J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Measure of Risk and Risk- Adjusted Returns April 16, 2007 (LA) or April 10, 2007 (OCC)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Fundamental Finance Concepts u Portfolios –Investors have more than one asset –Anyone can build a portfolio u Efficiency –Specific meaning: informational efficiency u Arbitrage –Strong economic force operating at all times –“Buy cheap, sell dear” to make profits

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Returns u Investors in assets want highest returns to maximize increases in wealth u Realized returns are actual historical returns earned by investors over a holding period u Yield to maturity is the yield a default risk-free bond will earn if held to maturity but may differ with a shorter holding period u Expected return is the future return investor anticipates for an asset given its risk

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Holding Period Returns u An stock investor’s return t to t+1 (p. 259) u For all assets (including bonds), we have in general

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 NKE Returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 NKE Returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 JNJ Monthly Returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Table Total Annual Returns u Ibbotson and Sinquefield, Stocks, Bonds, Bills, and Inflation: 2003 Yearbook u Large-company common Stocks % u Small Company Stocks – 17.4% u U.S. Treasury Bills - 3.8% u Risk premium = Expected Return – Risk- Free Return u Average large company stock risk premium 8.5%

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk and Return u Returns increase wealth, large returns increase wealth more u Investors assumed to love return (remember maximize shareholders’ wealth) u Investors dislike risk u Risk measured as variability of returns u Standard measure is standard deviation of returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Portfolios and Risk u Portfolio contains two or more assets u Risky portfolios are different combinations (weights) invested in risky assets u Expected return on a portfolio of two assets is (p. 286): u X’s (portfolio weights) must add up to one

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Portfolio Theory and Markowitz u Variance of a two-asset portfolio (p. 286): u Note covariance between two assets is: u If two assets perfectly correlated, correlation coefficient = +1.0

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Variance of Portfolios u Using expression for covariance above: u If correlation is perfect, variance is u Standard deviation (square root of variance) is weighted average of two assets’ risks

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Portfolio Risk Return  A A AA Correlation << 1 BB BB Risk

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Multiple Assets and Risk Efficient Frontier Returns Risk AA XX YY BB  A A  X X  Y Y  B B

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 NKE v JNJ Returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Correlations JNJRETNKERET ORCLRET JNJRET NKERET ORCLRET

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Correlation between Returns u Correlation between monthly returns of Nike and Johnson & Johnson between 1984 and 2002 is.34 u Correlation between monthly returns of Nike and Oracle is 0.26 u Correlation between monthly returns of Johnson & Johnson and Oracle is 0.13 u Correlation between Nike and S&P index return is.45

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Asset Pricing Model u “Capital assets” are risky assets like real investments or financial claims on them like stocks and bonds u “Pricing model” means risk adjustments affecting prices of financial claims u Risk adjustments are made in discount rate applied to expected future cash flows

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 CAPM Conceptual Structure u Example of “price of risk” adjustment: if risk-free rate is 6% and an risky asset has a 10% risk “adjustment”, use 16% to discount u Assume an expected future cash flow from the asset of $10,000: u If investors have same expectations and risk adjustment, equilibrium value is $8,621

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 CAPM u A risk-free rate exists and there is one common risk - market or systematic risk u Other risks are uncorrelated and can be diversified to neglible levels: diversifiable risks are unsystematic or idiosyncratic u Risks that matter are an asset’s contribution to a portfolio’s risk u In CAPM, everyone holds market portfolio

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk-Free Asset and Tradeoffs Efficient Frontier Returns Risk AA XX YY BB  A A  X X  Y Y  B B Efficient Frontier M RFRF

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Nike and S&P 500 Returns

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Beta Coefficient u Beta measures contribution of an asset to the systematic risk of a portfolio u Beta is familiar from statistics and is defined (p. 306) u Recall linear regression in statistics

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Cost of Equity Capital (CAPM) u Easily computed using Wharton CRSP data and E-Views (or other statistics software) u Use risk-free rate and premium on average large-company stock (in text Treasury bill rate and 8.5%) u For a stock with a given beta (p. 308): u Need only know a stock’s beta

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Sources of Beta Estimates u Value Line Investment Survey –Box in upper left of individual company report u Standard and Poor’s “Stock Reports” u Many internet sources u Important Issues –Beta estimates differ because of time period and market index used (e.g. Value Line index, S & P 500 index, etc.)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk Premium Issues u Risk premium relative to Treasury bills as in text (p. 307) or long-term Treasury bonds as in Valuation by Copeland et al u Risk premium certainly varies through time and is difficult to estimate u Fama and French (1992) find that beta coefficients do not explaiin differences in returns across stocks but that BV/MVand market cap do

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Problems with CAPM and outlook for Alternatives u Assumptions u Beta estimates u Predictions (Fama and French) u Simplicity works two ways u Arbitrage Pricing Theory (APT) meets objections in many ways u APT not gaining acceptability u CAPM will be around for a while

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Class 12 -April 23 (LA) & 12 (OCC) u Read Chapter 12 and do assigned problems u Start reading ahead in the text as there is quite a bit of reading before the final u Complete Part 3 of group project u Begin thinking about a strategy for reviewing for final, start looking over course objectives, previous class slides, and old examinations