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04: Page 1 of 26 MODULE 04 RISK AND RETURN Module 3 introduced to you the idea of opportunity cost and the crucial role it plays in determining the time value of money, intrinsic value, and the accumulation of wealth. Now, you are ready to read about how some investors determine the opportunity cost they use in the calculations. Module 4 begins by showing you the role of information in determining the way investors act and react in financial markets. You will learn that only unexpected (new) information influences investors and their valuation of securities because they have already used expected (old) information in valuing securities and making investment decisions. The way unexpected information influences stock prices has much to say about efficiency of the stock market. The module then turns to a discussion of risk. Be sure to understand the difference between the two types of risk (diversifiable and non-diversifiable) and the role of each in determining opportunity cost and required return on investment. (One of them plays no role!) Also, you need to understand that intrinsic value of a common stock is a function of (varies with) expected cash flows from the holding the stock and from required rate of return. It’s an easy model to carry around in your head, and here’s the way it looks: Signs above each influence tell you the direction of the relationship. If you’ve had a course in statistics, you’ll recognize it as the direction of correlation. The plus (+) above cash flows tells you that the correlation is positive: An increase in cash flows is associated with an increase in intrinsic value. The minus ( ! ) above required return tells you the correlation is negative or opposite: An increase in required return is associated with a decrease intrinsic value. Pay particular attention in this module to the way investors calculate non- diversifiable risk and use it in the capital asset pricing model. Mastering this part of the module will furnish you with a useful way to look at the financial world. The module concludes with a discussion of the sources of non-diversifiable risk in a portfolio. You will see that many operating, investing, and financing activities implemented by management contribute to the non-diversifiable risk of a stock. When you finish this module you will be able to do the following: 1. Explain the role of information and the meaning and forms of efficient markets. 2. Understand various investor risk attitudes and the role of standard deviation as a measure of risk. 3. Know the difference between diversifiable and non-diversifiable risk and the unique role of non-diversifiable risk in determining required return. 4.View the link between risk and return using the capital asset pricing model; calculate a required rate of return on investment in a common stock using the capital asset pricing model. 5. Interpret stocks as overpriced and underpriced by referring to the capital asset pricing model and its graph, the security market line.
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This note was uploaded on 05/10/2010 for the course FINA 3770 taught by Professor Chandy during the Fall '08 term at North Texas.

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