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Lecture 7 Introduction to Risk, Return, and the Opportunity Cost of Capital

Lecture 7 Introduction to Risk, Return, and the Opportunity Cost of Capital. Managerial Finance FINA 6335 Ronald F. Singer. Topics Covered. 72 Years of Capital Market History Measuring Risk Portfolio Risk Beta and Unique Risk Diversification. The Value of an Investment of $1 in 1926.

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Lecture 7 Introduction to Risk, Return, and the Opportunity Cost of Capital

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  1. Lecture 7Introduction to Risk, Return, and the Opportunity Cost of Capital Managerial Finance FINA 6335 Ronald F. Singer

  2. Topics Covered • 72 Years of Capital Market History • Measuring Risk • Portfolio Risk • Beta and Unique Risk • Diversification

  3. The Value of an Investment of $1 in 1926 55201828 55.3839.0714.25 Index Year End

  4. The Value of an Investment of $1 in 1926 Real returns 613 203 6.154.341.58 Index Year End

  5. Rates of Return 1926-1997 Percentage Return Year

  6. 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

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

  8. Measuring Risk # of Years Return %

  9. 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.”

  10. Measuring Portfolio Return

  11. Measuring Risk

  12. Measuring Risk

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

  14. Example Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. The expected dollar return on your BM is .10 x 55 = 5.50 and on McDonald’s it is .20 x 45 = 9.00. The expected dollar return on your portfolio is 5.50 + 9.00 = 14.50. The portfolio rate of return is 14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 0.15. Assume the Standard Deviation of BM is 17.1%, and of McD is 20.8%

  15. Example

  16. 1 2 3 4 5 6 N 1 2 3 4 5 6 N Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. To calculate portfolio variance add up the boxes STOCK STOCK

  17. Expected stock return beta +10% • 10% Expected - 10% + 10% market return -10% Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes.

  18. 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.

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

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