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Unformatted text preview: FIN 819: lecture 5 Risk, Returns, CAPM and the Cost of Capital Where does the discount rate come from? 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 FIN 819: lecture 5 Today’s plan (continue) Portfolio rules and diversification Measure market risk: beta Efficient portfolio frontiers Tangency portfolio CAPM WACC 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 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 FIN 819: lecture 5 Rates of Return 19262000 Source: Ibbotson Associates604020 20 40 60 2 6 3 3 5 4 4 5 5 5 5 6 6 5 7 7 5 8 8 5 9 9 5 2 Common Stocks Long TBonds TBills Year Percentage Return 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 riskfree government bonds or Tbills. Over the last century, the average risk premium is about 7% for stocks. Why is this risk premium so high? 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 riskfree security. How to measure the risk of a security? 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 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. 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 ) ) ( )( ( ] [ FIN 819: lecture 5 Portfolio A portfolio is a set of securities and can be regarded as a security....
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This note was uploaded on 04/24/2010 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.
 Spring '08
 Staff
 Cost Of Capital

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