1. Copyright © 2006 McGraw Hill Ryerson Limited10-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

2. Copyright © 2006 McGraw Hill Ryerson Limited10-2 Chapter 10 Introduction to Risk, Return and the Opportunity Cost of Capital Rates of Return: A Review 79 Years of Capital Market History Measuring Risk Risk and Diversification Thinking about Risk

3. Copyright © 2006 McGraw Hill Ryerson Limited10-3 Rates of Return: A Review Measuring Rate of Return  The total return on an investment is made up of:  Income (dividend or interest payments).  Capital gains (or losses). Percentage Return = Capital Gain + Dividend Initial share Price

4. Copyright © 2006 McGraw Hill Ryerson Limited10-4 Rates of Return: A Review

5. Copyright © 2006 McGraw Hill Ryerson Limited10-5 79 Years of Capital Market History Market index: Measure of the investment performance of the overall market  S&P/TSX Composite Index - Index of the investment performance of a portfolio of the major stocks listed on the Toronto Stock Exchange.  Dow Jones Industrial Average - Value of a portfolio holding one share in each of 30 large industrial firms.

6. Copyright © 2006 McGraw Hill Ryerson Limited10-6 79 Years of Capital Market History Value of a $1 investment made in 1925:

7. Copyright © 2006 McGraw Hill Ryerson Limited10-7 79 Years of Capital Market History Average returns on T-bills, government bonds and common stocks (1926-2004) : Average AnnualAverage PortfolioRate of ReturnRisk Premium* Treasury Bills4.7% - Gov’t Bonds6.4% 1.7%capitals Common Stocks11.4%6.7%capitals

8. Copyright © 2006 McGraw Hill Ryerson Limited10-8 79 Years of Capital Market History Can the past tell us about the future?  The historical record shows that investors have received a risk premium for holding risky assets. Rate of Return = Interest Rate + Market Risk on Any Security on T-bills Premium

9. Copyright © 2006 McGraw Hill Ryerson Limited10-9 Measuring Risk Variance and Standard Deviation  Variance:  The average value of squared deviations from the mean.  Standard Deviation  The square root of the variance.  Both variance and standard deviation are measures of volatility.

10. Copyright © 2006 McGraw Hill Ryerson Limited10-10 Measuring Risk Coin Toss game  2 coins are flipped  For each head, you get 20%  For each tail, you lose 10%  Possible outcomes:  HH: 20+20=40  HT:20-10= 10  TH:-10+20=10  TT:-10-10=-20

11. Copyright © 2006 McGraw Hill Ryerson Limited10-11 Measuring Risk Calculating Standard Deviation for the Coin Toss Game

12. Copyright © 2006 McGraw Hill Ryerson Limited10-12 Measuring Risk Standard Deviation for Various Securities  Average rates of return and standard deviation for various investment classes (1926-2004): Average Annual Average Standard PortfolioRate of Return Risk Premium Deviation Treasury Bills4.7%- 4.2% Gov’t Bonds6.4% 1.7%capitals9.0% Common Stocks11.4%6.7%capitals18.6%

13. Copyright © 2006 McGraw Hill Ryerson Limited10-13 Measuring Risk Standard Deviation for Various Securities  Notice the risk-return trade-off:  T-bills have the lowest average rate of return, and the lowest level of volatility.  Stocks have the highest average rate of return and the highest level of volatility.  Bonds are in the middle.

14. Copyright © 2006 McGraw Hill Ryerson Limited10-14 Risk and Diversification Definitions  Diversification: Strategy designed to reduce risk by spreading the 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.

15. Copyright © 2006 McGraw Hill Ryerson Limited10-15 Risk and Diversification Diversification  Which stock would you pick? Rate of Return ScenarioProbability Auto Stock Gold Stock Recession1/3-8.0%20.0% Normal1/3 5.0%3.0% Boom1/318.0%-20.0% Expected Return5.0%1.0% Standard Deviation10.6%16.4%

16. Copyright © 2006 McGraw Hill Ryerson Limited10-16 Risk and Diversification Diversification  For a two-asset portfolio: Portfolio Rate = fraction of portfolio x rate of return of return in 1 st asset on 1 st asset + fraction of portfolio x rate of return in 2 nd asset on 2 nd asset ( )

17. Copyright © 2006 McGraw Hill Ryerson Limited10-17 Risk and Diversification Diversification  Rate of return for a portfolio comprising 75% auto stock and 25% gold: Rate of Return ScenarioProbability Auto Stock Gold Stock Portfolio Recession1/3-8.0%20.0% -1.0% Normal1/3 5.0%3.0%4.5% Boom1/318.0%-20.0%8.5% Expected Return5.0%1.0%4.0% Standard Deviation10.6%16.4%3.9%

18. Copyright © 2006 McGraw Hill Ryerson Limited10-18 Risk and Diversification Diversification  Addition of the gold stock stabilizes the returns on the portfolio.  Diversification reduces risk because the assets in the portfolio do not move in exact lock step with each other.  When one stock is doing poorly, the other is doing well, helping to offset the negative impact on return of the stock with the poorer performance.

19. Copyright © 2006 McGraw Hill Ryerson Limited10-19 Risk and Diversification Correlation Coefficient  A measure of how closely two variables move together.  The correlation coefficient is always a number between -1 and +1.

20. Copyright © 2006 McGraw Hill Ryerson Limited10-20 Risk and Diversification Correlation Coefficient   > 0  positive correlation  variables move in the same direction.   < 0  negative correlation  variables move in the opposite direction.   = 0  no correlation

21. Copyright © 2006 McGraw Hill Ryerson Limited10-21 Risk and Diversification Market Risk Versus Unique Risk  If you hold two stocks with a correlation coefficient less than 1, then the risk of the portfolio can be reduced below the risk of holding either stock by itself.  Adding stocks to the portfolio, decreases the risk of the portfolio.  How much can you decrease the portfolio risk?

22. Copyright © 2006 McGraw Hill Ryerson Limited10-22 Risk and Diversification Diversification Reduces Risk 0 2 4 6 8 10 12 14 16 051015202530 Number of Securities Portfolio Standard Deviation Market Risk Unique Risk

23. Copyright © 2006 McGraw Hill Ryerson Limited10-23 Risk and Diversification Market Risk Versus Unique Risk  You cannot eliminate all risk from a portfolio by adding securities.  Typically, once you get beyond 15 stocks, adding more stocks does very little to reduce the risk of the portfolio.  The risk that cannot be diversified away is called market risk.  For a reasonably well diversified portfolio, only market risk matters.

24. Copyright © 2006 McGraw Hill Ryerson Limited10-24 Thinking about Risk 3 Key Messages about Risk  Some risks look big and dangerous but are really diversifiable.  Unique risk can be minimized by creating a diversified portfolio.  Market risks are macro risks  Example: changes in interest rates, industrial production, inflation, exchange rates and energy cost.  Risk can be measured

25. Copyright © 2006 McGraw Hill Ryerson Limited10-25 Summary of Chapter 10  Standard deviation and variance are measures of risk.  Diversification reduces risk because stocks do not move in exact lock step, meaning that poor performance by one stock can be offset by strong performance by another.  Correlation coefficient is a measure of how two variables move with respect to each other.

26. Copyright © 2006 McGraw Hill Ryerson Limited10-26 Summary of Chapter 10  Risk which can be eliminated by diversification is known as unique risk.  Risk which cannot be eliminated by diversification is called market risk.  For a well-diversified portfolio, only market risk matters.