Lecture6 - Chapter 8 07/15/11 20:30 Portfolios and...

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Portfolios and Diversification • We continue to assume perfect markets , including: 1. No differences in opinion. 2. No taxes. 3. No transaction costs. 4. No big sellers/buyers In this chapter, we lay the groundwork for understanding how investors choose among many different projects. • You need this [a] to think as a manager about your company’s investment risk; [b] more importantly to think about your “opportunity cost of capital,” Ε ( ) . 07/15/11 20:30 References Corporate Finance: An Introduction (Welch, 2009, Prentice Hall) Chapter 8
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2 Where we are going • In order to attract investors, a firm must offer a rate of return which at least matches the investors' best alternative After adjusting for risk, the expected rate of return of investing in the firm must equal/exceed the risk-free rate How do you adjust for risk of company's stock price? • To answer this question, we must think about an investment portfolio (a collection of different investments) Different investments in portfolio have different risk levels Furthermore, the risks can offset each other: one investment can go up when another goes down • To adjust for risk, we need to know how one project's risk interacts with another --- especially important for stocks 6-1
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3 What investors want • In finance, we assume people only care about two things: reward and risk We assume investors do not care about: company's name, how cool its products are, whether company has “morals” You already know how to measure reward: expected value Risk is measured by standard deviation (will learn soon) • A company manager needs to think about what investors want When manager has project that needs funding, they ask people to invest in the project Manager needs to understand investors' alternatives, to offer rate of return which is more attractive than alternatives Manager should know what type of portfolio investors have 6-1
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4 Example of Portfolio 8-1 Probability State of World Assets A B C 1/4 Yellow 10% 12% -1% 1/4 Red 8% 20% 0% 1/4 Green -2% -1% 1% 1/4 Blue 0% -15% 2% Q1: What is the expected payoff of each asset? Q2: If you could only pick two assets to form a portfolio, which would you pick? Would anyone want to buy asset C?
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5 Portfolio Expected Return 8-1 • A portfolio is a collection of multiple investments A portfolio can consist of three stocks, two stocks and one bond, three bonds, one stock and one house, etc. A manager should assume most investors own portfolios, so we need
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This document was uploaded on 11/04/2011 for the course FINANCE 0901 at Brown College.

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Lecture6 - Chapter 8 07/15/11 20:30 Portfolios and...

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