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

2. Topics Covered 72 Years of Capital Market History Measuring Risk
Portfolio Risk
Beta and Unique Risk
Diversification

3. The Value of an Investment of $1 in 1926
5520
1828
55.38
39.07
14.25
Index 1
Year End
Source: Ibbotson Associates 13

4. The Value of an Investment of $1 in 1926
Real returns
613
203
6.15
4.34
1.58
Index 1
Year End
Source: Ibbotson Associates 13

5. Rates of Return 1926-1997 Percentage Return Year
Source: Ibbotson Associates 14

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.

7. Measuring Risk
Coin Toss Game-calculating variance and standard deviation

8. Measuring Risk Histogram of Annual Stock Market Returns # of Years

9. 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.” 18

10. Measuring Risk 19

11. Measuring Risk 20

12. Measuring Risk 21

13. Portfolio Risk
The variance of a two stock portfolio is the sum of these four boxes: 19

14. Portfolio Risk Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = The expected dollar return on your portfolio is = The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

15. Portfolio Risk Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = The expected dollar return on your portfolio is = The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

16. Portfolio Risk Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = The expected dollar return on your portfolio is = The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

17. Portfolio Risk 19

18. Portfolio Risk To calculate portfolio variance add up the boxes
The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N
To calculate portfolio variance add up the boxes
STOCK
STOCK

19. Copyright 1996 by The McGraw-Hill Companies, Inc
Beta and Unique Risk
beta
Expected
return
market
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.

20. 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.

21. Beta and Unique Risk

22. Beta and Unique Risk
Covariance with the market
Variance of the market