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Chap011

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Morten Andersen

This chapter discusses risk and return, and their relationship to the cost of capital. It defines different types of returns, such as dividend yield and capital gain yield, and provides an example calculation. The chapter then discusses measuring risk through variance and standard deviation, and how diversification can help reduce overall portfolio risk by spreading investments across different asset classes. The key relationship discussed is that higher expected returns generally correspond to higher risks.

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McGraw-Hill/Irwin Copyright 息 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
11 -2 Risk and Return Risk and Return are related. How? This chapter will focus on risk and return and their relationship to the opportunity cost of capital.
11 -3 Equity Rates of Return: A Review Capital Gain + Dividend Initial Share Price Percentage Return = Dividend Yield = Dividend Initial Share Price Capital Gain Initial Share Price Capital Gain Yield =
11 -4 Rates of Return: Example Example: You purchase shares of GE stock at $15.13 on December 31, 2009. You sell them exactly one year later for $18.29. During this time GE paid $.46 in dividends per share. Ignoring transaction costs, what is your rate of return, dividend yield and capital gain yield? Percentage Return = $18.29 - $15.13 + + $.46 = 23.93% $15.13 Dividend Yield = $.46 3.04% $15.13 = Capital Gain Yield = $18.29 - $15.13 = $15.13 20.89%
11 -5 Real Rates of Return Recall the relationship between real rates and nominal rates: 1+ real rate of return = 1 + nominal rate of return 1 + inflation rate Example: Suppose inflation from December 2009 to December 2010 was 1.5%. What was GE stocks real rate of return, if its nominal rate of return was 23.93%?
11 -6 Capital Market History: Market Indexes Market Index - Measure of the investment performance of the overall market. Dow Jones Industrial Average (The Dow) Standard & Poors Composite Index (S&P 500) Other Market Indexes?
11 -7 Total Returns for Different Asset Classes The Value of an Investment of $1 in 1900
11 -8 What Drives the Difference in Total Returns? Maturity Premium: Extra average return from investing in long- versus short-term Treasury securities. Risk Premium: Expected return in excess of risk-free return as compensation for risk.
11 -9 Risk Premium: Example Interest Rate on Normal Risk Expected Market Return = + Treasury Bills Premium 1981: 21.4% = 14% + 7.4% 2008: 9.6% = 2.2% + 7.4%
11 - 10 Returns and Risk How are the expected returns and the risk of a security related?
11 - 11 Measuring Risk Variance: Average value of squared deviations from mean. A measure of volatility. Standard Deviation: Square root of variance. Also a measure of volatility. What is risk? How can it be measured?
11 - 12 Variance and Standard Deviation: Example Coin Toss Game: calculating variance and standard deviation (assume a mean of 10) (1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 0 0 - 20 - 30 900 Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%
11 - 13 Histogram of Returns What is the relationship between the volatility of these securities and their expected returns?
11 - 14 Historical Risk (1900-2010)
11 - 15 Risk and Diversification Diversification Strategy designed to reduce risk by spreading a 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.
11 - 16 Diversification: Building a Portfolio A portfolios rate of return is the weighted sum of each assets rate of return. fraction of portfolio rate of return 脱 旦 脱 旦 巽 存 巽 存 竪 淡 竪 淡 脱 旦 脱 旦 巽 存 巽 存 竪 淡 竪 淡 Portfolio Rate of Return = x in first asset on first asset fraction of portfolio rate of return + x in second asset on second asset Two Asset Case:
11 - 17 Building a Portfolio: Example Consider the following portfolio: Stock Weight Rate of Return IBM w = 50% r = 8.3% IBM IBM Starbucks w = 25% r = 12.5% SBUX SBUX Walmart w = 25% r = 4.7% W W What is the portfolio rate of return? ( wIBM 卒rIBM ) + ( wSBUX 卒rSBUX ) + ( wW 卒rW ) ( ) ( ) Portfolio Rate of Return = = 卒 + 卒 + 卒 = (50% 8.3%) 25% 12.5% 25% 4.7% 8.45%
11 - 18 Do stock prices move together? What effect does diversification have on a portfolios total risk, unique risk and market risk?
11 - 19 Risk and Diversification
11 - 20 Thinking About Risk Message 1 Some Risks Look Big and Dangerous but Really Are Diversifiable Message 2 Market Risks Are Macro Risks Message 3 Risk Can Be Measured

