Chapter 08 Expected Value of individual security o Expected Value A statistical measure of the mean or average value of the possible outcomes Operationally it is defined as the weighted average of the possible outcomes with the weights being the probability of occurrence Standard deviation of individual security o The standard deviation is an important measure of the total risk or variability of possible outcomes each having an associated probability of occurrence o The larger the standard deviation the more variable an investment s returns are and the more riskier is the investment o A standard deviation of zero indicates no variability and thus no risk Coefficient of Variation o Coefficient of variation The ratio of the standard deviation to the expected value It provides a relative measure of risk o The coefficient of variation is a useful total risk measure when comparing two inv estments with different expected returns Different types of risk o Risk from an investment perspective refers to the chance that returns from an investment will be different from those expected o The lower the correlations among the individual securities the greater the possibilities of risk reduction o When the returns from the two securities are perfectly positively correlated the risk of the portfolio is equal to the weighted average of the risk of the individual securities 10 and 20 percent in this example Therefore no risk reduction is ach ieved when perfectly positively correlated securities are combined in a portfolio An increasing function of time Returns generated early can be predicted with greater certainty o Maturity risk Maturity The length of the life of a debt obligation Longer time to maturity lower required return downward sloping Longer time to maturity higher required return upward sloping Expectations Theory According to the expectations theory long term interest rates are a function of expected future that is forward short term interest rates If future short term interest rates are expected to rise the yield curve will tend to be upward sloping In contrast a downward sloping yield curve reflects an expectation of declining future short term interest rates According to the expectations theory current and expected future interest rates are dependent on expectations about future rates of inflation Many economic and political conditions can cause expected future inflation and interest rates to rise or fall These conditions include expected future government deficits or surpluses changes in Federal Reserve monetary policy that is the rate of growth of the money supply and cyclical business conditions o Yield on longer term bonds is made up of what we expect short term bonds to pay in the future Liquidity Premium Theory The liquidity or maturity premium theory of the yield curve holds that required returns on long term securities tend to be greater the longer the time to maturity The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer term securities As discussed in chapter the value of a bond tends to vary more as interest rates change the longer the term to maturity Thus if interest rates rise the holder of a long term bond will find that the value of the investment has declined substantially more than that of the holder of a short term bond In addition the short term bondholder has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate The long term bondholder must wait much longer before this opportunity is available Accordingly it is argued that whatever the shape of the yield curve a liquidity or maturity premium is reflected in it The liquidity premium is larger for long term bonds than for short term bonds Market Segmentation Theory According to the market segmentation theory the securities markets are segmented by maturity Furthermore interest rates within each maturity segment are determined to a certain extent by the supply and demand interactions of the segment s borrowers and lenders If strong borrower demand exists for long term funds and these funds are in short supply the yield curve will be upward sloping Conversely if strong borrower demand exists for short term funds and these funds are in short supply the yield curve will be downward sloping Default risk The risk that a borrower will fail to make interest payments principal payments or both on a loan Very important for market interest rates Seniority risk the less senior the claims of the security holder the greater the required rate of return demanded by investors in that security Also in the case of bankruptcy all senior claim holders must be paid before common stockholders receive any proceeds from the liquidation of the firm Marketability Risk The ability of an investor to buy and sell an asset security quickly and without a significant loss of value Business vs Financial risk Business risk The variability in a firm s operating earnings EBIT Financial risk The additional variability of a company s earnings per share and the increased probability of insolvency that result from the use of fixed cost sources of funds such as debt and preferred stock In general the more financial leverage a firm uses the greater is its financial risk Systematic vs Unsystematic risk Systematic Risk That portion of the variability of an individual security s returns that is caused by the factors affecting the market as a whole This also is called nondiversifiable risk Unsystematic Risk Risk that is unique to a firm This is also called diversifiable risk Portfolios o Portfolio A collection of two or more financial securities or physical assets o Market Portfolio The portfolio of securities consisting of all available securities weighted by their respective market values o Expected return The benefits price appreciation and distributions an individual anticipates receiving from an investment o Standard Deviation A statistical measure of the dispersion or variability of possible outcomes around the expected value or mean Operationally it is defined as the square root of the weighted average squared deviations of possible outcomes from the expected value The standard deviation provides an absolute measure of risk o Diversification The act of investing in a set of financial securities or physical assets having different risk