chapter11 - 11-1 Chapter 11 Risk, Return and Capital...

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Semih Yildirim ADMS3530 11-1 Chapter 11 Risk, Return and Capital Budgeting Chapter Outline Measuring Market Risk The Beta of an Asset Risk and Return Capital Asset Pricing Model – CAPM Security Market Line – SML Capital Budgeting and Project Risk
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Semih Yildirim ADMS3530 11-2 Measuring Market Risk The Market Portfolio We learned in the last chapter that we should be interested in market risk. Market risk is a result of macroeconomic events which affect almost all companies and the returns on almost all stocks. We can measure market risk by tracking the performance of a market portfolio of all securities. But, in this chapter, we want to define and measure the relevant risk on an individual stock , not a portfolio of stocks. Since we now know that unique risk is not of concern to investors, what we want to measure is the market risk of an individual stock.
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Semih Yildirim ADMS3530 11-3 Measuring Market Risk The Market Portfolio We will measure a stock’s market risk by comparing the sensitivity of the stock’s returns to fluctuations in the market portfolio. We will call this measure of sensitivity beta ( β ). In theory, the market portfolio should contain all the assets in the world economy. Not just stocks, but bonds, foreign securities, real estate, etc. In reality, financial analysts use indexes of the stock market, such as the S&P/TSX Compsite Index as proxies for the market portfolio.
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Semih Yildirim ADMS3530 11-4 Measuring Beta To measure a stock’s beta, the following steps should be followed: 1. Collecting data on the returns on the market portfolio over a specified time period. 2. Collecting data on the returns on a stock over the same time period. 3. Graphing the returns on the stock against the returns on the market. 4. Drawing a regression line through the points and measuring its slope. 5. The slope of the regression line is the stock’s beta.
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Semih Yildirim ADMS3530 11-5 -1 -0.5 0.5 1 1.5 -1.5 -1 -0.5 0.5 1 1.5 Market Return (%) Stock Return (%) Calculating Beta Measuring Beta β = slope of line = 0.804 Return to stock j vs return to market
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Semih Yildirim ADMS3530 11-6 Measuring Beta
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Semih Yildirim ADMS3530 11-7 Measuring Beta
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Semih Yildirim ADMS3530 11-8 Measuring Beta
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ADMS3530 11-9 Measuring Beta Example, you know: The correlation of the stock’s return with the market’s return ( ρ jm ) = 0.70 The covariance of the stock’s return with the market’s return ( cov jm ) = 0.042 The standard deviation of the market ( σ m ) = 20%. The standard deviation of the stock (
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chapter11 - 11-1 Chapter 11 Risk, Return and Capital...

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