Presentation is loading. Please wait.

Presentation is loading. Please wait.

Risk /Return Return = r = Discount rate = Cost of Capital (COC)

Published byJemima Baker Modified over 8 years ago

Similar presentations

Presentation on theme: "Risk /Return Return = r = Discount rate = Cost of Capital (COC)"— Presentation transcript:

1 Risk /Return Return = r = Discount rate = Cost of Capital (COC)

2 Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk

3 Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk Two Extremes Treasury Notes are risk free = Retrun is low

4 Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk Two Extremes Treasury Notes are risk free = Retrun is low Junk Bonds are high risk = Return is high

5 Risk Variance & Standard Deviation yard sticks that measure risk Return is measured

6 Risk Variance & Standard Deviation yard sticks that measure risk Return is measured

7 The Value of an Investment of $1 in 1900

8 Real Returns

9 Rates of Return 1900-2003 Source: Ibbotson Associates Year Percentage Return Stock Market Index Returns

10 Diversification Diversification is the combining of assets. In financial theory, diversification can reduce risk. The risk of the combined assets is lower than the risk of the assets held separately.

11 Efficient Frontier Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Additive Standard Deviation (common sense): = 28 (60%) + 42 (40%) = 33.6 WRONG Real Standard Deviation: = (28 2) (.6 2 ) + (42 2 )(.4 2 ) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT

12 Efficient Frontier Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Real Standard Deviation: = (28 2) (.6 2 ) + (42 2 )(.4 2 ) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT Return : r = (15%)(.60) + (21%)(.4) = 17.4%

13 Efficient Frontier Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

14 Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20%

15 Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

16 Diversification

17 Efficient Frontier A B Return Risk (measured as O)

18 Efficient Frontier A B Return Risk AB

19 Efficient Frontier A B N Return Risk AB

20 Efficient Frontier A B N Return Risk AB ABN

21 Efficient Frontier A B N Return Risk AB Goal is to move up and left. WHY? ABN

22 Efficient Frontier Return Risk Low Risk High Return

23 Efficient Frontier Return Risk Low Risk High Return High Risk High Return

24 Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return

25 Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

26 Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

27 Efficient Frontier Return Risk A B N AB ABN

28 Markowitz Portfolio Theory Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation. Correlation coefficients make this possible. efficient portfolios The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

29 Markowitz Portfolio Theory Bristol-Myers Squibb McDonald’s Standard Deviation Expected Return (%) 45% McDonald’s  Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

30 Efficient Frontier Standard Deviation Expected Return (%) Each half egg shell represents the possible weighted combinations for two stocks. The composite of all stock sets constitutes the efficient frontier

31 Diversification 0 51015 Number of Securities Portfolio standard deviation

32 Diversification 0 51015 Number of Securities Portfolio standard deviation Market risk Unique risk

33 Efficient Frontier Standard Deviation Expected Return (%) Lending or Borrowing at the risk free rate ( r f ) allows us to exist outside the efficient frontier. rfrf Lending Borrowing T S

34 Efficient Frontier Return Risk A B N AB ABN

35 Security Market Line Return Risk. rfrf Efficient Portfolio Risk Free Return =

36 Security Market Line Return Risk. rfrf Risk Free Return = Market Return = r m Efficient Portfolio

37 Security Market Line Return Risk. rfrf Risk Free Return = Market Return = r m Efficient Portfolio

38 Security Market Line Return BETA. rfrf Risk Free Return = Market Return = r m Efficient Portfolio 1.0

39 Risk & Beta Market Beta = 1.0 = (O market )(O market ) = O m 2 (O market )(O market ) O m 2

40 Risk & Beta Market Beta = 1.0 = (O market )(O market ) = O m 2 (O market )(O market ) O m 2 Covariance

41 Risk & Beta Market Beta = 1.0 = (O market )(O market ) = O m 2 (O market )(O market ) O m 2 Stock Beta = O sm O m 2 Covariance

42 Risk & Beta Market Beta = 1.0 = (O market )(O market ) = O m 2 (O market )(O market ) O m 2 Stock Beta = O sm O m 2 Covariance covariance of market & stock

43 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.

44 Beta and Unique Risk

45 Covariance with the market Variance of the market

46 Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER 10 (High betas) 35 69 9 18 54 8 16 45 7 13 41 6 14 39 5 14 42 4 13 40 3 16 45 2 21 61 1 (Low betas) 40 62 Source: Sharpe and Cooper (1972)

47 Security Market Line Return BETA rfrf Risk Free Return = Market Return = r m 1.0 Security Market Line (SML)

48 Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

49 Capital Asset Pricing Model (CAPM) R = r f + B ( r m - r f )

50 Testing the CAPM Avg Risk Premium 1931-2002 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium

51 Testing the CAPM Avg Risk Premium 1931-65 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium

52 Testing the CAPM Avg Risk Premium 1966-2002 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium

53 Testing the CAPM High-minus low book-to-market Return vs. Book-to-Market Dollars (log scale) Small minus big http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html 2003

