Relation between expected return and risk for portfolios and individual assets Trade off between expect4ed return and risk when cap. Markets are in equilibrium. The returns that shareholders can expect to obtain are the ones they require from firms when firms evaluate risky investment projects. The shareholders’ required return is the firm’s cost of equity capital. Ch 9: History of U.S. CAP mkts The return on risky assets has been higher on average than return on risk free asset … this supports perspective for our examination of risk and return Intro to several key intuitions of modern finance and show how they dcan be useful in determining a firm’s cost of capital Ch. 10 and 11: Advanced discussion of risk and expected return What determines the relationship between return and risk for portfolios and CAPM Ch. 12: Estimating a firm’s cost of equity capital and some of the problems that are encountered in doing so. Chapter 9: Capital Market Theory: An overview Ch. 4: Riskless cash flows should be discounted at the riskless iRate. A different discount rate must be used because of more risky flows 1. Find a measure of risk. If one asset use variance of St. Dev of returns 2. Ch. 10: Examines a portfolio of many assets … use a Companies Beta as a measure of the securities contribution Ex. Stock: returns high when returns on a large diversified portfolio are low and vice versa. This stock has a negative beta. It acts as a hedge implying that the stock actually tends to reduce the risk of the portfolio . However the stock could have a high variance implying high risk for an investor holding only this security. Seems as if one is tending towards 0 expected returns …?? 3. Only will hold a risky security if expected return is high enough to compensate for its risk. The expected return on a security should be positively related to the security’s beta. Relationship btwn risk and expected return can be expressed: Expected return on a Security = risk-free rate + Beta ( Expected return on mkt portfolio – Risk free rate) Beta acts as a multiplier…multiplying residual of market return Market return is higher than risk free rate b/c risk is higher Term in parentheses is positive, expected return on a security is a positive function of its beta. This equation is referred to as CAPM, capital asset pricing model 4. 12 applies theories of 9 and 10 to a selection of discount rates. In a world where 1. a project has the same risk as the firm and 2. the firm has no debt the expected return on the stock should serve as the project’s discount rate START with the calculation of a security’s return: 1. RETURNS: Return on your stock comes in two forms: 1. Income component of your return: Dividends 2. Capital gain on investment. Purchased 100 shares of stock
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This note was uploaded on 10/06/2010 for the course FNCE 100 taught by Professor Jaffe during the Spring '10 term at UNC Asheville.