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Introduction To Risk, Return, and The Opportunity Cost of Capital
Introduction To Risk, Return, and The Opportunity Cost of Capital
Introduction To Risk, Return, and The Opportunity Cost of Capital
Corporate Chapter 7
Finance
Introduction to Risk, Return,
Seventh Edition
and the Opportunity Cost of
Richard A. Brealey Capital
Stewart C. Myers
Slides by
Matthew Will
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 2
Topics Covered
75 Years of Capital Market History
Measuring Risk
Portfolio Risk
Beta and Unique Risk
Diversification
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 3
S&P
6402
Small Cap 2587
1000 Corp Bonds
Long Bond
T Bill
64.1
48.9
Index
10 16.6
0.1
1925 1940 1955 1970 1985 2000
10 6.6
5.0
1 1.7
0.1
1925 1940 1955 1970 1985 2000
60
Percentage Return
40
20
-20
00
26
30
40
45
50
55
60
65
70
75
85
95
35
80
90
20
Year
Source: Ibbotson Associates
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7- 6
Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0
Ger
Bel
Swi
Can
Neth
Den
Jap
Aus
USA
It
Spa
Fra
Swe
Ire
UK
Country
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Measuring Risk
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Measuring Risk
Coin Toss Game-calculating variance and standard deviation
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
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Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
-50 to -40
0 to 10
10 to 20
50 to 60
-40 to -30
-30 to -20
-20 to -10
-10 to 0
20 to 30
30 to 40
40 to 50
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
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Measuring Risk
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
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Measuring Risk
Portfolio rate
of return (
=
fraction of portfolio
in first asset )( x
rate of return
on first asset )
(
+
fraction of portfolio
in second asset
x
)(
rate of return
on second asset )
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 12
Measuring Risk
Portfolio standard deviation
0
5 10 15
Number of Securities
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7- 13
Measuring Risk
Portfolio standard deviation
Unique
risk
Market risk
0
5 10 15
Number of Securities
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7- 14
Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes
Stock 1 Stock 2
x 1x 2σ 12 =
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 =
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2
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Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-
Cola and 35% in Reebok. The expected dollar
return on your CC is 10% x 65% = 6.5% and on
Reebok it is 20% x 35% = 7.0%. The expected
return on your portfolio is 6.5 + 7.0 = 13.50%.
Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 16
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 17
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 18
Portfolio Risk
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Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes
N
1 2 3 4 5 6 N
STOCK
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7- 20
1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%
Copyright 1996
McGraw by The McGraw-Hill Companies, Inc
Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
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σ im
Bi = 2
σm
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7- 23
σ im
Bi = 2
σm
Covariance with the
market
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