Lecture11 - LECTURE 11 RISK AND RETURN, PART 2 Reading:...

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137 L ECTURE 11 R ISK AND R ETURN , P ART 2 Reading: Chapter 10 Homework: Online Objectives: Understand what risk is and how we measure it Understand and be able to calculate mean, standard deviation, covariance, and correlation Understand how to compute the expected return and standard deviation of a portfolio of securities Understand how diversification reduces risk Understand why an asset’s correlation and covariance with other assets in a portfolio are important
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138 O VERVIEW OF ANALYSIS OF INVESTMENT OPPORTUNITIES To evaluate an investment opportunity we need to estimate the following: 1. Expected level and timing of incremental free cash flow 2. The required return or discount rate In this part of the course we turn our attention to the second item, i.e., estimating the required return (r) The overall objective is to identify and undertake investment opportunities that add value to a firm's assets (or to stockholders' wealth) This means - Undertaking investment opportunities with a positive net present value, or Undertaking investments that are expected to earn a return that is greater than the expected return of investments in the financial market with the same level of risk. Therefore, we need to know how risk and return are measured and related to one another in the financial markets.
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139 RISK AND RETURN IN THE FINANCIAL MARKETS Average Annual Rates of Return, 1900-2004 Treasury Bills LT Gov’t Bonds The Entire Stock Market Small Firm Stocks (Starts in 1926) Avg Returns 4.0% 5.6% 11.6% 17.4% Standard Deviation 2.8% 8.3% 20.0% 37.4% Inflation over the same period: 3.0% std dev 1.9% We can thus approximate the Stock Market Risk Premium : Stock Risk Premium = Expected stock returns – “Risk Free Rate” 7.6% = 11.6% -4.0% It’s actually lower. The above estimate is based on realized returns, but the risk premium is about expected returns. Ideally, we should use forward looking data, not return history, to estimate it. Most forward looking estimates place it at about 7.0%, but some researchers argue it is as low as 5.5%. We will use 7% because that seems to be the most widely accepted figure.
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140 DEFINING RISK Definition : Risk is related to the probability and magnitude of obtaining outcomes that are below their expected value. It measures the variability of the possible results. With bonds , we were worried about: Default risk Æ risky bond yield = risk-free yield + expected loss + risk premium Interest rate risk & Reinvestment risk Determine the shape of the yield curve In capital budgeting we are worried about the range of possible outcomes for NPV. Boeing may not be able to sell as many cargo planes as it expects; there might be a recession, Airbus might make a better product, etc. With stocks , we are worried about the company not being able to pay the dividends we expected it to pay, and hence the price going down.
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Lecture11 - LECTURE 11 RISK AND RETURN, PART 2 Reading:...

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