1. Chapter 8 Principles PrinciplesofCorporateFinance Ninth Edition Introduction to Risk, Return, and The Opportunity Cost of Capital Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. 8- 2 Topics Covered  Over a Century of Capital Market History  Measuring Portfolio Risk  Calculating Portfolio Risk  How Individual Securities Affect Portfolio Risk  Diversification & Value Additivity

3. 8- 3 The Value of an Investment of $1 in 1900

4. 8- 4 The Value of an Investment of $1 in 1900 Real Returns

5. 8- 5 Average Market Risk Premia (by country) Risk premium, % Country

6. 8- 6 Dividend Yield (1900-2006)

7. 8- 7 Rates of Return 1900-2006 Source: Ibbotson Associates Year Percentage Return Stock Market Index Returns

8. 8- 8 Measuring Risk Return % # of Years Histogram of Annual Stock Market Returns (1900-2006)

9. 8- 9 Equity Market Risk (by country) Standard Deviation of Annual Returns, % Average Risk (1900-2006)

10. 8- 10 Dow Jones Risk Annualized Standard Deviation of the DJIA over the preceding 52 weeks (1900 – 2006)

11. 8- 11 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.

12. 8- 12 Measuring Risk Coin Toss Game-calculating variance and standard deviation

13. 8- 13 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.”

14. 8- 14 Measuring Risk

15. 8- 15 Measuring Risk

16. 8- 16 Measuring Risk

17. 8- 17 Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes

18. 8- 18 Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal- Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The expected return on your portfolio is:

19. 8- 19 Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

20. 8- 20 Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

21. 8- 21 Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is:

22. 8- 22 Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

23. 8- 23 Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

24. 8- 24 Portfolio Risk

25. 8- 25 Portfolio Risk Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Real Standard Deviation: = (28 2) (.6 2 ) + (42 2 )(.4 2 ) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT Return : r = (15%)(.60) + (21%)(.4) = 17.4%

26. 8- 26 Portfolio Risk Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

27. 8- 27 Portfolio Risk Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

28. 8- 28 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

29. 8- 29 Beta and Unique Risk beta Expected return Expected market return 10% -+ - 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

30. 8- 30 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.

31. 8- 31 Beta and Unique Risk

32. 8- 32 Beta and Unique Risk Covariance with the market Variance of the market

33. 8- 33 Beta

34. 8- 34 Web Resources www.globalfindata.com www.econ.yale.edu/~shiller Click to access web sites Internet connection required