Introduction to Risk, Return, and the Opportunity Cost of Capital

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Presentation transcript:

Introduction to Risk, Return, and the Opportunity Cost of Capital Chapter 10 Fundamentals of Corporate Finance Fifth Edition Introduction to Risk, Return, and the Opportunity Cost of Capital Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 1 1 1 1 2 1

Topics Covered Rates of Return: A Review A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk 2

Rates of Return 5

Rates of Return 6

Rates of Return 8

Rates of Return Nominal vs. Real 11

Market Indexes Dow Jones Industrial Average (The Dow) Value of a portfolio holding one share in each of 30 large industrial firms. Standard & Poor’s Composite Index (The S&P 500) Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues. 12

The Value of an Investment of $1 in 1900 $17,545 Index $160 $61 2004 Year End Source: Ibbotson Associates 13

Rates of Return Common Stocks (1900-2004) 2004

Expected Return 15

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. 16

Measuring Risk Coin Toss Game-calculating variance and standard deviation 17

Risk and Diversification 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

Risk and Diversification

Risk and Diversification 19

Stock Market Volatility 1926-2004 Std Dev 2004

Country Risk Premia (%)

Histogram of Returns

Risk and Diversification 20

Risk and Diversification 21

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