A Chapter 12 Risk and Return and the Capital Asset Pricing Model 1 Risk is measured by price or return volatility Greater return greater risk a Treasury Bills lower returns 2 4 b Stocks higher returns 6 10 c Market risk premium average market return average t bill return 2 Rate of Return a Cash payment change in price price paid b Dividends quarterly payments made on some stocks ownership c Interest semi annual payments made on bonds debt 3 Standard Deviation of Return a Greater standard deviation means more fluctuations and greater risk b Calculation of SD i Take simple average return ii Take each individual observed return and subtract the average to get the deviation of return iii Square the resulting difference and add the squares to get the sum of the squares iv Divide the sum of the squares by the total number of observations minus 1 variance v The square root of the variance is the SD of the returns 1 4 Beta Finance 301 Final Exam a Measure of market related systematic risk of an asset b Lower beta less volatile c A stock with a beta of 2 is twice as risky as the market 5 Clicker Questions a Which of the following statements are true Simple Average Returns are more representative of actual investment performance than Compound A negative percentage return in the calculation of a simple average will produce an upwards Average Returns biased result A smaller standard deviation means more fluctuations and greater risk B Chapter 13 Efficient Capital Markets and Random Walks 1 Alpha a Observed return of asset expected return of asset b Stocks that perform worse than their expected return will have a negative alpha c Example Calculate Alpha Beta 1 5 T Bills Rate 3 0 S P 500 averaged return rate 10 Actual Return on the Portfolio 13 Expected return 3 1 5 10 3 135 Alpha 13 13 5 0 5 Answer 05 d Example Calculate Alpha Dividend 2 Beg Price 25 End Price 27 Expected Return 12 return 27 25 2 25 16 Alpha 16 12 04 or 4 2 Unsystematic Risk 3 Systematic Risk publicly available information 5 Random Walk Hypothesis 6 Types of Market Efficiency a Weak Form Efficiency firm specific risk that can be diversified away Risk you are not paid to take market related risk measured by beta Risk that can not be diversified away Risk You are paid to take 4 Efficient Capital Markets a Asset prices react very quickly to the receipt of new information 2 b Efficient Market Hypothesis stock prices react instantaneously completely and accurately to all Finance 301 Final Exam a In efficient markets share prices react immediately to news and share price changes are random b The future direction of a path cannot be predicted solely on the basis of past movements i Stock prices reflect information contained in the history of past stock prices and trading volume ii Stock price changes are independent b Semi strong form efficiency i Stock prices reflect all publicly available information ii Prevents investors from earning abnormal returns c Strong form efficiency community 7 Tests of Market Efficiency i Stock prices reflect ALL information including information not available to investment a Behavioral Finance challenged assumption that investors are rational and markets behave rationally b Fama and French Study states that stocks with small market caps outperform stocks with large market caps stocks with low p e ratios outperform stocks with high p e ratios 8 Clicker Questions a Calculate Expected Return beta 9 market return 8 Tbill 3 CAPM 3 9 8 3 7 5 4 b T F If a market is efficient all investments lie on the risk expected return line true c If a firm is plotted above the risk expected return line then the stock is considered UNDERVALUED below the line overvalued C Chapter 14 Interest Rates and Bond Valuation 1 Bonds in General a Bond debt financial contract under which the issuer is obligated to make periodic interest payments and repay the principal at some predetermined time b Indenture legal agreement between issuer of bonds and the investors c Principal Value Par Amount Maturity Value amount that is originally borrowed and the amount that is repaid when the bonds mature and the principal payment is due d Interest Coupon Rate rate at which interest accrues or is paid by the issuer to the owner of the bond i Fixed Rate Structures Fixed rate Par Bond issuer issues bond at par value and pays fixed interest semi annually on 3 predetermined dates and repays the full par value of the bond on maturity Finance 301 Final Exam Par Bond coupon rate that is equal to market yield Fixed Rate Discount Bond issued at coupon rate that creates a market value of less than par at the time of pricing and offering a yield that is higher than coupon rate Fixed Rate Premium Bond market a bond with a coupon and interest rate that creates a market value of more than par at the time of pricing and offering yield that is lower than coupon rate ii Floating Rate Structures Rate setting mechanisms have been developed that are designed to create a bond that always trades at or near par value Significantly lower than rates on fixed coupon bonds Issuer retains the interest rate risk inherent in a bond issue iii Issuers of floating rate bonds retain the interest rate risk e Security issued by US Gov and usually assumed to be risk free f Municipal Bonds may be secured in a variety of ways such as by the issuer s taxing power revenues g Callable bonds are more uncertain about cash flows hence will require a higher yield on callable and credit enhancement devices bonds than on non callable bonds h Example Calculate the value of a non callable 10 year bond with a face value of 1 000 and a coupon rate of 10 compounded semi annually if you expect 8 yield on the bond i Calculate the taxable equivalent bond yield of a municipal bond with an interest rate of 7 for an n 20 double because semi annually fv 1000 i y 8 2 4 pmt 1 05 50 pv 1 136 investor in the 46 tax bracket taxable equivalent bond yield interest rate yield 1 tax bracket 07 1 46 12 96 2 Four Types of Risk a Default Risk risk that the bond will not pay interest or principal when due b Reinvestment Risk unknown rate at which cash inflows may be reinvested c Prepayment Risk when an issues calls a bond prior to its maturity d Interest Rate Risk the risk that a change in market interest rates will affect the value of the bond i Most difficult rate to assess ii The longer the maturity of a bond the higher the volatility of bond prices the greater the rick iii The lower the coupon on a bond the