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Chapter 11

by: Hong Nguyen

Chapter 11 FINC318

Hong Nguyen
LA Tech
GPA 3.8

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Material for the second test
Business Finance
Dr. McCumber
Class Notes
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This 4 page Class Notes was uploaded by Hong Nguyen on Friday February 19, 2016. The Class Notes belongs to FINC318 at Louisiana Tech University taught by Dr. McCumber in Winter 2016. Since its upload, it has received 24 views. For similar materials see Business Finance in Finance at Louisiana Tech University.

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Date Created: 02/19/16
Risk and Return Expected returns and variances  1 .     Expected return ­ (Projected/expected) risk premium = (expected) return on risky investment – certain return on risk­ free investment  ­ Expected return on security or other asset = sum of possible returns * their probabilities 2. Calculating the variances ­ Determine squared deviations from expected returns ­ Multiply each possible squared deviation by its probability ­ Add these up and the result is variance 2 ­ Standard deviation = (variance) Portfolios ­ Portfolio = group of assets such as stocks and bonds held by an investor 1. Portfolio weights ­ Percentage of a portfolio’s total value in a particular asset 2. Portfolio expected returns ­ Suppose we had n assets in our portfolio, where n is any number. If we let x stand fir percentage of  our many in asset I then the expected return is: o E(R ) = x [E(R )] + x [E(R )] + … + x [E(R )] P 1 1 2 2 n n ­ Expected return on a portfolio is a straightforward combination of the expected returns on assets in  that portfolio 3. Portfolio variance ­ Combining assets into portfolio can substantially alter risks faced by investor. Announcements, surprises, and expected returns 1. Expected and unexpected returns ­ The return on any stock traded in a financial market is composed of 2 parts o Normal (expected) return from stock is the part of return that shareholders in market predict  or expect  Information shareholders have that bears on the stock  Market’s understanding today of important factors that will influence the stock in  coming year o Uncertainty (risk)  Unexpected information revealed within the year  ­ Total return (R) = expected return (E(R)) + unexpected return (U) o On average, actual return = expected return  o Over time, average value will be 0  2. Announcements and news ­ When government actually announces GDP figures for the ear, what will happen to the firm depends on what figure is released, or how much of the figure is new information  ­ At the beginning of the year, market participants will have some idea or forecast of what yearly GDP will be  o Prediction will already be factored into expected part of return on stock (E(R)) o If announced GDP is a surprise, effect will be part of U, the unanticipated portion of return   Announcement isn’t new = the market has already “discounted” the announcement  Difference between actual result and forecast = innovation/surprise  Risk and Return ­ Announcement can be broken into 2 parts, the anticipated (expected) part and the surprise  (innovation)  o Expected part of any announcement is part of information that the market uses to form  expectation (E(R)) of return on stock  o Surprise is news that influences unanticipated return on stock  ­ When we speak of news, we mean surprise part of announcement and not the portion that market has expected and therefore already discounted Risk: systematic and unsystematic ­ The unanticipated part of return, that portion resulting from surprises, is the true risk of any  investment  ­ The risk of owning an assets comes from surprises – unanticipated events  1. Systematic and unsystematic risk ­ Systematic risk = market risk o Affect a large number of assets (marketwide effect) o Examples:   Uncertainties about general economic conditions (GDP, interest rates, inflation)  ­ Unsystematic risk = unique (asset­specific) risk o Affect a single asset or a small group of assets  o Unique to individual companies or assets  o Example: announcements of an oil strike in a company will primarily affect that company  and perhaps a few others (primary competitors and suppliers)  2. Systematic and unsystematic components of return ­ Even the most narrow and peculiar bit of news about a company ripples through the economy,  however, because no matter how tiny an enterprise is, it’s a part of the economy ­ The distinction between types of risks allows us to break down surprise portion (U) o U = systematic portion (m) + unsystematic portion (e) ­ It is unrelated to unsystematic portion of return on most other assets   Diversification and portfolio risk 1. The effect of diversification: another lesson from market history ­ The standard deviation declines as the number of securities is increased  ­ Small difference exists because portfolio securities and time periods examined aren’t identical  2. The principle of diversification ­ Benefit in terms of risk reduction from adding securities drops off as we add more and more  ­ Some of riskiness associated w individual assets can be eliminated by forming portfolios o Process