Chapter 11

# Chapter 11 - Chapter 11 Risk Return and Capital Budgeting 1...

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1 Chapter 11 Risk, Return, and Capital Budgeting

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2 Plan of the lecture Measuring market risk ( β ) Capital Asset Pricing Model ( CAPM ) and Security Market Line ( SML ) Opportunity cost of capital and project risk
3 Purpose of this chapter We develop a measure of the market risk of an individual stock ( β ), since we can diversify away its unique risk by holding a well diversified portfolio We introduce the Capital Asset Pricing Model ( CAPM ) and Security Market Line ( SML ), which tells us the expected rate of return on a security given its β We then use the CAPM to determine the opportunity cost of capital on a project

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4 Measuring market risk We measure the market risk of an individual stock by comparing the sensitivity of the stock’s returns to the changes in the returns on the market portfolio This measure of sensitivity is called beta ( β ) of the stock
5 Measuring market risk In theory, the market portfolio should include all the assets in the world: all the stocks, all the bonds, … But there are almost countless assets! So in reality, people use the stock markets indexes , such as the S&P/TSX index or the , as proxies for the market portfolio

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6 Measuring market risk We measure beta by: 1) Collecting data on the returns on a stock and the returns on the market portfolio over a specified time period 2) Plotting the returns on the stock against the returns on the market portfolio 3) Fitting a regression line through the observations showing the average returns to the stock ( dependent variable ) at different market returns ( independent variable ) 4) The slope of this regression line is the stock’s beta
7 Measuring market risk -1 -0.5 0.5 1 1.5 -1.5 -1 -0.5 0.5 1 1.5 Market return (%) Stock j’s return (%) Calculating beta Return on stock j vs. return on the market β = slope of line = 0.783 0

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8 Measuring market risk We can use the Slope function in Excel to compute the slope of the regression line on the previous slide, which is the beta of stock j Month Market return Stock j's return 1 1.10% 1.30% 2 0.80% 0.90% 3 0.65% 0.75% 4 0.45% 0.80% 5 0.25% 0.25% 6 0.05% 0.30% 7 -0.20% 0.40% 8 -0.25% -0.05% 9 -0.60% -0.25% 10 -0.75% -0.05% 11 -0.95% -0.50% Slope of the regression line ( β 29 = 0.783
9 Measuring market risk Alternatively, we can measure the beta of a stock if we know: 1) the correlation of the stock’s return with the market’s return, ρ , Beta of stock j = β j = m j jm σ ρ

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10 Measuring market risk From the formula on the previous slide, we can see that the beta of a stock depends on: the correlation of the stock with the market portfolio ( ρ ),
11 Measuring market risk Example of beta : 247 . 0 3

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Chapter 11 - Chapter 11 Risk Return and Capital Budgeting 1...

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