Lecture 8Risk and Return.ppt

Lecture 8Risk and Return Managerial Finance FINA 6335 Ronald F. Singer Topics Covered Markowitz Portfolio Theory Risk and Return Relationship Testing the CAPM CAPM Alternatives Markowitz Portfolio Theory Combining stocks into portfolios can reduce standard deviation below the level obtained from a simple weighted average calculation. Correlation coefficients make this possible. The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios. Markowitz Portfolio Theory Price changes vs. Normal distribution Microsoft - Daily % change 1986-1997 Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment C Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment D Markowitz Portfolio Theory Efficient Frontier Efficient Frontier Efficient Frontier Correlation Coefficient 0.4 Stocks s % of Portfolio Avg. Return ABC Corp 28 60% 15% Big Corp 42 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 Efficient Frontier Correlation Coefficient .3 Stocks s % of Portfolio Avg. Return Portfolio 28.1 50% 17.4% New Corp 30 50% 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 Efficient Frontier Efficient Frontier Efficient Frontier Efficient Frontier Efficient Frontier Efficient Frontier Security Market Line Security Market Line Security Market Line Security Market Line Security Market Line Security Market Line Capital Asset Pricing Model Testing the CAPM Testing the CAPM Testing the CAPM Testing the CAPM Consumption Betas Vs. Market Betas Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium r - rf Bfactor1 rfactor1 - rf + Bf2 rf2 - rf + … Return a + bfactor1