Chapter 11 Learning Objectives 1. Estimate the opportunity cost of capital for an “average-risk” project. 2. Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. 3. Understand why diversification reduces risk. 4. Distinguish between specific risk, which can be diversified away, and market risk, which cannot.

Risk and Return are related. How? This chapter will focus on risk and return and their relationship to the opportunity cost of capital. Chapter 11 Outline Rates of Return: A Review Dividends and Capital Gains Real Rates of Return A Century of Capital Market History Market Indexes Measuring Risk Risk & Diversification Thinking About Risk 2

Equity Rates of Return: A Review Dividend — Periodic cash distribution to shareholders. Capital Gain – The difference between the sell price and the buy price of a security. 5

Rates of Return: Example Example: You purchase shares of GE stock at $15.13 on December 31, 2009. You sell them exactly one year later for $18.29. During this time GE paid $.46 in dividends per share. Ignoring transaction costs, what is your rate of return, dividend yield and capital gain yield? 8

Real Rates of Return Recall the relationship between real rates and nominal rates: Example: Suppose inflation from December 2009 to December 2010 was 1.5%. What was GE stock’s real rate of return, if its nominal rate of return was 23.93%?   Rate of Return – Total income and capital appreciation per period per dollar invested. Inflation – Rate at which prices as a whole are increasing.   11

Capital Market History: Market Indexes Market Index - Measure of the investment performance of the overall market. Dow Jones Industrial Average (The Dow) Standard & Poor’s Composite Index (S&P 500) Other Market Indexes? Market Index – Measure of the investment performance of the overall market. Dow Jones Industrial Average – Index of the investment performance of a portfolio of 30 “bluechip” stocks. S&P Composite Index – Index of the investment performance of a portfolio of 500 large stocks. Also called the S&P 500. 12

Total Returns for Different Asset Classes The Value of an Investment of $1 in 1900 Notes: The y-axis is in log-dollars. Equities = Diversified Portfolio of Common Stocks Bonds = Treasury bonds issued by the U.S. government with average maturity of 10 years Bills = Treasury bills issued by the U.S. government with maturity of 3-months. 13

What Drives the Difference in Total Returns? Maturity Premium: Extra average return from investing in long- versus short-term Treasury securities. Risk Premium: Expected return in excess of risk-free return as compensation for risk. Maturity Premium – Extra average return from investing in long- versus short-term Treasury securities. Risk Premium – Expected return in excess of risk-free return as compensation for risk 15

Risk Premium: Example 15

How are the expected returns and the risk of a security related? Returns and Risk How are the expected returns and the risk of a security related?

Measuring Risk What is risk? How can it be measured? Variance: Average value of squared deviations from mean. A measure of volatility. Standard Deviation: Square root of variance. Also a measure of volatility. Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation – Square root of variance. A measure of volatility. 16

Variance and Standard Deviation: Example Coin Toss Game: calculating variance and standard deviation (assume a mean of 10) Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation – Square root of variance. A measure of volatility. 17

Histogram of Returns What is the relationship between the volatility of these securities and their expected returns?

Historical Risk (1900-2010)

Risk and Diversification Strategy designed to reduce risk by spreading a 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.” 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

Diversification: Building a Portfolio A portfolio’s rate of return is the weighted sum of each asset’s rate of return. Two Asset Case: 19

Building a Portfolio: Example Consider the following portfolio: Stock Weight Rate of Return IBM Starbucks Walmart What is the portfolio rate of return? 19

Do stock prices move together? 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.” What effect does diversification have on a portfolio’s total risk, unique risk and market risk?

Risk and Diversification 21

Thinking About Risk Message 1 Message 2 Message 3 Some Risks Look Big and Dangerous but Really Are Diversifiable Message 2 Market Risks Are Macro Risks Message 3 Risk Can Be Measured