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Analytical Methods for Lawyers (Finance). Risk Discount rate Capital Asset Pricing Model (CAPM). (last updated 20 Apr 09). Merton on risk. What is the value of $1000?. What is the value of $1000? Nominal? When? Risk?. Value a business. spreadsheet. What is risk?.
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Analytical Methodsfor Lawyers (Finance) Risk Discount rate Capital Asset Pricing Model (CAPM) (last updated 20 Apr 09)
What is the value of $1000? Nominal? When? Risk?
Value a business spreadsheet
What is risk? How do markets “price” risk? What is ECMH? What is CAPM?
ECMH Ronald Gilson (Stanford) Reinier Kraakman (Harvard) Market Information Price Can you beat the market?
Brownian motion (Louis Bachelier)
One hundred thousand lemings can’t all be wrong
Return Risk
What is beta? The Beta coefficient is a key parameter in CAPM. It measures the part of the asset's statistical variance that cannot be mitigated by portfolio diversification, and thus is correlated with the return of assets in the portfolio.
Stock A Stock B Compare returns to market average
Stock A Stock B Market average Market average
Stock A Stock B Slope = 1.7 Slope = 0.6 Market average Market average
Risk vs. Return Return (%) Stock A = 1.7 Mkt = 1.0 Stock B = 0.6 Risk (measured as beta)
Risk vs. Return Return Return (%) Stock A = 1.7 Mkt = 1.0 Stock B = 0.6 Risk (measured as beta)
Capital Asset Pricing Model rm Return (%) Mkt = 1.0 rf Risk (measured as beta)
Capital Asset Pricing Model E(r) = rf + b(rm- rf ) E(r) rm Return (%) E(r) Beta = 1.7 Mkt = 1.0 rf Beta = 0.6 Risk (measured as beta)
Assume: rm = 11.7% / rf = 3.2% E(r) = rf + b(rm- rf ) E(r) = 3.2% + 0.6*(11.7% – 3.2%) E(r) = 3.2% + 0.6*(8.5%) E(r) = 3.2% + 5.1% = 8.3% Return (%) rm= 11.7% E(r) Mkt = 1.0 rf = 3.2% Beta = 0.6 Risk (measured as beta)
Assume: rm = 11.7% / rf = 3.2% E(r) = rf + b(rm- rf ) E(r) = 3.2% + 1.7*(11.7% – 3.2%) E(r) = 3.2% + 1.7*(8.5%) E(r) = 3.2% + 13.45% = 16.65% Return (%) E(r) rm= 11.7% Beta = 1.7 Mkt = 1.0 rf = 3.2% Risk (measured as beta)
Study after study has found that beta isn't a good measure of risk … It’s better to be vaguely right, than precisely wrong …