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BC MF 02101 - CHAPTER 11 INTRODUCTION TO RISK, RETURN, AND THE OCC

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CHAPTER 11INTRODUCTION TO RISK, RETURN, AND THE OCCCHAPTER SUMMARY:Standard & Poor’s Composite IndexCommon stocks: avg a 7.4% higher return than SAFE treasury billsRisk premiumInvestors have taken on the risk of investing in stocksLT bonds = higher return than T bills but <<< stocksOCC for an avg risk project (same risk as typical share of common stock)Variance/Standard DeviationSpread of outcomes on different investmentsVarianceAvg of the squared deviations around the avg outcomeSDSquare root of the varianceFor mkt port of common stocks – avg around 20% a yearSD – gen higher on individual stocks than on the mktInd. Stocks DN move in lockstepRisk = Diversified AwaySpread portfolio among mult investments = smoothSpecific riskRisk that can be eliminated through diversificationNot all risk can be eliminatedMarket riskRisk that the mkt as a whole will slumpMacro changes that effect most stocks and overall stock mktHigh rise stockMakes an above average contribution to the risk of a diversified portfolioWorry about risk you can’t diversify awayDepends on stock’s sensitivity to macro conditionsKEY TERMS:MKT INDEXMeasure of the inv per of the overall mktDOW JONES IND. AVG.Index of the inv perf of a portfolio of 30 blue chip stocksS&P COMPOSITE INDEXIndex of the inv perf of a portfolio of 500 companiesSPECIFIC RISKAffecting only that firm (diversifiable)MARKET RISKEconomy-wide sources that affect overall stock market (systematic)RATES OF RETURN1. Buy a stock or bondReturn=A. Div or Int PmtB. Capital Gain or Loss2. % on a return (see equation)Cap gain + div yield///initial share price3. OR …4. Dividend yieldDividend yield ///Initial share price5. % Capital gainCapital gain ///Initial share price^^^ NOMINAL1 + real rate of return = 1 + nominal rate of return / 1 + inflation rate1 – real rate of return = ***MATURITY/RISK PREMIAPORTFOLIOT. BILLST. BONDSCOMMON STOCKSAVG ANN AVG PREMRATE RET EXTRA RET4.05.2 1.211.4 7.4VARIANCE/STD DEVIATIONBoth are measures of volatilityMore variable returns imply greater investment riskUNIQUE/MARKET RISKIf reasonably well diversified; only market risk matters.POR STD DEVSpecific risk ^^^Market risk ^^^Specific risk/diversifiable risk:Can be eliminated by DIVRisk factors affecting only that firmMarket/systematic risk:Why stocks tend to move togetherEconomy-wide sources of risk that affect the overall stock marketEQUATIONS 11.1 – 11.311.1 PERCENTAGE RETURN11.2 VARIANCE11.3 STANDARD DEVIATIONCapital gain + dividend /// initial share priceAvg of squared deviations aroundthe avgSquare root of varianceCHAPTER 12CHAPTER SUMMARY:BETASensitivity 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 stocksRisk premiumExtra return that investors require for taking riskMarket risk premiumRisk premium on the mkt portfolioAvg 7.4% btw 1900 – 2010CAPM – Capital Asset Pricing ModelExpected risk premium of an investment should be proportional to both its beta and the mkt risk premiumExpected rate of return = risk-free interest rate + risk premiumR = rf + BETA (rm – rf)Security market lineGraphical representation of the CAPM equationRelates the expected return investorsOpportunity cost of capitalDetermined by the use to which the capital is putReq ROR – depend on risk of projectNOT: on risk of firm’s existing businessProject cost of capitalMin acceptable expected ROR on a project given its riskCash flow forecasts?Already factor in chances of pleasant and unpleasant surprisesPotential bad outcomes should be reflected in the DRate only to extent that they affect the betaKEY TERMS:MKT PORTFOLIOPort of all assets in the economyBroad stock mkt is used to represent the mktBETASensitivity of a stock’s return on the mkt portfolioMKT RISK PREMIUMRisk premium of mkt portfolioDiff btw mkt return and return on risk free T BillsCAPMTheory of the relationship between risk and returnExpected risk premium on any security = beta * market risk premiumSECURITY MKT LINERel btw exp return and betaCOMPANY COST OF CAPITALExp rate of return demanded by investors in a companyDet by avg risk of comp’s secPROJECT COST OF CAPITALMin acceptable expected ROR on a project given its riskBETADefine and measure the risk of individual stocksDepends on exposure to macroeconomic conditions & can be measured as the sensitivity of a stock’s return to fluctuationsReduce risk by diversificationAn investor with a diversified portfolio will be int in the effect each stock has on its portfolioDef – low betas; not senAgg – high betas; are senMKT UP = aggMKT DN = defAVG BETA =1 for all stocksPORTFOLIO BETAThe beta of a portfolio is just an avg of the betas of the securities in the portfolioWell Diversified PortfolioAll kinds of stocksAvg beta 1.0Has the same variability as the mkt indexDiv decreases variability from specific risk but not from market riskDEFINITION(Fraction of portfolio in first stock * beta of first stock) +++(Fraction of portolio in second stock * beta of second stock)B 0-1: move in the same direction as the mkt but not as far.xx times as variable as the mktCAPM/SECURITY MARKET LINEExpected market return = rmTreasury bill rate / risk-free interest rate = rfMarket risk premium = rm – rfRisk premium = (rm-rf)* BExpected return = rCAPMSECURITY MARKET LINERisk premium on investment =Beta * exp market risk premiumMarket risk premium = rm – rfRisk premium = r–rf = B(rm –rf)Exp ROR = rfr + rpremExpected return =risk free rate +++ risk premiumr = rf + B(rm-rf)Exp ROR dem by inv depend on two things1. Compensation for the value of money (risk free rate – rf)2. Risk premium – depends on the beta and mkt value premiumRel btw exp return and betaSML – describes the exp returns and risks from investing different fractions of your funds in the mktStandard for other investmentsOnly 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 CAPITALExp ROR demanded by investors in a company det by the avg risk of the company’s secPROJECT COST OF CAPITALMin acc ROR on a project given its riskPROJECT RISKUse CCC to discount cash flows on all new projectsRequire higher ROR from a risky company  risky firms have a higher COC; set higher discount rate for their new inv oppsDepends not on the risk of the company but on the risk of the projectExp ROR? Above SML; + NPV invSML = standard for


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