1 Chapter 10 Estimating Risk and Return McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Expected Returns Expected return is a forward-looking calculation Includes risk measures 10-2

Expected Return Multiply each possible return by the probability of that return occurring 10-3

Risk Premiums Required return is the return that investors demand for the level of risk taken Risk premium is the reward investors require for taking risk Market risk premium is the reward for taking unsystematic stock market risk 10-4

The Market Portfolio Capital Asset Pricing Model (CAPM) –Best known capital asset pricing model –Starts with modern portfolio theory 10-5

Efficient Frontier The efficient frontier demonstrates the highest expected return for each level of risk 10-6

Efficient Frontier Adding a risk-free asset improves return for each level of risk 10-7

CAPM Calculate the Security Market Line for risk/return relationship Substituting into line equation results in CAPM 10-8

Beta Measures the sensitivity of a stock or portfolio to market risk – Beta greater than 1 = more risky than market (higher risk premium) –Beta less than 1 = less risky (lower risk premium) 10-9

Security Market Line Shows relationship between risk and return for any stock or portfolio Similar to capital market line –Risk is characterized by beta, not standard deviation 10-10

Security Market Line Uses Beta as Risk Measure 10-11

Portfolio Beta Weighted average of portfolio stocks’ betas 10-12

Finding Beta Two ways –Can compute with data from company’s and market portfolio returns –Find in published data from financial outlets 10-13

Capital Market Efficiency Efficient markets feature –Many buyers and sellers –No high barriers to entry –Free and available information –Low trading or transaction costs 10-14

Efficient Market Hypothesis States that security prices fully reflect all available information Three levels –Weak form –Semi-strong form –Strong form 10-15

Weak-form Efficiency Current prices reflect all information derived from trading –Includes current and past stock prices and trading volume 10-16

Semi-strong form Efficiency Current prices reflect all available public information –Includes information like financial statements, news, analysts’ opinions 10-17

Strong-form Efficiency Current prices reflect all information –Public –Privately-held information 10-18

Behavioral Finance People behave in “irrational” ways –Both optimism and pessimism can be extreme –Overconfidence is tendency to overestimate knowledge and underestimate risk 10-19

Implications for Financial Managers Managers must... –understand the risk/return relationship and implications –address stockholders’ concerns and requirements 10-20

Constant-Growth Model Assumes stock is efficiently priced Uses dividend and price data and forward estimate 10-21