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Corporate Finance page 10

# Corporate Finance page 10 - Chapter 10 Probability...

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- Chapter 10 - Probability distribution – assigns probability that each possible return will occur. Expected return is the calculated weighted average of the possible returns. Variance is the expected square deviation from the mean. Standard deviation = volatility = square root of variance. - (1 + Rannual) = (1 + Rq1)(1 + Rq2)(1 + Rq3)(1 + Rq4) - Var(R) = 1/(T-1) * Sum from t=1 to T ((Rt – R_ave)^2) - Standard Error = SD(Individual Risk)/(sqrt # observations) - Investments with higher volatility should have a higher risk premium and therefore higher returns - Risks: Common risk is when a risk is perfectly correlated across everything (earthquakes for many households), and independent risk is when the risks of one thing isn’t related to the other thing (theft). So you want a diversification in order to average out the independent risks in a large portfolio. Diversification is used to reduce risk. - There is firm-specific, idiosyncratic, unsystematic, unique, and diversifiable risk. - For diversified, good news will affect some stocks positively and others negatively - Systematic risk will affect all firms (and therefore the entire portfolio) - EX: S firms affected only by strength of economy and I firms have idiosyncratic, firm-specified risks. There are 10 S firms and 10 I firms. If market will 50:50 be 40% or -20%. What is volatility and average return of each firm? Type S: .5*.4 + . 5*-.2 = .1. SD = 30%. For type I, it will 50:50 be 35% or -25%. Expected return is 5% and SD is also 30%. The average return of ten type S firms is also 10% and the volatility is also 30%. The average return of ten type I firms is 5% and has volatility .3/Sqrt(10) = 9.5% - The risk premium for diversifiable risk is 0 so investors are not compensated for holding firm-specified risk. The risk premium depends on systematic risk and not on diversifiable risk. - Systematic risk can only be eliminated by sacrificing expected returns - An efficient portfolio cannot be diversified further - The beta is the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio. Unlike volatility, it measures the riskiness relative specifically to the market.

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Corporate Finance page 10 - Chapter 10 Probability...

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