset‟s risk characteristics to its required risk premium (i.e. it‟s return)  Such a theory is called an “asset pricing theory”  The most famous asset pricing theory is the Capital Asset Pricing Model (or CAPM)100
  101. 101. CAPM101
  102. 102. CAPM  We saw how we can construct an efficiency frontier comprised of „efficient portfolios.‟102
  103. 103. CAPM  We saw how we can construct an efficiency frontier comprised of „efficient portfolios.‟  Each portfolio combines a group of assets in such a way that they provide the highest expected return for a given level of risk.103
  104. 104. CAPM  We saw how we can construct an efficiency frontier comprised of „efficient portfolios.‟  Each portfolio combines a group of assets in such a way that they provide the highest expected return for a given level of risk.104
  105. 105. CAPM105
  106. 106. CAPM  The horizontal axis in this example starts at 10% risk (the standard deviation or volatility)106
  107. 107. CAPM  The horizontal axis in this example starts at 10% risk (the standard deviation or volatility)  But we could modify this graph – and our portfolio – by including some amount of the risk-free asset.107
  108. 108. CAPM108
  109. 109. CAPM109
  110. 110. CAPM  The top graph is simply the Efficiency frontier from the prior slide.110
  111. 111. CAPM  The top graph is simply the Efficiency frontier from the prior slide.  The bottom graph now includes the risk- free asset and the efficiency frontier.111
  112. 112. CAPM  The top graph is simply the Efficiency frontier from the prior slide.  The bottom graph now includes the risk- free asset and the efficiency frontier.  We can imagine a line being drawn that starts at the risk-free asset and running tangent to the112 efficiency frontier
  113. 113. CAPM  The top graph is simply the Efficiency frontier from the prior slide.  The bottom graph now includes the risk-free asset and the efficiency frontier.  We can imagine a line being drawn that starts at the risk-free asset and running tangent to the efficiency frontier  Such a line is known as the Capital Market Line (CML).113
  114. 114. CAPM114
  115. 115. CAPM115
  116. 116. CAPM  By using holding some combination of the risk-free asset and an optimal portfolio we can maximize our expected return.116
  117. 117. CAPM  By using holding some combination of the risk-free asset and an optimal portfolio we can maximize our expected return.  Such returns reside on the Capital Market Line.117
  118. 118. CAPM  By using holding some combination of the risk-free asset and an optimal portfolio we can maximize our expected return.  Such returns reside on the Capital Market Line.  The CML demonstrates that an investor will hold the market portfolio. Since such an investor will be fully diversified, the only relevant risk is market risk.118
  119. 119. CAPM119
  120. 120. CAPM  Since the investor has only market risk, it would be desirable to have a measure of risk that measured only market risk120
  121. 121. CAPM  Since the investor has only market risk, it would be desirable to have a measure of risk that measured only market risk  Such as measure is called beta (β):121
  122. 122. CAPM  Since the investor has only market risk, it would be desirable to have a measure of risk that measured only market risk  Such as measure is called beta (β): Required Return = Rf + β(Risk PremuimMarket)122
  123. 123. CAPM  Since the investor has only market risk, it would be desirable to have a measure of risk that measured only market risk  Such as measure is called beta (β): Required Return = Rf + β(Risk PremuimMarket) Required Return = Rf + β(RM – Rf)123
  124. 124. CAPM124
  125. 125. CAPM  Beta measures the co-movement between a stock and the market portfolio125
  126. 126. CAPM  Beta measures the co-movement between a stock and the market portfolio  The beta of the overall market is 1126
  127. 127. CAPM  Beta measures the co-movement between a stock and the market portfolio  The beta of the overall market is 1  Stocks with betas greater than 1 are considered riskier than the market portfolio and are called aggressive stocks127
  128. 128. CAPM  Beta measures the co-movement between a stock and the market portfolio  The beta of the overall market is 1  Stocks with betas greater than 1 are considered riskier than the market portfolio and are called aggressive stocks  Stocks with betas less than 1 are less risky than the market portfolio and are called defensive stocks128
  129. 129. CAPM129
  130. 130. CAPM130
  131. 131. CAPM  The CAPM equation allows us to estimate any stock‟s required return once we have determined the stock‟s beta, risk-free rate and market-risk premium.131
  132. 132. CAPM  The CAPM equation allows us to estimate any stock‟s required return once we have determined the stock‟s beta, risk-free rate and market-risk premium.  CAPM Equation is: Required Return = Rf + β(RM – Rf)132
