Introduction to Risk & Return

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Presentation transcript:

Introduction to Risk & Return Chapter 7 Principles of Corporate Finance Tenth Edition Introduction to Risk & Return Slides by Matthew Will McGraw Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

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

The Value of an Investment of $1 in 1900 13

The Value of an Investment of $1 in 1900 Real Returns 13

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

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.

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.” 18

Measuring Risk 21

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

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. 19

Portfolio Risk 19

Portfolio Risk Example Correlation Coefficient = .4 Stocks s % of Portfolio Avg Return ABC Corp 28 60% 15% Big Corp 42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Real Standard Deviation: = (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT Return : r = (15%)(.60) + (21%)(.4) = 17.4%

Portfolio Risk Let’s Add stock New Corp to the portfolio Example Correlation Coefficient = .4 Stocks s % of Portfolio Avg Return ABC Corp 28 60% 15% Big Corp 42 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

Portfolio Risk NOTE: Higher return & Lower risk Example Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio 28.1 50% 17.4% New Corp 30 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

Copyright 1996 by The McGraw-Hill Companies, Inc Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes beta Expected return market 10% - + +10% stock Copyright 1996 by The McGraw-Hill Companies, Inc -10%

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.