CHAPTER 11 INTRODUCTION TO RISK RETURN AND THE OCC CHAPTER SUMMARY 04 02 2013 o 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 o 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 o 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 o 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 o Measure of the inv per of the overall mkt DOW JONES IND AVG S P COMPOSITE INDEX o Index of the inv perf of a portfolio of 30 blue chip stocks o Index of the inv perf of a portfolio of 500 companies SPECIFIC RISK MARKET RISK o Affecting only that firm diversifiable o 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 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 MATURITY RISK PREMIA PORTFOLIO T BILLS T BONDS COMMON STOCKS VARIANCE STD DEVIATION UNIQUE MARKET RISK If reasonably well diversified only market risk matters POR STD DEV Specific risk Both are measures of volatility More variable returns imply greater investment risk Specific risk diversifiable 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 Market risk that affect the overall stock market EQUATIONS 11 1 11 3 11 1 PERCENTAGE RETURN Capital gain dividend initial share price 11 2 VARIANCE Avg of squared deviations around the avg 11 3 STANDARD DEVIATION Square root of variance CHAPTER 12 CHAPTER SUMMARY BETA o 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 o Extra return that investors require for taking risk Market risk premium Risk premium on the mkt portfolio Avg 7 4 btw 1900 2010 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 R rf BETA rm rf Security market line Graphical representation of the CAPM equation Relates the expected return investors Opportunity cost of capital o Determined by the use to which the capital is put o Req ROR depend on risk of project NOT on risk of firm s existing business o Project cost of capital Min acceptable expected ROR on a project given its risk Already factor in chances of pleasant and unpleasant o Cash flow forecasts surprises Potential bad outcomes should be reflected in the DRate only to extent that they affect the beta KEY TERMS MKT PORTFOLIO o Port of all assets in the economy o Broad stock mkt is used to represent the mkt BETA MKT RISK PREMIUM o Sensitivity of a stock s return on the mkt portfolio o Risk premium of mkt portfolio o Diff btw mkt return and return on risk free T Bills CAPM o Theory of the relationship between risk and return o Expected risk premium on any security beta market risk premium SECURITY MKT LINE o Rel btw exp return and beta COMPANY COST OF CAPITAL o Exp rate of return demanded by investors in a company o Det by avg risk of comp s sec PROJECT COST OF CAPITAL o Min acceptable expected ROR on a project given its risk BETA Define and measure the risk of individual stocks Depends on exposure to macroeconomic conditions can be measured as the sensitivity of a stock s return to fluctuations PORTFOLIO BETA The beta of a portfolio is just an avg of the betas of the securities in the portfolio Well Diversified Portfolio All kinds of stocks Avg beta 1 0 Has the same variability as the mkt index Reduce risk by diversification An investor with a diversified portfolio will be int in the effect each stock has on its portfolio Def low betas not sen Agg high betas are sen MKT UP agg MKT DN def AVG BETA 1 for all stocks Div decreases variability from specific risk but not from market risk DEFINITION 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 mkt CAPM SECURITY MARKET LINE Market risk premium rm rf Expected market return rm Treasury bill rate risk free interest rate rf Market risk premium rm rf Risk premium rm rf B Expected return r CAPM Risk premium r rf B rm rf Exp ROR rfr rprem Expected return risk free rate risk premium r rf B rm rf Exp ROR dem by inv depend on two things 1 Compensation for the value of SECURITY MARKET LINE Risk premium on investment Beta exp market risk premium COMPANY COST OF CAPITAL Exp ROR demanded by investors in a company det by the avg risk of the company s sec PROJECT COST OF CAPITAL Min acc ROR on a project given its risk PROJECT RISK money risk free rate rf 2 Risk premium depends on the beta and mkt value premium Rel btw exp return and beta SML describes the exp returns and risks from investing different fractions of your funds in the mkt 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 Use CCC to discount cash flows on all new projects Require higher ROR from a risky company risky firms have a higher COC set higher discount rate for their new inv opps Depends not on the risk of the company but on the risk of the project Exp ROR Above SML NPV inv SML standard for project acceptance want above SML