More Related Content

Chap011

  • 1. McGraw-Hill/Irwin Copyright 息 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
  • 2. 11 -2 Risk and Return Risk and Return are related. How? This chapter will focus on risk and return and their relationship to the opportunity cost of capital.
  • 3. 11 -3 Equity Rates of Return: A Review Capital Gain + Dividend Initial Share Price Percentage Return = Dividend Yield = Dividend Initial Share Price Capital Gain Initial Share Price Capital Gain Yield =
  • 4. 11 -4 Rates of Return: Example Example: You purchase shares of GE stock at $15.13 on December 31, 2009. You sell them exactly one year later for $18.29. During this time GE paid $.46 in dividends per share. Ignoring transaction costs, what is your rate of return, dividend yield and capital gain yield? Percentage Return = $18.29 - $15.13 + + $.46 = 23.93% $15.13 Dividend Yield = $.46 3.04% $15.13 = Capital Gain Yield = $18.29 - $15.13 = $15.13 20.89%
  • 5. 11 -5 Real Rates of Return Recall the relationship between real rates and nominal rates: 1+ real rate of return = 1 + nominal rate of return 1 + inflation rate Example: Suppose inflation from December 2009 to December 2010 was 1.5%. What was GE stocks real rate of return, if its nominal rate of return was 23.93%?
  • 6. 11 -6 Capital Market History: Market Indexes Market Index - Measure of the investment performance of the overall market. Dow Jones Industrial Average (The Dow) Standard & Poors Composite Index (S&P 500) Other Market Indexes?
  • 7. 11 -7 Total Returns for Different Asset Classes The Value of an Investment of $1 in 1900
  • 8. 11 -8 What Drives the Difference in Total Returns? Maturity Premium: Extra average return from investing in long- versus short-term Treasury securities. Risk Premium: Expected return in excess of risk-free return as compensation for risk.
  • 9. 11 -9 Risk Premium: Example Interest Rate on Normal Risk Expected Market Return = + Treasury Bills Premium 1981: 21.4% = 14% + 7.4% 2008: 9.6% = 2.2% + 7.4%
  • 10. 11 - 10 Returns and Risk How are the expected returns and the risk of a security related?
  • 11. 11 - 11 Measuring Risk Variance: Average value of squared deviations from mean. A measure of volatility. Standard Deviation: Square root of variance. Also a measure of volatility. What is risk? How can it be measured?
  • 12. 11 - 12 Variance and Standard Deviation: Example Coin Toss Game: calculating variance and standard deviation (assume a mean of 10) (1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 0 0 - 20 - 30 900 Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%
  • 13. 11 - 13 Histogram of Returns What is the relationship between the volatility of these securities and their expected returns?
  • 14. 11 - 14 Historical Risk (1900-2010)
  • 15. 11 - 15 Risk and Diversification Diversification Strategy designed to reduce risk by spreading a 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.
  • 16. 11 - 16 Diversification: Building a Portfolio A portfolios rate of return is the weighted sum of each assets rate of return. fraction of portfolio rate of return 脱 旦 脱 旦 巽 存 巽 存 竪 淡 竪 淡 脱 旦 脱 旦 巽 存 巽 存 竪 淡 竪 淡 Portfolio Rate of Return = x in first asset on first asset fraction of portfolio rate of return + x in second asset on second asset Two Asset Case:
  • 17. 11 - 17 Building a Portfolio: Example Consider the following portfolio: Stock Weight Rate of Return IBM w = 50% r = 8.3% IBM IBM Starbucks w = 25% r = 12.5% SBUX SBUX Walmart w = 25% r = 4.7% W W What is the portfolio rate of return? ( wIBM 卒rIBM ) + ( wSBUX 卒rSBUX ) + ( wW 卒rW ) ( ) ( ) Portfolio Rate of Return = = 卒 + 卒 + 卒 = (50% 8.3%) 25% 12.5% 25% 4.7% 8.45%
  • 18. 11 - 18 Do stock prices move together? What effect does diversification have on a portfolios total risk, unique risk and market risk?
  • 19. 11 - 19 Risk and Diversification
  • 20. 11 - 20 Thinking About Risk Message 1 Some Risks Look Big and Dangerous but Really Are Diversifiable Message 2 Market Risks Are Macro Risks Message 3 Risk Can Be Measured

Editor's Notes

  • #2: Chapter 11 Learning Objectives 1. Estimate the opportunity cost of capital for an average-risk project. 2. Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. 3. Understand why diversification reduces risk. 4. Distinguish between specific risk, which can be diversified away, and market risk, which cannot.
  • #3: Chapter 11 Outline Rates of Return: A Review Dividends and Capital Gains Real Rates of Return A Century of Capital Market History Market Indexes Measuring Risk Risk & Diversification Thinking About Risk
  • #4: Dividend Periodic cash distribution to shareholders. Capital Gain The difference between the sell price and the buy price of a security.
  • #6: Rate of Return Total income and capital appreciation per period per dollar invested. Inflation Rate at which prices as a whole are increasing.
  • #7: Market Index Measure of the investment performance of the overall market. Dow Jones Industrial Average Index of the investment performance of a portfolio of 30 bluechip stocks. S&P Composite Index Index of the investment performance of a portfolio of 500 large stocks. Also called the S&P 500.
  • #8: Notes: The y-axis is in log-dollars. Equities = Diversified Portfolio of Common Stocks Bonds = Treasury bonds issued by the U.S. government with average maturity of 10 years Bills = Treasury bills issued by the U.S. government with maturity of 3-months.
  • #9: Maturity Premium Extra average return from investing in long- versus short-term Treasury securities. Risk Premium Expected return in excess of risk-free return as compensation for risk
  • #12: Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation Square root of variance. A measure of volatility.
  • #13: Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation Square root of variance. A measure of volatility.
  • #16: 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.
  • #19: 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.