of spreading an investment across assets is called diversification o Principle of diversification tell us that spreading an investment across many assets will  eliminate some of the risk  ­ There is a minimum level of risk that cannot be eliminated simply by diversifying = nondiversifiable risk  3. Diversification and unsystematic risk ­ If we only held a single stock, then value of investment would fluctuate because of company­specific events. If we hold a large portfolio, on the other hand, some of the stocks in portfolio will go up in  value because of positive company­specific events and some will go down in value because of  negative events. The net effect on overall value of portfolio will be relatively small, however, as  these effects will tend to cancel each other out  Risk and Return ­ Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has  almost no unsystematic risk  ­ Diversification risk and unsystematic risk are often used interchangeably  4. Diversification and systematic risk ­ No matter how many assets we put into a portfolio, systematic risk doesn’t go away. It cannot be  eliminated by diversification  ­ Systematic risk and nondiversifiable risk are used interchangeably  Systematic risk and beta 1. The systematic risk principle ­ The reward for bearing risk depends only on systematic risk of an investment ­ Since unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward  for bearing it: the market doesn’t reward risks that are borne unnecessarily  ­ Expected return on asset depends only on asset’s systematic risk  2. Measuring systematic risk ­ Beta coefficient tell us how much systematic risk a particular asset has relative to an average asset  o An average asset has a beta of 1.0 relative to itself  ­ Expected return and thus the risk premium, on an asset depends only on its systematic risk  o Since assets  w larger beta have greater systematic risks, they will have greater expected  returns  3. Portfolio beta ­ If we have a large number of assets in a portfolio, we would multiply each asset’s beta by its  portfolio weight and then add results up to get portfolio’s beta The security market line ­ Risk free asset has no systematic risk (or unsystematic risk) so risk free asset has beta of 0 1. Beta and the risk premium ­ The percentage invested in an asset exceed 100% if the investor borrow to invest in a risk­free asset a. The reward­to­risk ratio ­ Slope of risk premium for assets  ­ Slope = reward­to­risk ratio = [E(R ) A (R )]/T A b. The basic argument: an asset is better than another one if ­ For any given level of systematic risk, some combination of asset A and risk free asset always offer  a larger return ­ A offers a superior return for its level of risk OR reward­to­risk ratio A > that of B c. The fundamental result ­ The reward­to­risk ratio must be the same for all assets in the market  o Apply to active competitive well­functioning markets  2. The security market line (SML) ­ The line that results when we plot expected returns and beta coefficients  ­ Relationship between systematic risk and expected return in financial markets  a. Market portfolio ­ Market portfolio = portfolio made up of all the assets in the market  o Expected return on this market portfolio = E(R )  M o Beta = 1 ­ SML slope = [E(R ) ­MR ]/βT = EMR ) ­ RM T ­ E(R M ­ R =T arket risk  premium (risk premium on a market portfolio)  b. The capital asset pricing model Risk and Return ­ E(R T = R  T [E(R ) M R ]βT =Tcapital asset pricing model (CAPM) ­ Expected return for a particular asset depends on  o Pure time value of money = reward for merely waiting for your money without taking any  risk o Reward for bearing systematic risk = reward market offers for bearing an average amount of  systematic risk in addition to waiting o Amount of systematic risk  The SML and the cost of capital: a preview ­ Goal in studying risk and return is twofold o Risk is an extremely important consideration in almost all business decisions, so we want to  discuss just what risk is and how it is rewarded in market o Learn what determines the appropriate discount rate for future cash flows  1. The basic idea ­ At an absolute minimum, any new investment our firm undertakes must offer an expected return that is no worse than what financial markets offer for same risk  ­ The only way we benefit our shareholders is by finding investments with expected returns that are  superior to what financial markets offer for same risk o Have positive NPV (tell us the going rate for bearing risk in economy) o Appropriate discount rate is what we should use expected return offered in financial markets  on investments w same systematic risk  ­ To determine whether or not an investment has a positive NPV, we essentially compare expected  return on that new investment to what financial market offers on an investment w same beta  2. The cost of capital ­ The appropriate discount rate on new project is minimum expected rate of return on investment must offer to be attractive = cost of capital  o Required return is what the firm must earn on its capital investment in project just to break  even  o Interpreted as opportunity cost associated w firm’s capital investment


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