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ch7 - Chapter 7 Risk Return and Capital Budgeting ECO389...

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Chapter 7 - Risk, Return, and Capital Budgeting ECO389, Spring 2010 1 Measuring Market Risk 1.1 Concepts 1. Changes in interest rates, government spending, monetary policy, oil prices, foreign exchange rates, and other macroeconomic events affect almost all com- panies and the returns on almost all stocks. 2. We can assess the impact of “macro” news by tracking the rate of return on a market portfolio of all securities. 3. If the market is up on a particular day, then the net impact of macroeconomic changes must be positive. –The performance of the market reflects only macro events, because firm spe- cific events–that is, unique risks–average out when we look at the combined performance of thousands of companies and securities. 4. In principle the market portfolio should contain all assets in the world economy– not jut stocks, but bonds, foreign securities, real estate, and so on. In practice, however, financial analysts make do with indexes of the stock market, usually the S&P 500. 5. Out task here is to define and measure the risk of individual common stocks. You can probably see where we are headed. Risk depends on exposure to macroeconomic events and can be measured as the sensitivity of a stock’s returns to fluctuations in returns on the market portfolio. This sensitivity is called the stock’s beta . Beta is often written as the Greek letter β . 1
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–Beta: Sensitivity of a stock’s return to the return on the market portfolio. 6. Market Risk: –We’ve just learned that we can diversify away the firm specific risks of indi- vidual securities. Market risk is the nondiversifiable portion of the total risk. –The effects of macro events can best be observed on the market portfolio. Why? Because the individual firm-specific risks will average out. –What is the market portfolio? a. Theoretically, market portfolio is the portfolio of all assets (including stocks, bonds, real estate, foreign securities) available in an economy. b. In practice, we use the S&P 500 portfolio as the market portfolio since it is a good approximation. 1.2 Measuring Beta 1. Facts: Diversification can eliminate the risk that is unique to individual stocks, but not the risk that the market as a whole may decline, carrying your stocks with it. 2. Some stocks are less affected than others by market fluctuations. Investment managers talk about “defensive” and “aggressive” stocks. Defensive stocks are not very sensitive to market fluctuations. In contrast, aggressive stocks amplify any market movements. If the market goes up, its is good to be in aggressive stocks; if it goes down, it is better to be in defensive stocks (and better still to have your money in the bank). –Remember: Aggressive stocks have high betas, betas greater than 1.0, meaning that their returns tend to respond more than one-for-one to changes in the return of the overall market. The betas of defensive stocks are less than 1.0.
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