Chapter 10 and Section 6.6

Chapter 10 and Section 6.6 - Chapter 10 and Section 6.6...

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1 Chapter 10 and Section 6.6 Introduction to Risk and Return, and Market Efficiency
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2 Plan of the lecture Canadian capital market history (1926 -2004) Measuring risk Risk and diversification Correlation coefficient Market risk vs. unique risk Thinking about risk Random walk and market efficiency (Section 6.6 )
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3 Purpose of Chapter 10 Recall that Step 2 in the NPV calculation is to estimate an appropriate opportunity cost of capital (or discount rate ) of a project Managers begin estimating the opportunity cost of capital with a study of historical rates of return on investments of different levels of risk
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4 Purpose of Chapter 10 By looking at the rate of return on other, equivalent risk, investments, managers get a sense of the appropriate opportunity cost of capital I.e., the past can tell us something about the future The level of risk and the required rate of return are positively related So to begin with, we must first understand how to measure and quantify the risk of a project. This is the purpose of Chapter 10
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5 Canadian capital market history (1926 - 2004) In this chapter, we will look at the historical performance of the following three portfolios: A portfolio of 91 day government securities, known as Treasury bills ( T bills ) A portfolio of long term Canadian government bonds A portfolio of common stocks of large companies
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6 Canadian capital market history (1926 - 2004) These three portfolios are not equally risky: The T bill portfolio is a safe holding ( lowest risk ) The common stock portfolio is the riskiest among the three portfolios ( highest risk ) The portfolio of long term government bonds falls between the T bill portfolio and the common stock one in its level of risk ( intermediate risk )
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7 Canadian capital market history (1926 - 2004) We can summarize the average rates of return for each of the three portfolios for the period 1926 – 2004 as follows: Average annual Average Portfolio rate of return risk premium * Treasury bills 4.7% - Gov’t bonds 6.4% 1.7% Common stocks 11.4% 6.7% * Average risk premium = the rate of return on an investment - the rate of turn on a T bill
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8 Canadian capital market history (1926 - 2004) Common stocks and government bonds both had a higher rate of return than T bills On average, investors demanded 6.7% (= 11.4% - 4.7%) more on a common stock portfolio than on a T bill portfolio They demanded 1.7% (= 6.4% - 4.7%) more on a bond portfolio
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9 Canadian capital market history (1926 - 2004) This excess return, over and above the risk free rate (i.e., the T bill rate), is called the risk premium It is the extra return required by investors for investing in risky securities
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10 Canadian capital market history (1926 - 2004) These historical records show a positive relationship between risk and return: average returns on more risky assets exceed those on less risky assets In summary: Rate of return = rate of return risk premium
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This note was uploaded on 01/26/2010 for the course ADMS 3530 taught by Professor Unknown during the Spring '09 term at York University.

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Chapter 10 and Section 6.6 - Chapter 10 and Section 6.6...

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