Intermediate FinanceLecture 1: Introduction + Risk and ReturnMichael HaslerDepartment of Management UTSC0 / 36

FocusWhat is Corporate Finance?Why is Corporate Finance important?1 / 36

Course ObjectivesUnderstand concepts and methodsIBecome more knowledgeable/skilledIBecome smarterUse these skills toISolve exercisesIUnderstand better financial newspapersISolve real world financial/corporate issuesIUnderstand the financial world2 / 36

Risk and Return: ObjectivesA reminder onwhat risk, return, and expected return mean in a financial marketthe benefits of diversificationthe most famous asset pricing model: the CAPM3 / 36

Risk and ReturnsWhat does “risk” mean?What is the link between risk and return?S&P 500, Dec 2007-Dec20114 / 36

Risk and Return of a SecurityDefinition:The returnrbetween timest1andt2is the ratio of the differencebetween prices att2andt1and the price att1.Example:You bought Apple stock on Jan 1 2012 at $430On Dec 31 2012 the stock is worth $515Your return over a year isr=515≠430430=515430≠1=19.77%5 / 36

Risk and Return of a SecurityWe live in a world of uncertainty...∆The future is most of the timeunknown. Hence most assets future returns are randomBased on what we observe, we can try to describe/model thisuncertainty. For instance,IIf US GDP is more than 3% next year, then S&P 500 return will be(maybe) above 10% next yearIIf mortgage rates increase next year, then S&P 500 return will be(maybe) lower than 5% next yearI...We can, eventually, construct/model thedistributionof futurereturns6 / 36

Risk and Return of a SecurityDistribution of ReturnsCoca-Cola Company monthly return Jan 1962 to Jan 2013 (4% brackets)7 / 36

Risk and Return of a SecurityDistributionThe distribution of stockSreturns is typically described as followsThere areNpossible states in which the economy can be and youknow:IThe probabilitypnof each state(n=1,...,N)IThe returnrSnof stockSin each state(n=1,...,N)Example:StateProbabilitypnReturnrSnof stockSDepression0.1-30%Recession0.21%Normal0.513%Boom0.230%8 / 36

Risk and Return of a SecurityAn accurate description of an asset is the complete distribution of itsreturnsBut in this course, we restrict our attention to only 2 featuresof the distribution:ITheMeani.e. “Expected Return”¯rS©E(rS) =p1rS1+p2rS2+...+pNrSNIStandard Deviationi.e. “Volatility” i.e. Square-root of “Variance”‡S©ÚE1(rS≠¯rS)22=ÒE(rS2)≠¯r2S=Òp1(rS1≠¯rS)2+p2(rS2≠¯rS)2+...+pN(rSN≠¯rS)2=Òp1rS12+p2rS22+...+pNrSN2≠¯r2S9 / 36

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