04 02 2013 CHAPTER 11 INTRODUCTION TO RISK RETURN AND THE OCC CHAPTER SUMMARY Standard Poor s Composite Index Common stocks avg a 7 4 higher return than SAFE treasury bills Risk premium Investors have taken on the risk of investing in stocks LT bonds higher return than T bills but stocks OCC for an avg risk project same risk as typical share of common stock Variance Standard Deviation Spread of outcomes on different investments Variance Avg of the squared deviations around the avg outcome SD Square root of the variance For mkt port of common stocks avg around 20 a year SD gen higher on individual stocks than on the mkt Ind Stocks DN move in lockstep Risk Diversified Away Spread portfolio among mult investments smooth Specific risk Risk that can be eliminated through diversification Not all risk can be eliminated Market risk Risk that the mkt as a whole will slump Macro changes that effect most stocks and overall stock mkt High rise stock Makes an above average contribution to the risk of a diversified portfolio Worry about risk you can t diversify away Depends on stock s sensitivity to macro conditions KEY TERMS MKT INDEX Measure of the inv per of the overall mkt DOW JONES IND AVG Index of the inv perf of a portfolio of 30 blue chip stocks S P COMPOSITE INDEX Index of the inv perf of a portfolio of 500 companies SPECIFIC RISK MARKET RISK Affecting only that firm diversifiable Economy wide sources that affect overall stock market systematic RATES OF RETURN 1 Buy a stock or bond Return A Div or Int Pmt B Capital Gain or Loss 2 on a return see equation Cap gain div yield initial share price 3 OR 4 Dividend yield Dividend yield Initial share price 5 Capital gain Capital gain Initial share price NOMINAL VARIANCE STD DEVIATION Both are measures of volatility UNIQUE MARKET RISK Specific risk diversifiable risk If reasonably well diversified only market risk matters MATURITY RISK PREMIA PORTFOLIO T BILLS T BONDS COMMON STOCKS POR STD DEV Specific risk Market risk EQUATIONS 11 1 11 3 11 1 PERCENTAGE RETURN 11 2 VARIANCE 11 3 STANDARD DEVIATION 1 real rate of return 1 nominal rate of return 1 inflation rate 1 real rate of return AVG ANN AVG PREM RATE RET EXTRA RET 4 0 5 2 1 2 11 4 7 4 More variable returns imply greater investment risk Can be eliminated by DIV Risk factors affecting only that firm Market systematic risk Why stocks tend to move together Economy wide sources of risk that affect the overall stock market Capital gain dividend initial share price the avg Avg of squared deviations around Square root of variance CAPM Capital Asset Pricing Model Expected risk premium of an investment should be proportional to both its beta and the mkt risk premium Expected rate of return risk free interest rate risk premium CHAPTER 12 CHAPTER SUMMARY BETA Sensitivity of a stock to market movement is known as beta 1 0 known to be par sen to mkt fluctuations 1 0 not so sen 1 average beta of all stocks Risk premium Market risk premium Risk premium on the mkt portfolio Avg 7 4 btw 1900 2010 Extra return that investors require for taking risk R rf BETA rm rf Security market line Graphical representation of the CAPM equation Relates the expected return investors Opportunity cost of capital Determined by the use to which the capital is put Req ROR depend on risk of project NOT on risk of firm s existing business Project cost of capital Min acceptable expected ROR on a project given its risk Cash flow forecasts the beta KEY TERMS MKT PORTFOLIO Port of all assets in the economy Broad stock mkt is used to represent the mkt Already factor in chances of pleasant and unpleasant surprises Potential bad outcomes should be reflected in the DRate only to extent that they affect Sensitivity of a stock s return on the mkt portfolio MKT RISK PREMIUM Risk premium of mkt portfolio Diff btw mkt return and return on risk free T Bills BETA CAPM Theory of the relationship between risk and return Expected risk premium on any security beta market risk premium SECURITY MKT LINE Rel btw exp return and beta COMPANY COST OF CAPITAL Det by avg risk of comp s sec PROJECT COST OF CAPITAL Exp rate of return demanded by investors in a company Min acceptable expected ROR on a project given its risk BETA Define and measure the risk of An investor with a diversified portfolio individual stocks will be int in the effect each stock has Reduce risk by diversification Depends on exposure to on its portfolio macroeconomic conditions can be Def low betas not sen measured as the sensitivity of a stock s Agg high betas are sen return to fluctuations MKT UP agg MKT DN def AVG BETA 1 for all stocks PORTFOLIO BETA Div decreases variability from specific The beta of a portfolio is just an avg of risk but not from market risk the betas of the securities in the portfolio DEFINITION Fraction of portfolio in first stock Well Diversified Portfolio beta of first stock All kinds of stocks Avg beta 1 0 Fraction of portolio in second stock beta of second stock Has the same variability as the mkt index B 0 1 move in the same direction as the mkt but not as far xx times as variable as the mkt CAPM SECURITY MARKET LINE Market risk premium rm rf Expected market return rm Risk premium r rf B rm rf Treasury bill rate risk free interest rate Exp ROR rfr rprem rf Expected return Market risk premium rm rf risk free rate risk premium Risk premium rm rf B r rf B rm rf Expected return r CAPM things Exp ROR dem by inv depend on two 1 Compensation for the value of money risk free rate rf 2 Risk premium depends on the beta and mkt value premium Rel btw exp return and beta SECURITY MARKET LINE SML describes the exp returns and risks from investing different fractions Risk premium on investment of your funds in the mkt Beta exp market risk premium Standard for other investments Only willing to hold other investments if they are after equally good prospects Thus the required risk premium for any investment is given by the SML COMPANY COST OF CAPITAL Use CCC to discount cash flows on all Exp ROR demanded by investors in a new projects company det by the avg risk of the Require higher ROR from a risky company s sec company cid 224 risky firms have a higher COC set higher discount rate for their new inv opps PROJECT COST OF CAPITAL Depends not on the risk of the Min acc ROR on a project given its risk company but on the risk of the project Exp ROR Above SML NPV inv SML standard for project acceptance PROJECT RISK project projects with high costs tend to want above SML higher