HB 311 1st Edition Lecture 14 Current Lecture Components of Required Rates of Return Rick Free Rate of Return o Lower Rate o Safety of Principal When you invest in a riskier investment you expect to be paid more for incurring irsk o This is the risk premium over risk free rate o Greater risk requires a greater return o Formula kE Rf Risk Premium Risk categorized as o Business Risk variability of cash flows o Financial Risk Due to debt financing kE Rf business risk premium financial risk premium Inflation premium Nominal rate of return includes the inflation risk Portfolios Combining several securities in a portfolio can actually reduce overall risk Diversification Investing in more than one security to reduce risk If two stocks are perfectly positively correlated diversification has no effect on risk If two stocks are perfectly negatively correlated the portfolio is perfectly diversified Market risk Nondiversifiable cannot be reduced Company unique risk Is diversifiable can be reduced Market Risk Unexpected changes in interest rates Unexpected changes in cash flows due to tax rate changes foreign competition and the overall business cycle Negative political and economic environment Company unique risk A company s labor force goes on strike Top management dies in a plane crash 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 Oil tank bursts and floods and company s production area Catastrophic event prevents travel to hotels Infected food products affects sale of beef products Risk and Diversification By creating portfolio of investments reduce risk by diversifying risk Total risk firm specific market related risk Remember firm specific can be diversified while market or systematic risk is nondiversifiable As you add stocks to your portfolio company unique risk is reduced Beta Beta is a measure of market risk Measures how an individual stock s returns vary with market returns It s a measure of the sensitivity of an individual stock s returns to changes in the market Measuring Market s Beta Firm that has a beta 1 has average market risk No more or less volatile than the market A firm with a beta 1 is more volatile than the market A firm with a beta 1 is less volatile than the market Summary We know how to measure risk using standard deviation for overall risk and beta for market risk We know how to reduce overall risk to only market risk through diversification We need to know how to price risk so we will know how much extra return we should require for accepting extra risk