HB 311 1st EditionLecture 14Current LectureComponents of Required Rates of Return- Rick Free Rate of Returno Lower Rateo Safety of Principal - When you invest in a riskier investment you expect to be paid more for incurring irsko This is the risk premium over risk free rate.o Greater risk requires a greater returno 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
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