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The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition Introduction to Risk, Return, and the Opportunity Cost of Capital Slides by Matthew Will Chapter 7 Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

Topics Covered 72 Years of Capital Market History Measuring Risk Portfolio Risk Beta and Unique Risk Diversification

The Value of an Investment of $1 in 1926 5520 1828 55.38 39.07 14.25 Index 1 Year End Source: Ibbotson Associates 13

The Value of an Investment of $1 in 1926 Real returns 613 203 6.15 4.34 1.58 Index 1 Year End Source: Ibbotson Associates 13

Rates of Return 1926-1997 Percentage Return Year Source: Ibbotson Associates 14

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 Coin Toss Game-calculating variance and standard deviation

Measuring Risk Histogram of Annual Stock Market Returns # of Years

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 19

Measuring Risk 20

Measuring Risk 21

Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes: 19

Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = 9.90. The expected dollar return on your portfolio is 5.50 + 9300 = 14.50. The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = 9.90. The expected dollar return on your portfolio is 5.50 + 9300 = 14.50. The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = 9.90. The expected dollar return on your portfolio is 5.50 + 9300 = 14.50. The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1. 19

Portfolio Risk 19

Portfolio Risk To calculate portfolio variance add up the boxes The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N To calculate portfolio variance add up the boxes STOCK STOCK

Copyright 1996 by The McGraw-Hill Companies, Inc Beta and Unique Risk beta Expected return market 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.

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.

Beta and Unique Risk

Beta and Unique Risk Covariance with the market Variance of the market