Lecture 7 - Capital Markets and Risk

Lecture 7 - Capital Markets and Risk - Required Reading...

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Finance - I (MGCR 341) – Prof. de Mot a Capital Markets & Risk Finance - I (MGCR 341) – Prof. de Mot a 2 Required Reading Sections 10.1 to 10.6 from Chapter 10 , “Capital Markets and the Pricing of Risk” from Berk and De Marzo , Corporate Finance. Finance - I (MGCR 341) – Prof. de Mot a 3 Q. What determines the required rate of return on an investment? Q. What is risk? Q. How do we measure risk? Q. What type of risk do we care about? Q. How is risk priced? But first, let’s look at history… Finance - I (MGCR 341) – Prof. de Mot a 4 Value of $100 Invested at the End of 1925 Note: Also shown is the change in the consumer price index (CPI). Finance - I (MGCR 341) – Prof. de Mot a 5 Asset Returns Return = Dividend Yield + Capital Gains Rate where: P t is the share price at time t. Div t+1 is the dividend at time t+1 3 2 1 3 2 1 Rate Gains Capital 1 Yield Dividend 1 1 t t t t t t P P P P Div R + = + + + Finance - I (MGCR 341) – Prof. de Mot a 6 Asset Returns: Probability Distributions • Asset returns are uncertain. At time t we do not know for sure the dividends and prices at t+1, i.e. , Div t+1 and P t+1 . • We use probability distributions to characterize uncertainty. (Just like random variables.) • A probability distribution assigns a probability p R to each of possible return R that may occur. • We use summary statistics to describe probability distributions. Mean and Variance are the most popular ones.
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Finance - I (MGCR 341) – Prof. de Mot a 7 Mean and Variance Asset Returns Mean or Expected Return : Variance : Standard deviation ( σ ) : Square root of the variance. Variance and Standard Deviation are the two most commonly used measures of risk or volatility of a probability distribution. ()() 2 2 2 ) ( ) ( ) ( R E R p R E R E R VAR R R = = R p R E R R × = ) ( Finance - I (MGCR 341) – Prof. de Mot a 8 Example A stock that pays no dividends and has a current share price of $100 has the following probability distribution of the share price in one year.
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This note was uploaded on 12/10/2011 for the course MGCR 341 taught by Professor Trainor during the Winter '08 term at McGill.

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Lecture 7 - Capital Markets and Risk - Required Reading...

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