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Introduction to Risk, Return, and The Opportunity Cost of Capital
Principles of Corporate Finance Eighth Edition Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Over a Century of Capital Market History
Measuring Portfolio Risk Calculating Portfolio Risk Beta and Unique Risk Diversification & Value Additivity

The Value of an Investment of \$1 in 1900
13

The Value of an Investment of \$1 in 1900
Real Returns 13

Average Market Risk Premia (by country)
Risk premium, % Country

Stock Market Index Returns
Rates of Return Stock Market Index Returns Percentage Return Year Source: Ibbotson Associates 14

Measuring Risk Histogram of Annual Stock Market Returns # of Years

Measuring Risk Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

Measuring Risk Coin Toss Game-calculating variance and standard deviation

Measuring Risk Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.” Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.” 18

Measuring Risk 19

Measuring Risk 20

Measuring Risk 21

Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes 19

Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is: 19

Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance. 19

Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance. 19

Portfolio Risk In real life, the correlation coefficient is 0.4
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 0.4 and calculate the portfolio variance. 19

Portfolio Risk 19

Portfolio Risk To calculate portfolio variance add up the boxes
The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N To calculate portfolio variance add up the boxes STOCK STOCK

Copyright 1996 by The McGraw-Hill Companies, Inc
Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes beta Expected return market 10% - + +10% stock Copyright 1996 by The McGraw-Hill Companies, Inc -10%

Beta and Unique Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio.

Beta and Unique Risk

Beta and Unique Risk Covariance with the market Variance of the market

Web Resources Web Links www.globalfindata.com
Click to access web sites Internet connection required

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