1. Copyright 2008 The McGraw-Hill Companies 14W-1 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show 14 Financial Economics WEB

2. Copyright 2008 The McGraw-Hill Companies 14W-2 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Chapter Objectives The Idea of Present Value and Why it is Critical in Making Financial Decisions About the Most Popular Investments: Stocks, Bonds, and Mutual Funds How Investment Returns Compensate for Being Patient and for Bearing Risk

3. Copyright 2008 The McGraw-Hill Companies 14W-3 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Chapter Objectives About Portfolio Diversification and Why It Implies that Investors Can Focus on Nondiversifiable Risk When Evaluating an Investment Opportunity Why Higher Levels of Nondiversifiable Risk Are Associated With Higher Rates of Return Why Even Professionals Have a Hard Time Trying to “Beat the Market”

4. Copyright 2008 The McGraw-Hill Companies 14W-4 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Financial Investment Economic Investment Financial Investment Present Value –Compound Interest –The Present Value Model Dollars Today = X Dollars in t Years X ( 1 + i) t W 14W.1

5. Copyright 2008 The McGraw-Hill Companies 14W-5 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Applications Take the Money and Run Salary Caps and Deferred Compensation Some Popular Investments –Stocks –Bankrupt –Limited Liability Rule –Capital Gains –Dividends

6. Copyright 2008 The McGraw-Hill Companies 14W-6 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Applications Bonds –Default Mutual Fund –Portfolio –Index Funds –Actively Managed Funds –Passively Managed Funds Calculating Investment Returns –Percentage Rate of Return Asset Prices and Rates of Return Arbitrage

7. Copyright 2008 The McGraw-Hill Companies 14W-7 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Risk Diversification Diversifiable Risk Nondiversifiable Risk Comparing Risky Investments Average Expected Rate of Return Probability Weighted Average Beta –Market Portfolio O 14W.1

8. Copyright 2008 The McGraw-Hill Companies 14W-8 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Risk Relationship of Risk and Average Expected Rates of Return The Risk-Free Rate of Return Time Preference Risk-Free Interest Rate Risk Premium

9. Copyright 2008 The McGraw-Hill Companies 14W-9 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Risk GLOBAL PERSPECTIVE Investment Risks Across Different Countries Norway Luxembourg Switzerland Japan Chile United States China Mexico India Ghana Indonesia Nigeria Somalia Zimbabwe Iraq 0 20 40 60 80 100 Source: International Country Risk Guide

10. Copyright 2008 The McGraw-Hill Companies 14W-10 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show The Security Market Line Average Expected Rate of Return = Rate That Compensates For Time Preference + Rate That Compensates For Risk Security Market Line Market Portfolio Risk-Free Interest Rate, i f Average Expected Rate of Return Risk Level (beta) 0 1.0 Compensation For Time-Preference Equals i f Risk Premium for The Market Portfolio’s Risk Level of beta=1.0 A Risk-free Asset (i.e., a short-term U.S. Government bond)

11. Copyright 2008 The McGraw-Hill Companies 14W-11 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show The Security Market Line Security Market Line ifif Average Expected Rate of Return Risk Level (beta) 0 X Compensation For Time-Preference Equals i f Risk Premium for This Asset’s Risk Level of beta = X Risk Levels Determine Average Expected Rates of Return Y

12. Copyright 2008 The McGraw-Hill Companies 14W-12 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show The Security Market Line Security Market Line Average Expected Rate of Return Risk Level (beta) 0 X Arbitrage and the Security Market Y A B C

13. Copyright 2008 The McGraw-Hill Companies 14W-13 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show The Security Market Line SML 1 Average Expected Rate of Return Risk Level (beta) 0 X An Increase in the Risk-Free Rate Y2Y2 A Before Increase A After Increase SML 2 Y1Y1

14. Copyright 2008 The McGraw-Hill Companies 14W-14 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Why Do Index Funds Beat Actively Managed Funds Choice of Actively or Passively Managed Mutual Funds After Costs, Index Funds Outperform Actively Managed by 1% Per Year Management Costs Are Significant Index Funds May Pay More But Actively Managed Offer a More Exciting Opportunity to “Play” in the Market Last Word

15. Copyright 2008 The McGraw-Hill Companies 14W-15 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Key Terms economic investment financial investment compound interest present value stocks bankrupt limited liability rule capital gains dividends bonds default mutual funds portfolios index funds actively managed fundsactively managed funds passively managed fundspassively managed funds percentage rate of returnpercentage rate of return arbitrage risk diversification diversifiable risk nondiversifiable risk average expected rate of returnaverage expected rate of return probability weighted averageprobability weighted average beta market portfolio time preference risk-free interest rate Security Market Line risk premium

16. Copyright 2008 The McGraw-Hill Companies 14W-16 Financial Investment Applications Risk The Security Market Line Last Word Key Terms End Show Next Chapter Preview… Extending the Analysis Of Aggregate Supply