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

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1 BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer

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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

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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)

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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, and

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8 Covariance: In the example, Correlation: In the example,
9

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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

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12 Total Returns (%)
13 Total Returns (%)

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14 Total Returns (%)