1. Lecture 7 Introduction to Risk, Return, and the Opportunity Cost of Capital Managerial Finance FINA 6335 Ronald F. Singer

2. 7-2 Topics Covered  72 Years of Capital Market History  Measuring Risk  Portfolio Risk  Beta and Unique Risk  Diversification

3. 7-3 The Value of an Investment of $1 in 1926 5520 1828 55.38 39.07 14.25 Index Year End

4. 7-4 The Value of an Investment of $1 in 1926 Index Year End 613 203 6.15 4.34 1.58 Real returns

5. 7-5 Rates of Return 1926-1997 Year Percentage Return

6. 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

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

8. 7-8 Measuring Risk Return % # of Years

9. 7-9 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.”

10. 7-10 Measuring Portfolio Return

11. 7-11 Measuring Risk

12. 7-12 Measuring Risk

13. 7-13 Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes:

14. 7-14 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 = 9.00. The expected dollar return on your portfolio is 5.50 + 9.00 = 14.50. The portfolio rate of return is 14.50/100 =.145 or 14.5%. Assume a correlation coefficient of 0.15. Assume the Standard Deviation of BM is 17.1%, and of McD is 20.8% Example

15. 7-15 Example

16. 7-16 Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N 123456N STOCK To calculate portfolio variance add up the boxes

17. 7-17 Beta and Unique Risk beta Expected return Expected market return 10% -+ - 10%+10% stock -10% 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes.

18. 7-18 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.

19. 7-19 Beta and Unique Risk Covariance with the market Variance of the market