1. Introduction to Risk, Return, and The Opportunity Cost of Capital
Principles of
Corporate Finance
Eighth Edition
Chapter 7
Introduction to Risk, Return, and The Opportunity Cost of Capital
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered Over a Century of Capital Market History
Measuring Portfolio Risk
Calculating Portfolio Risk
Beta and Unique Risk
Diversification & Value Additivity

3. The Value of an Investment of $1 in 190013

4. The Value of an Investment of $1 in 1900
Real Returns 13

5. Average Market Risk Premia (by country)
Risk premium, %
Country

6. Stock Market Index Returns
Rates of Return
Stock Market Index Returns
Percentage Return
Year
Source: Ibbotson Associates 14

7. Measuring Risk Histogram of Annual Stock Market Returns # of Years

8. Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

9. Measuring Risk
Coin Toss Game-calculating variance and standard deviation

10. Measuring Risk
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.” 18

11. Measuring Risk 19

12. Measuring Risk 20

13. Measuring Risk 21

14. Portfolio Risk
The variance of a two stock portfolio is the sum of these four boxes 19

15. Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is: 19

16. Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance. 19

17. Portfolio Risk Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance. 19

18. Portfolio Risk In real life, the correlation coefficient is 0.4
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 0.4 and calculate the portfolio variance. 19

19. Portfolio Risk 19

20. Portfolio Risk To calculate portfolio variance add up the boxes
The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N
To calculate portfolio variance add up the boxes
STOCK
STOCK

21. Copyright 1996 by The McGraw-Hill Companies, Inc
Beta and Unique Risk
1. Total risk = diversifiable risk + market risk
2. Market risk is measured by beta, the sensitivity to market changes
beta
Expected
return
market
10% - +
+10%
stock
Copyright 1996 by The McGraw-Hill Companies, Inc
-10%

22. Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.
Beta - Sensitivity of a stock’s return to the return on the market portfolio.

23. Beta and Unique Risk

24. Beta and Unique Risk
Covariance with the market
Variance of the market

25. Web Resources Web Links www.globalfindata.com
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