# Week 6 - Week 6 Risk Return CAPM and Cost of Capital Paul...

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Week 6: Risk, Return, CAPM and Cost of Capital Paul Dou

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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.
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.

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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
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)

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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)
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

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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
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.

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

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Week 6 - Week 6 Risk Return CAPM and Cost of Capital Paul...

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