FINA274 lecture 2

FINA274 lecture 2 - Measuring risk Lecture 2.a. FINA 274...

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Measuring risk Lecture 2.a. FINA 274 1 Lecture 2: Risk, Cost of Capital, and
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Measuring Risk Why do we care about measuring risk? Capital budgeting requires a discount rate for future cash flows to assess a projects NPV But not all capital budgeting projects have the same risk 1. Suppose Intel is choosing between expanding a factory to build more Pentium microprocessors, and building a new factory to make cellular phone chip sets, a new venture. 2. Should they apply the same discount rates? Higher risk projects require a higher rate of return Determining the appropriate discount rate requires that we quantify the risk associated with the project FINA 274 Lecture 2: Risk, Cost of Capital, and 2
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Types of Risk Systematic Risk Risk factors that affect a large number of assets This risk is non-diversifiable (can’t get rid of it) Includes such things as changes in GDP, inflation, interest rates Also known as Market Risk Unsystematic Risk Risk factors that affect a limited number of assets This risk is diversifiable (by holding asset in a portfolio) Includes such things as labor strikes, part shortages Also known as firm/asset-specific or idiosyncratic risk Total risk = Systematic risk + unsystematic risk FINA 274 3 Lecture 2: Risk, Cost of Capital, and
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Which risk matters? Investors Hold a portfolio of firms Firm-specific risk is diversified away with sufficient # holdings Only care about systematic (market) risk Firms Hold a portfolio of projects Care about the specific risk of each project, but this is hard to measure (if not impossible) Managers will often use their firm’s borrowing rate, which is a function of the firm’s systematic risk, measured using its own past performance The measurement process is imprecise, and there are many ways to do it FINA 274 Lecture 2: Risk, Cost of Capital, and 4
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Capital Asset Pricing Model (CAPM) Provides an estimate of the expected return (R i ) On an individual firm’s security Which can be used in calculating discount rates in capital budgeting decisions at that firm How is this done? FINA 274 Lecture 2: Risk, Cost of Capital, and 5 R i = R f + b i ´ ( R m - R f ) Risk free rate (e.g. T-bills) “Expected” market return “Expected” return for security i Systematic risk of security i Estimating the expected return requires three inputs, each which also need to be measured
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Estimating Beta The best measure of the risk of a security (in a large portfolio) …the responsiveness of a security to movements in the market portfolio Numerator is the covariance of the security with the market portfolio Denominator is the variance of the market portfolio For the statistics major, this should look a lot like the slope of FINA 274 Lecture 2: Risk, Cost of Capital, and 6 ) ( ) ( 2 , M M i i R R R Cov σ β=
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Estimating Beta FINA 274 Lecture 2: Risk, Cost of Capital, and 7 Security Return (Ri) Market Return (Rm) Ri = α i + β iRm + e i = Slope = β i C h a r c t e i s L n β
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Calculating the market risk premium
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FINA274 lecture 2 - Measuring risk Lecture 2.a. FINA 274...

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