CF Winter 2014

Questions 1. What cash flows should I consider? 2. How does the market set r ? 3. How should I set r ?

2.Market r risk premium % 13.31small stocks r 10.29common stocks 9.01 long bonds 6.89treasury bills inflation4.35 %

2.Market r Real-World Bonds  perceived risk =  required return  flexibility =  required return exactly the same rules for any investment

2.Market r Expected return from market Expected return from Treasury Bills  considered risk-free Risk premium  “extra” return earned for taking on risk

2.Market r risk return rfrf inflation t-bills average risk average return rprp r em

2.Market r risk return rfrf inflation t-bills SML average risk average return lower return lower risk higher return higher risk

2.Market r risk return rfrf SML β em r em

2.Market r risk return rfrf SML βiβi r ei CAPM risk-to-reward ratio

risk return rfrf Is this true?

2.Market r Is this true?  Efficient Market Hypothesis prices already reflect all known info  measure collective belief of all investors new info  unknowable  random when new info comes  prices adjust »quickly »correctly  if investors over-react or under-react »they do so randomly new info  research  news

2.Market r Is this true?  Efficient Market Hypothesis can only be true if  investors »have diversified portfolios »want highest return for lowest risk »incorrect predictions are random  market is »transparent »free »unlimited Is this almost true? Is this true enough?

2.Market r If  Efficient Market Hypothesis is true DOESN’T MEAN  can’t make money in stock market DOES MEAN  no “abnormal” or “excess” returns  return proportional to risk  NPV of all market investments = 0  research (a.k.a. info) »useful to match market »can’t be used to beat market

2.Market r  Efficient Market Hypothesis flavours weak form efficient  all past price behaviour included semi-strong form efficient  weak form + all public info included strong form efficient  semi-strong + all private info included too

Weak Form Efficiency  prices reflect all past market info price & volume  if true trading on market info not useful technical analysis not useful market timing not useful some investment advice is  empirical evidence generally confirmed?

Semi-strong Form Efficiency  prices reflect all public info trading info annual reports press releases, etc.  if true value-investing not useful other investment advice may be useful  empirical evidence some, but not all

Strong Form Efficiency  prices reflect all info public & private  if true then info not valuable then no advantage to insider trading  empirical evidence nope insiders can earn abnormal returns

Risk % return # years risk = volatility = surprise

2.Market r return rfrf SML βiβi r ei CAPM risk-to-reward ratio risk volatility unpredictability “swing” β

Risk risk = volatility = surprise return time β = 1 β > 1

β  sensitivity to market swings  unpredictability  riskiness in a rational market  investors should be rewarded more for buying more volatile stocks

Market Reward for Risk risk = volatility = surprise risk = surprises affecting the whole market surprises affecting only one stock (or small group of stocks) eliminated by diversifying market will NOT reward you for this + unsystematic risksystematic risk β

Market Reward for Risk risk return rfrf Security Market Line β=1 r em What happens to stocks that are “out of line”?

Portfolios changing hats  let’s pretend we’re a financial planner

Portfolios a collection of stocks  mix of high risk med risk low risk  all publicly traded known β s

Portfolios yx 20%25% r ey r ex What will our portfolio’s return be? only 2 stocks 50% weight 22.5%

Portfolios yx 50% chance 10%70%+ good year 30%-20%- bad year 20%25%average r ey r ex What will out portfolio’s return be? only 2 stocks 50% weight

Portfolio Volatility yx 50% chance 10%70%+ good year 30%-20%- bad year 20%25%average r ey r ex What’s the Standard Deviation of each stock? 50% weight

Pause?

Ch 13 Q 4 have $10,000 2 stocks How much of each stock to earn 12.2% stockearns X14% Y9%

Ch 13 Q 13 4 stocks What is  of portfolio? stockweight  Q25%0.60 R20%1.70 S15%1.15 T40%1.34

Ch 13 Q 14 3 investments What is  2 ? investmentsweight  stock 1 v1v1 1/31.9 stock 2 v2v2 1/3? risk-free v3v3 1/3 portfolio:

Ch 13 Q 20