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4 Risk, Returns, CAPM and the Cost of Capital

4 Risk, Returns, CAPM and the Cost of Capital - Risk...

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FIN 819: lecture 5 Risk, Returns, CAPM and the Cost of Capital Where does the discount rate come from?
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FIN 819: lecture 5 Today’s plan Risk and returns 75 Years of Capital Market History How to measure risk Individual security risk Portfolio risk Diversification Unique risk Systematic risk or market risk Measure market risk: beta
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FIN 819: lecture 5 Today’s plan (continue) Portfolio rules and diversification Measure market risk: beta Efficient portfolio frontiers Tangency portfolio CAPM WACC
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FIN 819: lecture 5 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates 0.1 10 1000 1925 1940 1955 1970 1985 2000 S&P Small Cap Corp Bonds Long Bond T Bill Index Year End 1 6402 2587 64.1 48.9 16.6
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FIN 819: lecture 5 0.1 10 1000 1925 1940 1955 1970 1985 2000 S&P Small Cap Corp Bonds Long Bond T Bill Source: Ibbotson Associates Index Year End 1 660 267 6.6 5.0 1.7 Real returns The Value of an Investment of $1 in 1926
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FIN 819: lecture 5 Rates of Return 1926-2000 Source: Ibbotson Associates -60 -40 -20 0 20 40 60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000 Common Stocks Long T-Bonds T-Bills Year Percentage Return
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FIN 819: lecture 5 Risk premium The risk premium is the difference between the expected rate of return on a risky security and the expected rate of return on risk-free government bonds or T-bills. Over the last century, the average risk premium is about 7% for stocks. Why is this risk premium so high?
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FIN 819: lecture 5 Why do investors command a risk premium for stocks? When investors invest in a risky security, they require a risk premium, or they require a higher expected rate of return than investment in a risk-free security. How to measure the risk of a security?
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FIN 819: lecture 5 Measuring Risk In financial markets, we use the volatility of a security return to measure its risk. Variance – Weighted average value of squared deviations from mean. Standard Deviation – Weighted average value of absolute deviations from mean and is also the square root of the variance
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FIN 819: lecture 5 Calculating the risk of a security We can use two approaches to calculate the risk of a security, depending on what kind of information you are given. Using the basic definition of expectation and variance to calculate Using the portfolio rule to calculate In fact, these two approaches are exactly the same, but the second one can omit some detail calculation.
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FIN 819: lecture 5 Some basic concepts Before we go on to show how to use two approaches to calculate risk, let’s first review some basic formula for Expectation and Variance Let X be a return of a security in the next period. Then we have = = = N i i X i p X E X 1 ) ( ) ( ] [ = - = N i X i X i p X Var 1 2 ) ) ( )( ( ] [
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FIN 819: lecture 5 Portfolio A portfolio is a set of securities and can be regarded as a security.
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