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fmp201112_disc1-1 - Investment(1:ValuationFramework...

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Investment (1): Valuation Framework key material   Financial Management and Policy FMP 1 - 1 A. Risk and Return Systematic/Specific risk: diversification Asset pricing models: CAPM / APT / Empirical CAPM B. Capital Budgeting Principle Risk measurement Value drivers
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A. Risk and return relationship   Financial Management and Policy FMP 1 - 2 A1. Systematic versus specific risk : diversification Question: how should risk be measured ? Naive answer: the variance of each security it captures deviations from expectations it is a measure for a single security it is relevant for the Normal distribution Example: E[R A ] = E A = 0.13 ; σ 2 A = 0.04 variance gives total risk Investments Risk Returns FIRM
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Financial Management and Policy FMP 1 - 3 Smarter answer...: the contribution of each security to the variance of the most diversified portfolio it still captures a deviation from expectations it gives a measure related to the market it is relevant for the multivariate Normal distribution Example: E[R i ] = E i = 0.13 ; σ 2 i = σ 2 j = 0.04, ρ ij = 0.3 with two securities, equal holdings: σ 2 p = E[(0.5 (R i -E i ) + 0.5 (R j -E j )) 2 ] = 0.5 2 σ 2 i + 0.5 2 σ 2 j +2 (0.5) (0.5) E[(R i -E i ) (R j -E j )] = 2 x 0.25 σ 2 i + 2 x 0.25 x σ i σ j ρ ij = 0.026 !!
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Financial Management and Policy FMP 1 - 4 with N securities, same principle: σ 2 p = 1/N σ 2 i + (1-1/N) ρ ij σ 2 i ρ ij σ 2 i as N →∝ Thus, the portfolio variance can be reduced to 0.3 x 0.04 = 0.12 simply because of diversification ρ ij σ 2 i N 1 σ 2 i
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Financial Management and Policy FMP 1 - 5 A2. Asset Pricing Models: CAPM / APT /Multi-factor Question: how should risk and return be matched ? Systematic risk should be priced only Investors can mix risky assets with the riskless asset Diversification reduces risk: everybody should hold the most diversified portfolio
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Financial Management and Policy FMP 1 - 6 1. CAPM start from: R F , R A , R B investors try to maximize expected return and minimize risk E i R F σ A σ B 2 ) , cov( m m i i R R σ β = m CML All choose the same portfolio (m) and mix it with the riskless asset The market portfolio is the most diversified Risk is measured by *
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Financial Management and Policy FMP 1 - 7 Risk premium should reward systematic risk (SML) [ ] F m i F i R E R E - + = β Example: Market with three securities A, B and M E A = 0.14 ; σ 2 A = 0.04 E B = 0.1 ; σ 2 B = 0.02 E M = 0.13; σ 2 M = 0.0225 R F = 0.07
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