Fin 3303 1st Edition Lecture 11 Outline of Last Lecture I Bonds II Quoted Interest Rate III Inflation Premium IV Default Risk Premium V Liquidity Premium VI Maturity Risk Premium VII Practice Problems with Premiums Outline of Current Lecture I Portfolio Expected Return Problem II Diversification III CAPM Current Lecture Suppose you could invest in 4 companies 200 000 goes to IBM with an expected return of 10 300 000 goes to Exxon with an expected return of 12 250 000 goes to GE with an expected return of 8 Then 250 000 goes to Wal Mart with an expected return of 6 o Find the Weighted Average Return IBM 200 000 1 million 2 Exxon 300 000 1 million 3 GE 250 000 1 million 25 Wal Mart 250 000 1 million 25 o What is the Portfolio Expected Return E rp 2x10 3x12 25x8 25x6 9 1 Total Risk Systematic Risk Firm Specific Risk o Systematic risk is also known as Market Risk These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute It affects ALL companies o Firm specific risk is also known as Unique Risk or Diversifiable Risk Affects only SPECIFIC companies Diversification o Investing in 2 or more companies to reduce your risk CAPM o E ri rf Bi x E rm rf rf Risk free rate Ex Treasury bond t bill E rm Portfolio of all investments Bi How sensitive E ri are on E rm E rm rf Premium CAPM Example o rf 3 Bi 2 E rm 13 today and 14 tomorrow What is E ri for both days E rtoday 3 2 x 13 3 23 Today E rtomorrow 3 2 x 14 3 25 Tomorrow Since the B is 2 it shows that the expected return will increase by 2 o Systematic Risk Higher Beta higher risk o Use the following portfolio data for questions A C given a risk free rate of 3 and a market risk premium of 8 The portfolio consists of 100 000 in DR stock Beta of 5 50 000 in INTC stock Beta of 1 5 50 000 in PTEN stock Beta of 2 A What is the expected return on the market o E rm 3 8 o E rm 11 B What is the portfolio beta o Wdr 100 000 200 000 5 o Wintc 50 000 200 000 25 o Wpten 50 000 200 000 25 Bp 5x 5 25x1 5 25x 2 675 C What is the expected return on the portfolio o E rp 3 675 x 8 8 4