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# Chapter10nt[1] - Chapter 10 Estimating Risk and Return 1...

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1 Chapter 10 Estimating Risk and Return

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2 Chapter 10 Learning Goals LG1: Compute forward-looking expected return and risk LG2: Understand risk premiums LG3: Know and apply the Capital Asset Pricing Model (CAPM) LG4: Calculate and apply beta, a measure of market risk LG5: Differentiate among the different levels of market efficiency and their implications LG6: Calculate and explain investors’ required return and risk LG7: Use the constant growth rate model to compute required return
3 Introduction Financial managers and investors must make investment decisions based on their expectations about future risk and return Managers also need to know what return their shareholders require so that they can meet those expectations We saw in the last chapter that investors can easily diversify away firm-specific risk We need to find a way to measure the market risk portion of stock ownership

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4 Expected Returns In the previous chapter we characterized risk and return in historical terms Expected return is a forward-looking return calculation Overall economic conditions will affect a firm’s level of success Economists predict future economic conditions based on probabilities E.g. 70 percent chance of a good economy and 30 percent chance of a recession
5 A stock analyst predicts the return on a particular company’s stock in the event of a good or bad economy The expected return combines the possible returns with the probability that the returns will occur Expected return = (p 1 x Return 1 ) + (p 2 x Return 2 ) + … + (p s x Return s )

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6 Example on computing expected return: State of economy Probability of state Stock return in given state p x Return Recession 20% -15% -3.0 Normal 50% 9% 4.5 Boom 30% 16% 4.8 Expected Return 6.3%
7 Note that the expected return itself is not predicted to occur We can also use a distribution of returns to characterize risk Since we have a distribution of possible outcomes, we face uncertainty We can calculate the standard deviation of the distribution as our measure of risk

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8 Example on computing risk: State of economy p R E(R) R-E(R) (R-E(R)) 2 p x (R-E(R)) 2 Recession 20% -15% 6.3% -21.3 453.69 90.74 Normal 50% 9% 6.3% 2.7 7.29 3.65 Boom 30% 16% 6.3% 9.7 94.09 28.23 Variance 122.61 Std Dev 11.07% Want to look at another example on computing expected return and risk? See Interactive Example 10-1 . (move the cursor to the highlight area, right click your mouse and click Open Hyperlink). You can view interactive examples in other formats at http://highered.mcgraw-hill.com/sites/0073382256/student_view0/chapter10/interactive_examples.html
Risk Premiums An investment in a risk-free Treasury bill offers a low return with no risk Investors who take on risk expect a higher return An investor’s required return is expressed in two parts: Required Return = Risk-free Rate + Risk Premium The risk-free rate equals the real interest rate and expected inflation Typically considered the return on U.S. government bonds and bills

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Chapter10nt[1] - Chapter 10 Estimating Risk and Return 1...

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