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 that includes risk measures Very useful to estimate future stock performance. It depends on the state of the economy. We can’t accurately predict what the economy will be like next year (good or bad). Detailed forecast of economic conditions such as three states: red-hot economy, average expansion, and recession. 10-2

Expected Return Multiply each possible return by the probability of that return occurring Since economists not sure whether the economy will be good or bad next year, they may forecast for example 70% will be good & 30% chance of a recession. Refer to example 10-1 (pg. 332) 10-3

Market Risk – Risk Premium Required return (RR) is the return that investors demand for the level of risk taken. RR = risk-free rate + risk premium. Risk-free rate – the return on government bonds and bills. Risk premium is the reward investors require for taking risk. Market risk premium is the reward for taking unsystematic stock market risk. 10-4

Market Risk As discussed in chapter 9, the rewards for carrying risk apply only to the market risk (undiversified risk) portion of total risk. Total risks (SD) = Firm-specific risk (diversified risk) + market risk (undiversified risk) How much the portion of firm-specific risk and market risk? Firstly, we have to determine how much of a risk premium. Involves an equation that relates a stock’s required return to an appropriate risk premium - AP 5

The Market Portfolio The best-known asset pricing is the capital asset pricing model. Capital Asset Pricing Model (CAPM) –Starts with modern portfolio theory –The best combinations of securities possible use all the risky securities available (but not the risk- free asset) to create efficient frontier portfolios (see Figure 10.1 – panel A) –Panel B shows where the risk free asset would appear on the capital market line (CML) 10-6

Efficient Frontier The efficient frontier demonstrates the highest expected return for each level of risk 10-7

Efficient Frontier Adding a risk-free asset improves return for each level of risk 10-8

Market Portfolio Is the combination of securities that places the portfolio on the efficient frontier and on a line tangent from the risk-free rate. Represents ownership in all traded assets in the economy. It provides maximum diversification. Investor can locate optimal portfolio on capital market line by owning various combinations of the risk-free security and the market portfolio. Investors should locate their portfolios on the CML, rather than the efficient frontier. 9

CAPM Calculate the Security Market Line for risk/return relationship SML is similar to capital market line except risk is characterized by beta instead of SD. Beta indicates the market risk that each stock represents to investors. Higher the beta, the higher risk premium. Substituting into line equation results in CAPM 10-10

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) 10-11

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 10-12

Security Market Line Uses Beta as Risk Measure 10-13

Portfolio Beta Weighted average of portfolio stocks’ betas 10-14

Finding Beta Two ways –Can compute with data from company’s and market portfolio returns –Find in published data from financial outlets 10-15

Capital Market Efficiency A securities market in which prices fully reflect available information on each security. Efficient markets feature –Many buyers and sellers –No high barriers to entry –Free and available information –Low trading or transaction costs 10-16

Efficient Market Hypothesis A theory that describes what types of information are reflected in current stock prices. States that security prices fully reflect all available information Security prices change as new information becomes available. Three levels of market efficiency: –Weak form efficiency –Semi-strong form efficiency –Strong form efficiency 10-17

Weak-form Efficiency Current prices reflect all information derived from trading –Generally stock market information –Includes current and past stock prices and trading volume 10-18

Semi-strong form Efficiency Current prices reflect all available public information –This includes all information that has already been revealed to the public. –Like financial statements, news, analysts’ opinions 10-19

Strong-form Efficiency Current prices reflect all information –Include public information –Privately-held information that has not yet been released to the public, but may be known to some people, like managers, accountants, auditors, and so on

Behavioral Finance People behave in “irrational” ways –Both optimism and pessimism can be extreme –Overconfidence is tendency to overestimate knowledge and underestimate risk The biases of financial decision make by CEO or top management have a direct impact on decisions involving hundreds of millions, or even billions of dollars

Implications for Financial Managers Managers must... –understand the risk/return relationship and implications can help managers make better decisions for their corporation. –address stockholders’ concerns and requirements 10-22

Constant-Growth Model Alternative to the CAPM for computing shareholders’ required return. Assumes stock is efficiently priced Uses dividend and price data and forward estimate 10-23