54 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) Hewlett-Packard return (%) R 2 =.53 B = 1.35

55 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) Hewlett-Packard return (%) R 2 =.49 B = 1.33

56 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) Hewlett-Packard return (%) R 2 =.45 B = 1.70

57 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) Hewlett-Packard return (%) R 2 =.35 B = 1.69

58 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) A T & T (%) R 2 =.28 B = 0.21

59 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) R 2 =.23 B = 0.64 A T & T (%)

60 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) R 2 =.28 B = 0.90 A T & T (%)

61 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) R 2 =..17 B =.90 A T & T (%)

62 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - r f = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + …

63 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - r f = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + … Return= a + b factor1 (r factor1 ) + b f2 (r f2 ) + …

64 Arbitrage Pricing Theory Estimated risk premiums for taking on risk factors (1978-1990)

65 3 Factor Model Fama & French Expected Return = B market (r market factor ) + B size (r size factor ) + B book to market (r book to market factor ) Market factor = Rm – Rf Size Factor = R small cap – R large cap Book to Market Factor = R high B-M stocks – R low B-M stocks

Download ppt "Risk /Return Return = r = Discount rate = Cost of Capital (COC)"

Similar presentations

Chapter 8 Risk and Return. Topics Covered  Markowitz Portfolio Theory  Risk and Return Relationship  Testing the CAPM  CAPM Alternatives.

Chapter 8 Risk and Return. Topics Covered  Markowitz Portfolio Theory  Risk and Return Relationship  Testing the CAPM  CAPM Alternatives.
Chapter 8 Principles PrinciplesofCorporateFinance Tenth Edition Portfolio Theory and the Capital Asset Pricing Model Slides by Matthew Will Copyright ©

Chapter 8 Principles PrinciplesofCorporateFinance Tenth Edition Portfolio Theory and the Capital Asset Pricing Model Slides by Matthew Will Copyright ©
 Risk and Return Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 8 © The McGraw-Hill Companies, Inc., 2000.

 Risk and Return Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 8 © The McGraw-Hill Companies, Inc., 2000.
Introduction to Risk and Return

Introduction to Risk and Return
Chapter 8 Principles of Corporate Finance Eighth Edition Risk and Return Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All.

Chapter 8 Principles of Corporate Finance Eighth Edition Risk and Return Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All.
The McGraw-Hill Companies, Inc., 2000

The McGraw-Hill Companies, Inc., 2000
12- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard.

12- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard.
Diversification and Portfolio Management (Ch. 8)

Diversification and Portfolio Management (Ch. 8)
Jacoby, Stangeland and Wajeeh, 20001 Risk Return & The Capital Asset Pricing Model (CAPM) l To make “good” (i.e., value-maximizing) financial decisions,

Jacoby, Stangeland and Wajeeh, Risk Return & The Capital Asset Pricing Model (CAPM) l To make “good” (i.e., value-maximizing) financial decisions,
Today Risk and Return Reading Portfolio Theory

Today Risk and Return Reading Portfolio Theory
Mutual Investment Club of Cornell Week 8: Portfolio Theory April 7 th, 2011.

Mutual Investment Club of Cornell Week 8: Portfolio Theory April 7 th, 2011.
 Capital Budgeting and Risk Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 9 © The McGraw-Hill Companies,

 Capital Budgeting and Risk Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 9 © The McGraw-Hill Companies,
Return, Risk, and the Security Market Line

Return, Risk, and the Security Market Line
Return and Risk: The Capital Asset Pricing Model Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Return and Risk: The Capital Asset Pricing Model Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
CORPORATE FINANCIAL THEORY Lecture 2. Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk Two Extremes Treasury Notes.

CORPORATE FINANCIAL THEORY Lecture 2. Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk Two Extremes Treasury Notes.
Financial Management Lecture No. 27

Financial Management Lecture No. 27
Portfolio Theory and the Capital Asset Pricing Model 723g28 Linköpings Universitet, IEI 1.

Portfolio Theory and the Capital Asset Pricing Model 723g28 Linköpings Universitet, IEI 1.
CORPORATE FINANCE V ESCP-EAP - European Executive MBA 14-15 Dec. 2005, London Risk, Return, Diversification and CAPM I. Ertürk Senior Fellow in Banking.

CORPORATE FINANCE V ESCP-EAP - European Executive MBA Dec. 2005, London Risk, Return, Diversification and CAPM I. Ertürk Senior Fellow in Banking.
Risk Premiums and Risk Aversion

Risk Premiums and Risk Aversion
Risk and Return and the Capital Asset Pricing Model (CAPM) For 9.220, Chapter.

Risk and Return and the Capital Asset Pricing Model (CAPM) For 9.220, Chapter.

Similar presentations

Ads by Google