11-1 Lecture 11 Introduction to Risk, Return, and the Opportunity Cost of Capital.

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Presentation transcript:

11-1 Lecture 11 Introduction to Risk, Return, and the Opportunity Cost of Capital

11-2 Risk and Return Risk and Return are related. How? This chapter will focus on risk and return and their relationship to the opportunity cost of capital.

11-3 Equity Rates of Return: A Review

11-4 Rates of Return: Example Example: You purchase shares of GE stock at $15.13 on December 31, You sell them exactly one year later for $ During this time GE paid $.46 in dividends per share. Ignoring transaction costs, what is your rate of return, dividend yield and capital gain yield?

11-5 Real Rates of Return Example: Suppose inflation from December 2009 to December 2010 was 1.5%. What was GE stock’s real rate of return, if its nominal rate of return was 23.93%? Recall the relationship between real rates and nominal rates:

11-6 Capital Market History: Market Indexes Market Index - Measure of the investment performance of the overall market. Dow Jones Industrial Average (The Dow) Standard & Poor’s Composite Index (S&P 500) Other Market Indexes?

11-7 Total Returns for Different Asset Classes The Value of an Investment of $1 in 1900

11-8 What Drives the Difference in Total Returns? Maturity Premium: Extra average return from investing in long- versus short-term Treasury securities. Risk Premium: Expected return in excess of risk-free return as compensation for risk.

11-9 Risk Premium: Example

11-10 Returns and Risk How are the expected returns and the risk of a security related?

11-11 Measuring Risk Variance: Average value of squared deviations from mean. A measure of volatility. Standard Deviation: Square root of variance. Also a measure of volatility. What is risk? How can it be measured?

11-12 Variance and Standard Deviation: Example Coin Toss Game: calculating variance and standard deviation (assume a mean of 10)

11-13 Histogram of Returns What is the relationship between the volatility of these securities and their expected returns?

11-14 Historical Risk ( )

11-15 Risk and Diversification Diversification Strategy designed to reduce risk by spreading a 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.”

11-16 Diversification: Building a Portfolio A portfolio’s rate of return is the weighted sum of each asset’s rate of return. Two Asset Case:

11-17 Building a Portfolio: Example Consider the following portfolio: StockWeightRate of Return IBM Starbucks Walmart What is the portfolio rate of return?

11-18 Do stock prices move together? What effect does diversification have on a portfolio’s total risk, unique risk and market risk?

11-19 Risk and Diversification

11-20 Thinking About Risk  Message 1 Some Risks Look Big and Dangerous but Really Are Diversifiable  Message 2 Market Risks Are Macro Risks  Message 3 Risk Can Be Measured