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The McGraw-Hill Companies, Inc., 2000

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Presentation on theme: "The McGraw-Hill Companies, Inc., 2000"— Presentation transcript:

1 The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance Brealey and Myers Sixth Edition Risk and Return Slides by Matthew Will Chapter 8 Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

2 Topics Covered Markowitz Portfolio Theory Risk and Return Relationship
Testing the CAPM CAPM Alternatives

3 Markowitz Portfolio Theory
Combining stocks into portfolios can reduce standard deviation below the level obtained from a simple weighted average calculation. Correlation coefficients make this possible. The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

4 Markowitz Portfolio Theory
Price changes vs. Normal distribution Microsoft - Daily % change # of Days (frequency) Daily % Change

5 Markowitz Portfolio Theory
Price changes vs. Normal distribution Microsoft - Daily % change # of Days (frequency) Daily % Change

6 Markowitz Portfolio Theory
Standard Deviation VS. Expected Return Investment C % probability % return

7 Markowitz Portfolio Theory
Standard Deviation VS. Expected Return Investment D % probability % return

8 Markowitz Portfolio Theory
Expected Returns and Standard Deviations vary given different weighted combinations of the stocks. Expected Return (%) McDonald’s 45% McDonald’s Bristol-Myers Squibb Standard Deviation

9 Efficient Frontier Each half egg shell represents the possible weighted combinations for two stocks. The composite of all stock sets constitutes the efficient frontier. Expected Return (%) Standard Deviation

10 Efficient Frontier T rf S
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier. Expected Return (%) T Lending Borrowing rf S Standard Deviation

11 Efficient Frontier Example Correlation Coefficient = .4
Stocks s % of Portfolio Avg Return ABC Corp % % Big Corp % % Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4%

12 Efficient Frontier Let’s Add stock New Corp to the portfolio
Example Correlation Coefficient = .4 Stocks s % of Portfolio Avg Return ABC Corp % % Big Corp % % Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

13 Efficient Frontier Example Correlation Coefficient = .3
Stocks s % of Portfolio Avg Return Portfolio % % New Corp % % NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20%

14 Efficient Frontier NOTE: Higher return & Lower risk
Example Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio % % New Corp % % NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk

15 Efficient Frontier NOTE: Higher return & Lower risk
Example Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio % % New Corp % % NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that?

16 Efficient Frontier NOTE: Higher return & Lower risk
Example Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio % % New Corp % % NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

17 Efficient Frontier Return B A Risk (measured as s)

18 Efficient Frontier Return B AB A Risk

19 Efficient Frontier Return B N AB A Risk

20 Efficient Frontier Return B ABN N AB A Risk

21 Efficient Frontier Goal is to move up and left. Return WHY? B ABN N AB
Risk

22 Efficient Frontier Return Low Risk High Return Risk

23 Efficient Frontier Return Low Risk High Return High Risk High Return

24 Efficient Frontier Return Low Risk High Return High Risk High Return
Low Return Risk

25 Efficient Frontier Return Low Risk High Return High Risk High Return
Low Return High Risk Low Return Risk

26 Efficient Frontier Return Low Risk High Return High Risk High Return
Low Return High Risk Low Return Risk

27 Efficient Frontier Return B ABN N AB A Risk

28 . Security Market Line rf Return Efficient Portfolio Risk Free

29 . Security Market Line rf Return Market Return = rm
Efficient Portfolio Risk Free Return = rf Risk

30 . Security Market Line rf Return Market Return = rm
Efficient Portfolio Risk Free Return = rf Risk

31 . Security Market Line rf Return Market Return = rm
Efficient Portfolio Risk Free Return = rf BETA 1.0

32 Security Market Line rf Return Market Return = rm
Security Market Line (SML) Risk Free Return = rf BETA 1.0

33 Security Market Line rf SML Equation = rf + B ( rm - rf ) Return SML
BETA 1.0 SML Equation = rf + B ( rm - rf )

34 Capital Asset Pricing Model
R = rf + B ( rm - rf ) CAPM

35 Beta vs. Average Risk Premium
Testing the CAPM Beta vs. Average Risk Premium Avg Risk Premium SML 30 20 10 Investors Market Portfolio Portfolio Beta 1.0

36 Beta vs. Average Risk Premium
Testing the CAPM Beta vs. Average Risk Premium Avg Risk Premium 30 20 10 SML Investors Market Portfolio Portfolio Beta 1.0

37 Company Size vs. Average Return
Testing the CAPM Company Size vs. Average Return Average Return (%) Company size Smallest Largest

38 Book-Market vs. Average Return
Testing the CAPM Book-Market vs. Average Return Average Return (%) Book-Market Ratio Highest Lowest

39 Consumption Betas vs Market Betas
Stocks (and other risky assets) Wealth = market portfolio

40 Consumption Betas vs Market Betas
Stocks (and other risky assets) Market risk makes wealth uncertain. Wealth = market portfolio

41 Consumption Betas vs Market Betas
Stocks (and other risky assets) Market risk makes wealth uncertain. Standard CAPM Wealth = market portfolio

42 Consumption Betas vs Market Betas
Stocks (and other risky assets) Stocks (and other risky assets) Market risk makes wealth uncertain. Standard CAPM Wealth = market portfolio Consumption

43 Consumption Betas vs Market Betas
Stocks (and other risky assets) Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain. Standard CAPM Wealth Consumption is uncertain Wealth = market portfolio Consumption

44 Consumption Betas vs Market Betas
Stocks (and other risky assets) Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain. Consumption CAPM Standard CAPM Wealth Consumption is uncertain Wealth = market portfolio Consumption

45 Arbitrage Pricing Theory
Alternative to CAPM Expected Risk Premium = r - rf = Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …

46 Arbitrage Pricing Theory
Alternative to CAPM Expected Risk Premium = r - rf = Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + … Return = a + bfactor1(rfactor1) + bf2(rf2) + …

47 Arbitrage Pricing Theory
Estimated risk premiums for taking on risk factors ( )

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