Chapter 10 Capital Markets and the Pricing of Risk Chapter Outline 10 1 Risk and Return Insights from 86 Years of Investor History 10 2 Common Measures of Risk and Return 10 3 Historical Returns of Stocks and Bonds 10 4 The Historical Tradeoff Between Risk and Return 10 5 Common Versus Independent Risk 10 6 Diversification in Stock Portfolios 10 7 Measuring Systematic Risk 10 8 Beta and the Cost of Capital Copyright 2014 Pearson Education Inc All rights reserved Learning Objectives 1 2 3 Define a probability distribution the mean the variance the standard deviation and the volatility Compute the realized or total return for an investment Using the empirical distribution of realized returns estimate expected return variance and standard deviation or volatility of returns Copyright 2014 Pearson Education Inc All rights reserved Learning Objectives 4 5 6 Use the standard error of the estimate to gauge the amount of estimation error in the average Discuss the volatility and return characteristics of large stocks versus large stocks and bonds Describe the relationship between volatility and return of individual stocks Copyright 2014 Pearson Education Inc All rights reserved Learning Objectives 7 8 9 Define and contrast idiosyncratic and systematic risk and the risk premium required for taking each on Define an efficient portfolio and a market portfolio Discuss how beta can be used to measure the systematic risk of a security Copyright 2014 Pearson Education Inc All rights reserved Learning Objectives 10 11 12 Use the Capital Asset Pricing Model CAPM to calculate the expected return for a risky security Use the Capital Asset Pricing Model to calculate the cost of capital for a particular project Explain why in an efficient capital market the cost of capital depends on systematic risk rather than diversifiable risk Copyright 2014 Pearson Education Inc All rights reserved 10 1 Risk and Return Insights from 86 Years of Investor History Lab 3 How would 100 have grown if it were placed in one of the following investments Standard Poor s 500 90 U S stocks up to 1957 and 500 after that Leaders in their industries and among the largest firms traded on U S Markets Small stocks Securities traded on the NYSE with market capitalizations in the bottom 20 Copyright 2014 Pearson Education Inc All rights reserved 10 1 Risk and Return Insights from 86 Years of Investor History continued Lab 3 How would 100 have grown if it were placed in one of the following investments World Portfolio International stocks from all the world s major stock markets in North America Europe and Asia Corporate Bonds Long term AAA rated U S corporate bonds with maturities of approximately 20 years Treasury Bills An investment in three month Treasury bills Copyright 2014 Pearson Education Inc All rights reserved Figure 10 1 Value of 100 Invested at the End of 1925 Lab 3 Source Chicago Center for Research in Security Prices Standard and Poor s MSCI and Global Financial Data Copyright 2014 Pearson Education Inc All rights reserved 10 1 Risk and Return Insights from 86 Years of Investor History continued Lab 3 Small stocks had the highest long term returns while T Bills had the lowest longterm returns Small stocks had the largest fluctuations in price while T Bills had the lowest Higher risk requires a higher return Copyright 2014 Pearson Education Inc All rights reserved 10 1 Risk and Return Insights from 86 Years of Investor History continued Lab 3 Few people ever make an investment for 86 years More realistic investment horizons and different initial investment dates can greatly influence each investment s risk and return Copyright 2014 Pearson Education Inc All rights reserved Figure 10 2 Value of 100 Invested for Alternative Investment Horizons Source Chicago Center for Research in Security Prices Standard and Poor s MSCI and Global Financial Data Copyright 2014 Pearson Education Inc All rights reserved 10 2 Common Measures of Risk and Return Lab 3 Probability Distributions When an investment is risky there are different returns it may earn Each possible return has some likelihood of occurring This information is summarized with a probability distribution which assigns a probability PR that each possible return R will occur Assume BFI stock currently trades for 100 per share In one year there is a 25 chance the share price will be 140 a 50 chance it will be 110 and a 25 chance it will be 80 Copyright 2014 Pearson Education Inc All rights reserved Table 10 1 Probability Distribution of Returns for BFI Lab 3 Copyright 2014 Pearson Education Inc All rights reserved Figure 10 3 Probability Distribution of Returns for BFI Lab 3 Copyright 2014 Pearson Education Inc All rights reserved Expected Return Lab 3 Expected Mean Return Calculated as a weighted average of the possible returns where the weights correspond to the probabilities Copyright 2014 Pearson Education Inc All rights reserved Variance and Standard Deviation Lab 3 Variance Standard Deviation The expected squared deviation from the mean The square root of the variance i e the Volatility Both are measures of the risk of a probability distribution Copyright 2014 Pearson Education Inc All rights reserved Variance and Standard Deviation continued Lab 3 For BFI the variance and standard deviation are In finance the standard deviation of a return is also referred to as its volatility The standard deviation is easier to interpret because it is in the same units as the returns themselves Copyright 2014 Pearson Education Inc All rights reserved Textbook Example 10 1 Lab 3 Copyright 2014 Pearson Education Inc All rights reserved Textbook Example 10 1 continued Lab 3 Copyright 2014 Pearson Education Inc All rights reserved Alternative Example 10 1 Problem TXU stock is has the following probability distribution Probability Return 25 8 55 10 20 12 What are its expected return and standard deviation Copyright 2014 Pearson Education Inc All rights reserved Alternative Example 10 1 cont d Solution Expected Return E R 25 08 55 10 20 12 E R 0 020 0 055 0 024 0 099 9 9 Standard Deviation SD R 25 08 099 2 55 10 099 2 20 12 099 2 1 2 SD R 0 00009025 0 00000055 0 0000882 1 2 SD R 0 0001791 2 01338 1 338 Copyright 2014 Pearson Education Inc All rights reserved Figure 10 4 Probability Distributions for BFI and AMC Returns Copyright 2014 Pearson Education Inc All rights reserved 10 3 Historical Returns of Stocks and Bonds Computing Historical Returns Realized Return The return that actually