Transcript Market Risk

Principles
of
Corporate
Finance
Chapter 7
Introduction to Risk & Return
Tenth Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
8- 2
Topics Covered
Over a Century of Capital Market History
Measuring Portfolio Risk
Calculating Portfolio Risk
How Individual Securities Affect Portfolio
Risk
Diversification & Value Additivity
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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The Value of an Investment of $1 in 1900
$100,000
Common Stock
$10,000
21,536
US Govt Bonds
Dollars
T-Bills
$1,000
176
66
$100
$10
2007
19
00
19
10
19
20
19
30
19
40
19
50
19
60
19
70
19
80
19
90
20
00
$1
Start of Year
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The Value of an Investment of $1 in 1900
Real Returns
$1,000
914
Equities
Bonds
Bills
Dollars
$100
$10
7.48
2.82
2007
19
00
19
10
19
20
19
30
19
40
19
50
19
60
19
70
19
80
19
90
20
00
$1
Start of Year
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8- 5
Equity Market Risk (by country)
40
35
30
25
20
15
McGraw Hill/Irwin
Germany (ex 1922/3)
Italy
Japan
Norway
France
Average
Belgium
Sweden
S Africa
Netherlands
Spain
Ireland
UK
23.58 23.64 23.8 24.93
21.51 21.64 22.28 22.71 22.71 23.35
Denmark
USA
Switzerland
18.93 19.79
16.64 17.88
Australia
10
5
0
33.66 34.17
27.91 29.24
Canada
Standard Deviation of Annual Returns, %
Average Risk (1900-2006)
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Measuring Risk
Variance - Average value of squared deviations
from mean. A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.
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Measuring Risk
Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
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Portfolio standard deviation
Measuring Risk
Unique
risk
Market risk
0
5
10
15
Number of Securities
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Portfolio Risk
Example
Suppose you invest 60% of your portfolio in WalMart and 40% in IBM. The expected dollar return
on your Wal-Mart stock is 10% and on IBM is
15%. The expected return on your portfolio is:
ExpectedReturn  (.60  10)  (.40  15)  12%
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Portfolio Risk
Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in
IBM. The expected dollar return on your Wal-Mart stock is 10% and
on IBM is 15%. The standard deviation of their annualized daily
returns are 19.8% and 29.7%, respectively. Assume a correlation
coefficient of 1.0 and calculate the portfolio variance.
PortfolioVariance [(.60)2 x(19.8)2 ]
 [(.40)2 x(29.7)2 ]
 2(.40x.60x
19.8x29.7) 564.5
Standard Deviation 564.5  23.8%
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Portfolio Risk
ExpectedPortfolioReturn (x1 r1 )  (x 2 r2 )
PortfolioVariance  x12σ 12  x 22σ 22  2(x1x 2ρ 12σ 1σ 2 )
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Portfolio Risk
Example
Stocks
ABC Corp
Big Corp
s
28
42
Correlation Coefficient = .4
% of Portfolio
Avg Return
60%
15%
40%
21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Real Standard Deviation:
= (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4)
= 28.1 CORRECT
Return : r = (15%)(.60) + (21%)(.4) = 17.4%
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Portfolio Risk
Example
Stocks
ABC Corp
Big Corp
s
28
42
Correlation Coefficient = .4
% of Portfolio
Avg Return
60%
15%
40%
21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
Let’s Add stock New Corp to the portfolio
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Portfolio Risk
Example
Stocks
Portfolio
New Corp
Correlation Coefficient = .3
s
% of Portfolio
28.1
50%
30
50%
Avg Return
17.4%
19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that? DIVERSIFICATION
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Beta and Unique Risk
1. Total risk =
diversifiable risk +
market risk
2. Market risk is
measured by beta,
the sensitivity to
market changes
Expected
stock
return
beta
+10%
-10%
- 10%
+10%
-10%
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Expected
market
return
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Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.
Beta - Sensitivity of a stock’s return to the
return on the market portfolio.
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