How should the historical data affect decision making

8 25 0 risk free rate if you are looking at long term

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Unformatted text preview: rid of idiosyncratic risk, you should be compensated for it very little, but systematic risk you can’t get rid of so you need to be compensated. Each stock has volatility which can be broken down into two parts – idiosyncratic volatility and volatility due to the stock’s movement with the market (systematic risk) How do we measure volatility and compensation needed: Compensation for risk: Because unsystematic risk can be diversified away, an investor will not be compensated for it. Stocks that move more with the market have higher systematic risk and vice versa for those that move less. Similarly, because systematic risk cannot be diversified away, an investor should be compensated for it. Beta is the measure that tells you how much systematic risk a particular stock has relative to the market Market rating of 1 and stocks can be above or below 1. Beta calculated by running regression analysis for 60 months and finding slope (slope is beta) we might be concerned that beta is stable over time. By getting rid of systematic risk, beta becomes expected return. Like expected return, a portfolio’s Beta is just the weighted average of the component stock’s betas. How much more should you get paid for systematic risk? The Capital Asset Pricing Model (“CAPM”) E(Ri) = (E(Rm) – Rf) beta + Rf + alpha E(Ri) is what your expected return is for a stock If beta is 0.8, we are taking less risk than market Rf is risk free (equity risk premium) from history 7- 8% E(Ri) can be thought of as a company’s cost of equity capital Alpha is an error term if market is efficient, alpha should be 0 (there is no unusual return) So say for coca cola: 7% * 0.8 + 2.5% + 0 Risk free rate: if you are looking at long term capital project, that us...
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This document was uploaded on 03/27/2014 for the course FINC 150 at Georgetown.

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