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Unformatted text preview: ECON*2560- THEORY OF FINANCE CHAPTER 11: RISK, RETURN , AND CAPITAL BUDGETING 11.1 MEASURING MARKET RISK Recall: Market risks are macroeconomic events Examples include; Changes in interest rates, government spending, monetary policy, oil prices, foreign exchange rates- They affect almost all companies and the returns on almost all stocks - We can therefore assess the impact of macro news by tracking the rate of return on a market portfolio of all securities Market portfolio: portfolio of all assets in the economy. In practice, a broad stock market index such as the S&P/ TSX, is used to represent the market.- Know the performance of the market reflects only macro events, because firm-specific events ( unique risks) average out when we look at the combined performance of thousands of companies and securities- In principle, market portfolio should contain all assets in the world economy This includes ; stocks bonds, foreign securities, real estate etc o HOWEVER, analysts use what is available ( S&P/ TSX etc)- But how will we define and measure the risk of individual common stocks? o Risk depends on exposure to macroeconomic events and can be measured as the sensitivity of a stocks return to fluctuations in returns on the market portfolio This sensitivity is called the stocks beta ( ) Beta: sensitivity of a stocks return to the return on the market portfolio. MEASURING BETA - An investor with a diversified portfolio will be interested in the effect each stock has on the risk of the entire portfolio- Diversification can eliminate the risk that is unique to individual stocks, but not the risk that the market as a whole may decline( carrying your stocks with it ) o Some stocks are less affected by market fluctuations This is dictates what stocks are aggressive stocks and what is defensive stocks Defensive stocks are not very sensitive to market fluctuations Where aggressive stocks amply amplify any market movements o If the market goes up, it is good to be in aggressive stocks, if it goes down, it is better to be in defensive stocks ( and even better to have your money in a bank!) aggressive stocks have high betas betas greater than 1.0 meaning that their returns tend to respond more than one- for- one to changes in the return of the overall market. The betas of defensive stocks are less than 1.0. the returns of these stocks vary less than one-for-on with market returns. The average beta of all stocks is no surprises here 1.0 exactly Because stocks are risky, and thus tend to amplify the market we can break down common stock returns into two parts: the part explained by market returns and the firms beta, and the part due to news that is specific to the firm. Fluctuations in the first part reflect market risk; fluctuations in the second part reflect unique risk The procedure to measure a real companies beta is the same process of that on page 339 1. Observe rates of return, usually monthly, for the stock and the market...
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