 Introduction to Risk, Return, and the Opportunity Cost of Capital Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will.

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 Introduction to Risk, Return, and the Opportunity Cost of Capital Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 7 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 2 Topics Covered  72 Years of Capital Market History  Measuring Risk  Portfolio Risk  Beta and Unique Risk  Diversification

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 3 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 4 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End Real returns

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 5 Rates of Return Source: Ibbotson Associates Year Percentage Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 6 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 7 Measuring Risk Coin Toss Game-calculating variance and standard deviation

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 8 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.”

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 9 Measuring Risk

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Measuring Risk

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 11

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Portfolio Risk

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms N N STOCK To calculate portfolio variance add up the boxes

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Beta and Unique Risk beta Expected return Expected market return 10% %+10% stock Copyright 1996 by The McGraw-Hill Companies, Inc -10% 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Beta and Unique Risk

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Beta and Unique Risk Covariance with the market Variance of the market