Week 6 - Week 6: Risk, Return, CAPM and Cost of Capital...

Info iconThis preview shows pages 1–12. Sign up to view the full content.

View Full Document Right Arrow Icon
Week 6: Risk, Return, CAPM and Cost of Capital Paul Dou
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 Recall One way to calculate re is to imply from the observed share price, using models such as the Gordon Growth Model (revise week 5 if necessary) Another way to calculate re is to use Capital Asset Pricing Model (CAPM). We shall investigate this issue in this module.
Background image of page 2
3 Objectives and learning outcomes from this week Appreciate the risk return trade-off. Understand the concept of risk free rate. Understand the concept of Market Risk Premium (MRP). Understand what part of risk is compensated (β). Identify how risk is measured through CAPM. Understand the definition of Security Market Line (SML). Understand the connection to cost of capital and NPV.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
4 Risk and return Return is related to risk. The higher the risk, the higher the expected return. The actual return from holding an asset is defined as 0 1 0 1 P CF P P r + - = (1) where r = actual return; Pt=0, 1 = asset price at t =0 and 1; CF1 = cash flow at t =1
Background image of page 4
5 Risk and return However, the return from a risky asset is unpredictable. Thus, we usually calculate the expected (weighted average) return of the asset, defined as = = N i i i r w r E 1 ) ( where wi is the weight from i =1 to N (2)
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6 Risk and return We are also interested in computing the standard deviation of the return, defined as: ( 29 = - = σ N i i i r E r w 1 2 ) ( (3)
Background image of page 6
7 Risk and return Example: Rate of return Scenario Probability Stock Bond Recession 0.2 -5% +14% Normal economy 0.6 +15% +8% Boom 0.2 +25% +4% Expected rate of return for the stock is % 13 ) 25 ( 2 . 0 ) 15 ( 6 . 0 ) 5 ( 2 . 0 ) ( 1 = + + - = = = N i i i r w r E
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
8 Risk and return Example: Rate of return Scenario Probability Stock Bond Recession 0.2 -5% +14% Normal economy 0.6 +15% +8% Boom 0.2 +25% +4% Standard deviation for the stock is ( 29 % 8 . 9 ) 13 25 ( 2 . 0 ) 13 15 ( 6 . 0 ) 13 5 ( 2 . 0 ) ( 2 2 2 1 2 = - + - + - - = - = σ = N i i i r E r w
Background image of page 8
9 Risk and return The actual return = Expected return + Unexpected (surprise) return r = E(r) + U Total Risk = Unsystematic risk + systematic risk Unsystematic risk is also called firm-specific or unique risk.
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
10 Risk and return Individual investors can diversify the unsystematic risk by forming a portfolio consisting of many stocks.
Background image of page 10
11 Risk and return Systematic risk is also called beta or market risk , which cannot be diversified away. Investors are
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 35

Week 6 - Week 6: Risk, Return, CAPM and Cost of Capital...

This preview shows document pages 1 - 12. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online