Chapter 12 - 1 BA 3341 Business Finance Nataliya...

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Unformatted text preview: 1 BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer 2 "In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.“ J. KENFIELD MORLEY, "Some Things I Believe," The Rotarian. February 1937 3 •Introduction: Why do we care? •Review: Probability and statistics –crush course •How to measure risk? • Not all risk is priced • Diversification • From Risk to Return 4 • The opportunity cost of capital for a project is the rate of return on an investment with similar 1. time to maturity 2. risk • Time to maturity is analyzed with the term structure of interest rates (yield curve). • How do we evaluate risk ? • What is similar risk? 5 •How is your 401( k) invested? •How it should be invested? •More educated investors in general participate less or not at all in the following dangerous activities ( Don’t Try These At Home! ) : 30% - 100% of 401( k) portfolios in a “really strong” employer stock Day trading away their kids college fund Gamble in casino ( the least dangerous of the three listed) 6 Two random variables: x and y For example suppose that x and y take on the values: State Probability Value of x Value of y 1 p 1 =0.2 x(1)=1 y(1)=5 2 p 2 =0.5 x(2)=3 y(2)=2 3 p 3 =0.3 x(3)=7 y(3)=10 Expected or Average Value : In the example, Similarly, E(y)=5 7 Variance: In the example, Similarly, Standard Deviation: In the example, 7 Variance: In the example, Similarly, Standard Deviation: In the example, and 8 Covariance: In the example, Correlation: In the example, 9 10 1. a company’s stock or its bond ? 2. a U.S. government bond or a corporate bond with same coupon, maturity and face value? 3. a long-term (20 years) U.S. government bond or a short-term (3 months) U.S. Treasury bill (T-bill)? Let’s look at the historical returns on stocks, government bonds and T-bills. 11 Example of real ( adjusted for inflation) returns from 1925 to 1986: Security Initial Total Return E ( r )(%) σ (%) Small Stocks $1 231.05 8.9 34.7 S& P500 $1 75.82 7.0 21.0 Corporate Bonds $1 3.61 2.0 9.9 Long Term Government Bonds $1 2.45 1.4 10.1 T- Bills $1 1.37 .5 4.4 12 Total Returns (%) 13 Total Returns (%) 14 Total Returns (%) 15 What should be a measure of risk ? • Statistical uncertainty- σ ( standard deviation) or σ 2 (variance) . Under proper assumptions measures total risk that individual cares about. • We will need a measure of risk similarity for adjusting discounts rates across different projects. • Is total risk appropriate ? • Are we rewarded just for high σ ? 16 ? 17 "October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February.“ MARK TWAIN, Pudd'nhead Wilson's Calendar (1899), p. 108 18 19 • What would be your investment worth if you purchased $ 10,000 of Apple stock in September 1994 ?...
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This note was uploaded on 11/24/2009 for the course BA 3341 taught by Professor Polkovnichenko during the Fall '08 term at University of Texas at Dallas, Richardson.

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Chapter 12 - 1 BA 3341 Business Finance Nataliya...

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