Chapter 8 Principles of Corporate Finance Eighth Edition Risk and Return Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 2 McGraw-Hill/Irwin Topics Covered  Markowitz Portfolio Theory  Risk and Return Relationship  Validity and the Role of the CAPM  Some Alternative Theories

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 3 McGraw-Hill/Irwin Markowitz Portfolio Theory  Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation.  Correlation coefficients make this possible. efficient portfolios  The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 4 McGraw-Hill/Irwin Markowitz Portfolio Theory Price changes vs. Normal distribution Coca Cola - Daily % change Proportion of Days Daily % Change

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 5 McGraw-Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment A % probability % return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 6 McGraw-Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment B % probability % return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 7 McGraw-Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment C % probability % return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 8 McGraw-Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment D % probability % return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 8- 9 McGraw-Hill/Irwin Markowitz Portfolio Theory Exxon Mobil Coca Cola Standard Deviation Expected Return (%) 40% in Coca Cola  Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Standard Deviation Expected Return (%) Each half egg shell represents the possible weighted combinations for two stocks. The composite of all stock sets constitutes the efficient frontier

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Standard Deviation Expected Return (%) Lending or Borrowing at the risk free rate ( r f ) allows us to exist outside the efficient frontier. rfrf Lending Borrowing T S

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier 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%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier A B Return Risk (measured as  )

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier A B Return Risk AB

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier A B N Return Risk AB

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier A B N Return Risk AB ABN

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier A B N Return Risk AB Goal is to move up and left. WHY? ABN

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Efficient Frontier Return Risk A B N AB ABN

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Security Market Line Return Risk. rfrf Risk Free Return = Efficient Portfolio Market Return = r m

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Security Market Line Return. rfrf Risk Free Return = Efficient Portfolio Market Return = r m BETA1.0

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Security Market Line Return. rfrf Risk Free Return = BETA Security Market Line (SML)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Asset Pricing Model R = r f + B ( r m - r f ) CAPM

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Testing the CAPM High-minus low book-to-market Return vs. Book-to-Market Dollars (log scale) Small minus big

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth = market portfolio Market risk makes wealth uncertain. Stocks (and other risky assets) Consumption Wealth Wealth is uncertain Consumption is uncertain Standard CAPM Consumption CAPM

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - r f = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + … Return= a + b factor1 (r factor1 ) + b f2 (r f2 ) + …

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Arbitrage Pricing Theory Estimated risk premiums for taking on risk factors ( )

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