Lect 09 Fin 221 print

Lect 09 Fin 221 print - Managerial Finance Lecture 9 Market...

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1 Managerial Finance Lecture 9 Market Pricing of Risk
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2 Class 8: Summary Historically investments with higher volatilities have rewarded investors with higher average returns Holds for portfolios of securities but does not hold for individual stocks Why? Diversification! Investors hold portfolios to eliminate some risks at no cost Diversification does not eliminate common or systematic risk Investors expect to be compensated for holding un-diversifiable or systematic risk An efficient portfolio contains only systematic risk and cannot be diversified further There is no way to reduce its risks without reducing its expected return 2 Non-diversifiable or common risks affect expected returns / cost of capital
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3 Optimal portfolios You are considering investing your money in the following stocks: Adobe Systems (ADBE) Berkshire Hathaway Inc. (BRK-A) Comcast (CMCSA) You carefully analyze these stocks and arrive to the following conclusions (assumptions): ADBE is a high risk, high expected return stock • Expected return = 30%, volatility = 20% BRK-A is a low risk, lower expected return stock • Expected return = 10%, volatility = 10% CMCSA is a high risk, lower expected return stock Expected return = 6% volatility = 10% Expected return = 6%, volatility = 10% Question : How would you allocate your money if you can invest in only one stock? In two stocks? Three stocks? 3
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4 Assume perfect positive correlation 2-Stock Portfolios: investments in lockstep In this case, there are no benefits from diversification Exp. Return Std Dev Corr Stock A 30% 20% Stock B 10% 10% X A X B Std(R P )E [ R P ] 100% 35% 100% 0% 20.0% 30.0% 90% 10% 19.0% 28.0% 80% 20% 18.0% 26.0% 70% 30% 17.0% 24.0% 60% 40% 16.0% 22.0% 50% 50% 15.0% 20.0% 40% 60% 14.0% 18.0% 30% 70% 13.0% 16.0% 10% 15% 20% 25% 30% E[R] A 20% 80% 12.0% 14.0% 10% 90% 11.0% 12.0% 0% 100% 10.0% 10.0% 0% 5% 0% 5% 10% 15% 20% 25% 30% Std Dev B Every combination of stocks A and B is efficient : no combination obtains a lower volatility without sacrificing a lower expected return
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5 2-Stock Portfolios with diversification gains General Case With less than perfect correlation risk is diversified With , risk is diversified Assume correlation A,B =10% Which portfolios are efficient? Exp. Return Std Dev Corr Stock A 30% 20% Stock B 10% 10% 10% X A X B Std(R P ) E[R P ] 100% 0% 20.0% 30.0% 90% 10% 18.1% 28.0% 80% 20% 16.3% 26.0% 70% 30% 14.6% 24.0% 60% 40% 13.0% 22.0% 50% 50% 11.6% 20.0% 40% 60% 10.5% 18.0% 15% 20% 25% 30% 35% E[R] A Efficient portfolios 30% 70% 9.7% 16.0% 20% 80% 9.3% 14.0% 10% 90% 9.4% 12.0% 0% 100% 10.0% 10.0% 0% 5% 10% 0% 5% 10% 15% 20% 25% 30% Std Dev B Some portfolios are inefficient : possible to increase E[R] without increasing the volatility Inefficient portfolios
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6 Short Sales Short Selling a Stock A “short sale” is when you sell a stock that you do not own • A negative investment in a security: you sell a stock that you do not own and then buy that stock back in the future It is a way to bet on the stock dropping , rather than rising How it works: Your broker borrows the stock from someone who owns it The stock is then Your broker borrows the stock from someone who owns it. The stock is then sold and you receive the proceeds
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This note was uploaded on 01/08/2012 for the course MS&E 245G taught by Professor Perez-gonzalas during the Fall '11 term at Stanford.

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Lect 09 Fin 221 print - Managerial Finance Lecture 9 Market...

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