  133. 133. CAPM  The CAPM equation allows us to estimate any stock‟s required return once we have determined the stock‟s beta, risk-free rate and market-risk premium.  CAPM Equation is: Required Return = Rf + β(RM – Rf)  Example:133
  134. 134. CAPM  The CAPM equation allows us to estimate any stock‟s required return once we have determined the stock‟s beta, risk-free rate and market-risk premium.  CAPM Equation is: Required Return = Rf + β(RM – Rf)  Example:  Let‟s say we expect the market portfolio to earn 12%, and T-bill yields are 5%. Home Depot has a beta of 1.08. Calculate Home Depot‟s required return134
  135. 135. CAPM  The CAPM equation allows us to estimate any stock‟s required return once we have determined the stock‟s beta, risk-free rate and market-risk premium.  CAPM Equation is: Required Return = Rf + β(RM – Rf)  Example:  Let‟s say we expect the market portfolio to earn 12%, and T-bill yields are 5%. Home Depot has a beta of 1.08. Calculate Home Depot‟s required return  Required Return = 5% + 1.08(12% - 5%) = 12.56%135
  136. 136. CAPM136
  137. 137. CAPM  Finding Beta137
  138. 138. CAPM  Finding Beta  The easiest way to find betas is to look them up. Many companies provide betas:138
  139. 139. CAPM  Finding Beta  The easiest way to find betas is to look them up. Many companies provide betas:  Value Line Investment Survey  Hoovers  MSN Money  Yahoo! Finance  Zacks139
  140. 140. CAPM  Finding Beta  The easiest way to find betas is to look them up. Many companies provide betas:  Value Line Investment Survey  Hoovers  MSN Money  Yahoo! Finance  Zacks  You can also calculate beta for yourself140
  141. 141. Caveats141
  142. 142. Caveats  Measures of betas for a given asset can vary depending on how it is calculated142
  143. 143. Caveats  Measures of betas for a given asset can vary depending on how it is calculated  The “risk / return” relationship rests on the assumption that the stock (or asset) is priced “correctly”143
  144. 144. Caveats  Measures of betas for a given asset can vary depending on how it is calculated  The “risk / return” relationship rests on the assumption that the stock (or asset) is priced “correctly”  This in turn, requires that asset markets price assets correctly144
  145. 145. Caveats  Measures of betas for a given asset can vary depending on how it is calculated  The “risk / return” relationship rests on the assumption that the stock (or asset) is priced “correctly”  This in turn, requires that asset markets price assets correctly  Given historical events and other evidence, there are reasons to question how “efficient” markets are at pricing an asset at its true price145
  146. 146. Summary146
  147. 147. Summary  We need the expectation of extra reward for taking on more risk147
  148. 148. Summary  We need the expectation of extra reward for taking on more risk  An asset‟s risk premium is the additional compensation required above the risk-free rate for holding that asset148
  149. 149. Summary  We need the expectation of extra reward for taking on more risk  An asset‟s risk premium is the additional compensation required above the risk-free rate for holding that asset  At the market level, the market risk premium is the additional return above the risk-free rate to hold the market portfolio149
  150. 150. Summary  We need the expectation of extra reward for taking on more risk  An asset‟s risk premium is the additional compensation required above the risk-free rate for holding that asset  At the market level, the market risk premium is the additional return above the risk-free rate to hold the market portfolio  For a given asset, the CAPM will tell us how much return we will require for holding that asset relative to the risk free rate and market portfolio150
  151. 151. Summary  We need the expectation of extra reward for taking on more risk  An asset‟s risk premium is the additional compensation required above the risk-free rate for holding that asset  At the market level, the market risk premium is the additional return above the risk-free rate to hold the market portfolio  For a given asset, the CAPM will tell us how much return we will require for holding that asset relative to the risk free rate and market portfolio  Required Return = Rf + β(RM – Rf)151
  152. 152. Summary  We need the expectation of extra reward for taking on more risk  An asset‟s risk premium is the additional compensation required above the risk-free rate for holding that asset  At the market level, the market risk premium is the additional return above the risk-free rate to hold the market portfolio  For a given asset, the CAPM will tell us how much return we will require for holding that asset relative to the risk free rate and market portfolio  Required Return = Rf + β(RM – Rf)152

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