Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate...
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![Page 1: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/1.jpg)
Chapter 7
Introduction to Risk, Return, and The Opportunity Cost of Capital
Principles of
Corporate FinanceEighth Edition
Slides by
Matthew Will
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
![Page 2: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/2.jpg)
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
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Topics Covered
Over a Century of Capital Market HistoryMeasuring Portfolio RiskCalculating Portfolio RiskBeta and Unique RiskDiversification & Value Additivity
![Page 3: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/3.jpg)
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The Value of an Investment of $1 in 1900
$1
$10
$100
$1,000
$10,000
$100,000
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
Start of Year
Dol
lars
Common Stock
US Govt Bonds
T-Bills
15,578
14761
2004
![Page 4: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/4.jpg)
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The Value of an Investment of $1 in 1900
$1
$10
$100
$1,000
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
Start of Year
Dol
lars
Equities
Bonds
Bills
719
6.81
2.80
2004
Real Returns
![Page 5: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/5.jpg)
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Average Market Risk Premia (by country)
4.3 4.7 5.1 5.3 5.8 5.9 5.9 6.3 6.4 6.67.6 8.1 8.2 8.6
9.310
10.7
0123456789
1011
Den
mar
k
Bel
giu
m
Sw
itze
rlan
d
Sp
ain
Can
ada
Irel
and
Ger
man
y
UK
Ave
rage
Net
her
lan
ds
US
A
Sw
eden
Sou
th A
fric
a
Au
stra
lia
Fra
nce
Jap
an
Ital
y
Risk premium, %
Country
![Page 6: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/6.jpg)
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Rates of Return 1900-2003
Source: Ibbotson Associates
-60%
-40%
-20%
0%
20%
40%
60%
80%
1900 1920 1940 1960 1980 2000
Year
Per
cent
age
Ret
urn
Stock Market Index Returns
![Page 7: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/7.jpg)
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Measuring Risk
1 14
1012
19
15
24
13
32
0
4
8
12
16
20
24
-50
to -
40
-40
to -
30
-30
to -
20
-20
to -
10
-10
to 0
0 to
10
10 t
o 20
20 t
o 30
30 t
o 40
40 t
o 50
50 t
o 60
Return %
# of Years
Histogram of Annual Stock Market ReturnsHistogram of Annual Stock Market Returns
![Page 8: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/8.jpg)
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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.
![Page 9: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/9.jpg)
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Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
![Page 10: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/10.jpg)
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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.”
![Page 11: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/11.jpg)
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Measuring Risk
Portfolio rate
of return=
fraction of portfolio
in first assetx
rate of return
on first asset
+fraction of portfolio
in second assetx
rate of return
on second asset
((
((
))
))
![Page 12: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/12.jpg)
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Measuring Risk
0
5 10 15
Number of Securities
Po
rtfo
lio s
tan
da
rd d
ev
iati
on
![Page 13: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/13.jpg)
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Measuring Risk
0
5 10 15
Number of Securities
Po
rtfo
lio s
tan
da
rd d
ev
iati
on
Market risk
Uniquerisk
![Page 14: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/14.jpg)
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Portfolio Risk
22
22
211221
1221
211221
122121
21
σxσσρxx
σxx2Stock
σσρxx
σxxσx1Stock
2Stock 1Stock
The variance of a two stock portfolio is the sum of these four boxes
![Page 15: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/15.jpg)
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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:
%12)1540(.)1060(. ReturnExpected
![Page 16: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/16.jpg)
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Portfolio Risk
2222
22
211221
2112212221
21
)3.27()40(.σx3.272.181
60.40.σσρxxCola-Coca
3.272.181
60.40.σσρxx)2.18()60(.σxMobil-Exxon
Cola-CocaMobil-Exxon
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.
![Page 17: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/17.jpg)
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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.
% 21.8 0.477 Deviation Standard
0.4773)1x18.2x27.2(.40x.60x
]x(27.3)[(.40)
]x(18.2)[(.60) Variance Portfolio22
22
![Page 18: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/18.jpg)
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Portfolio Risk
In real life, the correlation coefficient is 0.4
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 0.4 and calculate the portfolio variance.
% 18.3 9.333 Deviation Standard
9.333x27.3)0x0.4x18.22(0.40x0.6
]x(27.3)[(.40)
]x(18.2)[(.60) Variance Portfolio22
22
![Page 19: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/19.jpg)
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Portfolio Risk
)rx()r(x Return PortfolioExpected 2211
)σσρxx(2σxσxVariance Portfolio 21122122
22
21
21
![Page 20: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/20.jpg)
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Portfolio Risk
The shaded boxes contain variance terms; the remainder contain covariance terms.
1
2
3
4
5
6
N
1 2 3 4 5 6 N
STOCK
STOCKTo calculate portfolio variance add up the boxes
![Page 21: Chapter 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Principles of Corporate Finance Eighth Edition Slides by Matthew Will Copyright.](https://reader035.fdocuments.net/reader035/viewer/2022062221/56649d625503460f94a4530f/html5/thumbnails/21.jpg)
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Beta and Unique Risk
beta
Expected
return
Expectedmarketreturn
10%10%- +
-10%+10%
stock
Copyright 1996 by The McGraw-Hill Companies, Inc
-10%
1. Total risk = diversifiable risk + market risk2. Market risk is measured by beta, the sensitivity to market changes
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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.
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Beta and Unique Risk
2m
imiB
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Beta and Unique Risk
2m
imiB
Covariance with the market
Variance of the market
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Web Resources
www.globalfindata.com
www.econ.yale.edu/~shiller
Click to access web sitesClick to access web sites
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