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2. Risk and Return BMA Ch 8,9 Capital Market History of Risk and Return Market Risk and Return Measuring and Reducing Risk Markowitz Portfolio Theory Capital Asset Pricing Model

3. Capital Market History future value of $1 invested in 1900 (nominal)

4. Market Risk and Return r f risk-free rate (on t-bills) r m (stock) market rate (r m -r f )market risk premium

5. Market Risk and Return average market risk premia by country %

6. Market Risk and Return Histogram of Annual Stock Market Returns Return % # of Years

7. Measuring and Reducing Risk Variance - Average value of squared deviations from mean Standard Deviation – Square root of average value of squared deviations from mean. A common financial measure of volatility or risk

8. Measuring and Reducing Risk Diversification –Strategy designed to reduce risk by spreading the portfolio across many investments Unique Risk –Risk factors affecting specific firms –Can be eliminated by diversification –Also called “diversifiable risk” Market Risk –Economy-wide sources of risk that affect the overall stock market –Also called “systematic risk”

9. Measuring and Reducing Risk

10. Markowitz Portfolio Theory Investment (postpone consumption) –Take on risk –Expect a return Twin investment goals –Increase expected return –Reduce risk Portfolios (stock combinations) can reduce risk – Correlation (negative) of returns across stocks Efficient Portfolios –Weighted combinations of stocks that maximize return for given risk

11. Markowitz Portfolio Theory Standard Deviation vs. Expected Return Investment A % probability % return

12. Markowitz Portfolio Theory Standard Deviation vs. Expected Return Investment B % probability % return

13. Markowitz Portfolio Theory Standard Deviation vs. Expected Return Investment C % probability % return

14. Markowitz Portfolio Theory Standard Deviation vs. Expected Return Investment D % probability % return

15. Markowitz Portfolio Theory Efficient Frontier B C Return Risk (measured as  )

16. B C Return Risk BC Markowitz Portfolio Theory Efficient Frontier

17. B C N Return Risk BCN Markowitz Portfolio Theory Efficient Frontier Goal is to move up and left.

18. Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return Markowitz Portfolio Theory Efficient Frontier

19. Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return Markowitz Portfolio Theory Efficient Frontier

20. Markowitz Portfolio Theory Security Market Line Return Risk. rfrf Risk Free Return = Efficient Portfolio Market Return = r m

21. Markowitz Portfolio Theory Security Market Line Return. rfrf Risk Free Return = Efficient Portfolio Market Return = r m BETA1.0 SML Equation = r f + β ( r m - r f )

22. Capital Asset Pricing Model r = r f + β ( r m - r f ) CAPM