1 learning goals 1. understand the meaning of risk and return 2. understand the portfolio...

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Learning goals

1. Understand the meaning of risk and return

2. Understand the portfolio diversification

3. Usage of CAPM and SML

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Risk 1Task of financial

manager: Assess of risk and

return to maximize

Investors, shareholders:Assess of risk and

return to make investment decisions

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Risk 2Risk definitions:- classic risk – risk of damage

The chance of financial loss - insurance- modern – uncertainty

The variability of returns associated with a given asset

- difference between expected and real result : T- bill? Corporate bonds? Corporate stocks?

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Risk and return

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BUX ETF

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http://www.bet.hu/magyar_egyeb/charts/bux_historikus

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Return 1Definition: the total gain or

experienced on an investment over a given period of time

To measure stock required return:

r = [DIV1 + (P1 –P0) ] / P0

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Rate of ReturnExample: Investment cashflow begining end of period A -100 800 1,100 B 15,000 120,000

118,000 C 7,000 48,000

48,000

r = ?

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Historical returns for selected security 1926 – 2000 (%)

Type of sec. Nom. Return real return premium on T-bills

Small Stocks 17.7 14.5 13.9 Large Stocks 13.0 9.8

9.2 Corp. Bonds 6.1 2.9 2.3 T-bonds 5.6 2.4 1.8 T-Bills 3.8 0.6 0.0

Source: Ibbotson Associetes, Stocks, Bonds and Inflation * inflation averaged 3.2% over this period

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Historical returns

WHERE TO FIND DATA?

Historical returns (up to 50 years) from T. Rowe Price. Juggling the risk in Forbes. Chapter 1 of William Goetzmann's "An Introduction to Investment Theory" has a table of

Ibbotson data (near the bottom of the page). Dr. Ed Yardeni's Economics Network has an excellent supply of publications in Adobe Acrobat

format. Global Financial Data from Bryan Taylor II, Ph.D. Asset Strategy Consulting's Capital Markets with returns data for the past 20 years. History, as written by the winners in Forbes (6/16/97). Professor Robert J. Shiller's Annual Data on the US Stock Market: Prices, Dividends, Earnings,

1871-present. Financial Data Finder from Ohio State University's Department of Finance. Morgan Stanley and Salomon Brothers among others maintain extensive historical data for

asset classes.

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Chart 1. US: Returns and Risk (in % Annualized) 1975 - 2005

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http://www.google.com/finance?q=INDEXSP:.INX

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Risk preferences 1Human behaviours to risks:

Risk - averse ( need more return to take more risk)

Risk – seeking (enjoy risk , taking risk , give up some return)

Risk indifferent ( nonsense )

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Risk preferences 2Investors attitudes to risks:HedgerRisk taker

A) speculators ( for risk premiums)B) hazard (0 premium )

Arbitrageur

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Risk of a single assetProbability

distributionChance to occur a

given outcome (80% probability?)

Types:Bar chartContinuous

distributionSee :

www.riskgrades.com 1717

Risk measurementMeasures of risk:

Standard deviation:

Variance: 2

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Portfolio diversification 1

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Portfolio diversification 2

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Risk of a portfolioDiversification or single investment?

Portfolio theoryTotal risk = market risk + unique riskUnique = unsystematic risk , diversifiable Risk specific to a firmMarket = systematic, non-diversifiable risk, effect

all firms

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CAPM: the Capital Asset Pricing ModelEquation:r = rf + ß X ( rm – rf )r = free risk return

+ market premium

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SML: Security Market Line

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ProblemsEfficient

market?Betas rely on

past varies in time

CAPM in 60’s and now

VAR?

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ExampleCurrently under consideration is a project

with a beta of 1.50. At this time the risk free rate of return 7%, and the return on the market portfolio of assets is 10%. The project is actually expected to earn an annual rate of return of 11%.

A. If the return on the market portfolio were to increase by 10%, what would you expect to happen to the project’s required return ?

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Example cont.B. Use the capital asset pricing model to

find the required return on this investment.

C. On the basis of your calculation in part b, would you recommend this investment?

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www.riskgrades.com

(MSFT) Microsoft Corp (05/01/2007) RiskGrade: 95      Min: 59 Max: 103 Avg: 79 Add benchmarks to chart:

Investment RiskRanking In other words 78% of the tickers in US Markets are riskier than MSFT.

Minimum RiskGrade in US Markets: 10Maximum RiskGrade in US Markets: 16278Average RiskGrade in US Markets: 211

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Learning goals

1. Understand the meaning of risk and return

2. Understand the portfolio diversification

3. Usage of CAPM and SML

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