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Learning goals 1. Understand the meaning of risk and return 2. Understand the portfolio diversification 3. Usage of CAPM and SML 2

Risk 1 Task of financial manager: Assess of risk and return to maximize Investors, shareholders: Assess of risk and return to make investment decisions 3

Risk 2 Risk definitions: - classic risk – risk of damage The chance of financial loss - insurance - modern – uncertainty The variability of returns associated with a given asset - difference between expected and real result : T- bill? Corporate bonds? Corporate stocks? 4

Risk and return 5

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BUX ETF 7

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Return 1 Definition: the total gain or experienced on an investment over a given period of time To measure stock required return: r = [DIV 1 + (P 1 –P 0 ) ] / P 0 9

Rate of Return Example: Investment cashflow begining end of period A ,100 B 15, ,000118,000 C 7,000 48,000 48,000 r = ? 10

Historical returns for selected security 1926 – 2000 (%) Type of sec. Nom. Return real return premium on T-bills Small Stocks Large Stocks Corp. Bonds T-bonds T-Bills Source: Ibbotson Associetes, Stocks, Bonds and Inflation * inflation averaged 3.2% over this period 11

Historical returns WHERE TO FIND DATA? Historical returns (up to 50 years) from T. Rowe Price. Historical returnsT. Rowe Price Juggling the risk in Forbes. Juggling the riskForbes Chapter 1 of William Goetzmann's "An Introduction to Investment Theory" has a table of Ibbotson data (near the bottom of the page). Chapter 1William Goetzmann"An Introduction to Investment Theory" Dr. Ed Yardeni's Economics Network has an excellent supply of publications in Adobe Acrobat format. Dr. Ed YardeniAdobe Acrobat Global Financial Data from Bryan Taylor II, Ph.D. Global Financial Data Asset Strategy Consulting's Capital Markets with returns data for the past 20 years. Asset Strategy ConsultingCapital Markets History, as written by the winners in Forbes (6/16/97). History, as written by the winnersForbes Professor Robert J. Shiller's Annual Data on the US Stock Market: Prices, Dividends, Earnings, 1871-present.Robert J. ShillerAnnual Data on the US Stock Market: Financial Data Finder from Ohio State University's Department of Finance. Financial Data Finder Morgan Stanley and Salomon Brothers among others maintain extensive historical data for asset classes. asset classes 12

Chart 1. US: Returns and Risk (in % Annualized)

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Risk preferences 1 Human behaviours to risks: Risk - averse ( need more return to take more risk) Risk – seeking (enjoy risk, taking risk, give up some return) Risk indifferent ( nonsense ) 15

Risk preferences 2 Investors attitudes to risks: Hedger Risk taker A) speculators ( for risk premiums) B) hazard (0 premium ) Arbitrageur 16

Risk of a single asset Probability distribution Chance to occur a given outcome (80% probability?) Types: Bar chart Continuous distribution See : 17

Risk measurement Measures of risk: Standard deviation:  Variance:  2 18

Portfolio diversification 1 19

Portfolio diversification 2 20

Risk of a portfolio Diversification or single investment? Portfolio theory Total risk = market risk + unique risk Unique = unsystematic risk, diversifiable Risk specific to a firm Market = systematic, non-diversifiable risk, effect all firms 21

CAPM: the Capital Asset Pricing Model Equation: r = r f + ß X ( r m – r f ) r = free risk return + market premium 22

SML: Security Market Line 23

Problems Efficient market? Betas rely on past varies in time CAPM in 60’s and now VAR? 24

Example Currently under consideration is a project with a beta of At this time the risk free rate of return 7%, and the return on the market portfolio of assets is 10%. The project is actually expected to earn an annual rate of return of 11%. A. If the return on the market portfolio were to increase by 10%, what would you expect to happen to the project’s required return ? 25

Example cont. B. Use the capital asset pricing model to find the required return on this investment. C. On the basis of your calculation in part b, would you recommend this investment? 26

(MSFT) Microsoft Corp (05/01/2007) RiskGrade: 95 Min: 59 Max: 103 Avg: 79 Add benchmarks to chart: Investment RiskRanking In other words 78% of the tickers in US Markets are riskier than MSFT.US Markets Minimum RiskGrade in US Markets: 10 Maximum RiskGrade in US Markets: Average RiskGrade in US Markets:

Learning goals 1. Understand the meaning of risk and return 2. Understand the portfolio diversification 3. Usage of CAPM and SML 28

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