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Chapter 5 Risk and Return Premiums
1.
Holding Period return capital gain income plus dividend income per dollar invested in the stock.
a.
HPR= Ending Price of a share Beginning price + Cash Dividend / Beginning Price
b.
HPR= Dividend Yield + Capital gains
i.
Assumes that the payment is made at the end of the period and ignores reinvestment
income
2.
Risk Free Rate
The rate you can earn by leaving money in risk free assets
a.
Risk Premium
 The difference in return – risk free rate
b.
Excess return
 Risk premium
c.
Risk Aversion
 The degree to which investors are willing to commit funds
3.
Real Vs. Nominal Risk Nominal = real + inflation
a.
When the rate of inflation equals the nominal rate of interest there is no growth in purchasing
power
b.
Risk free assets are only risk free in nominal terms, In real terms they can be very risky with
inflation
c.
Fishers law R=r+ expected inflation
4.
Return distributions and Value at risk
a.
The value of a stock is based on its discounted expected future cash flows
b.
Normal Distribution
Has two properties
i.
It is symmetric and completely descried by two parameters, mean and standard
deviation
1.
Implies that the risk of a normally distributed investment return is fully
described by its standard deviation
2.
Small stocks have the largest standard deviations, then large stocks, then
long term bonds, then t bills
ii.
A weighted average of variables that are normally distributed will be normally
distributed
c.
Value at Risk (VaR)
highlights the potential loss from extreme negative returns
i.
Quantile of a distribution the value below which lie q% of the values
ii.
VaR always 1.65 standard deviations from the mean,
5.
Arithmetic Vs Geometric
a.
Arithmetic derived from statistics and unbiased.
b.
Geometric used for forecasts of cumulative returns over long horizons.
6.
Summary
a.
Economies equilibrium level of real interest rate depends on the supply (saving from
consumers) and demand (spending from firms)
b.
US rates of return for stocks are normal compared to other countries
Chapter 18 Equity Valuation Models
1.
Intrinsic Value Vs Market Price
a.
Expected
HPR expected price appreciation.
i.
If a stock is priced correctly then the expected HPR equals the required return
b.
Intrinsic Value
V
0
– the present value of all cash payments to the investor in the stock,
including dividends as well as the proceeds from the ultimate sale of the stock discounted at the
appropriate risk level,
k
i.
If intrinsic value, or owners perceived value, is greater than the market price, the stock
is undervalued and considered a good price
c.
Market Capitalization Rate
 Market consensus value of the required rate of return,
k
Dividend Discount Models
2.
DDM
The stock price should equal the present value of all expected future dividends into perpetuity.
a.
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 Fall '07
 MADIGAN,GE

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