07 Introduction to Risk, Return, and the Opportunity Cost of Capital.pptVIP

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07 Introduction to Risk, Return, and the Opportunity Cost of Capital.ppt

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07 Introduction to Risk, Return, and the Opportunity Cost of Capital

Slides by Matthew Will Topics Covered 75 Years of Capital Market History Measuring Risk Portfolio Risk Beta and Unique Risk Diversification Average Market Risk Premia (1999-2000) 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. Measuring Risk Coin Toss Game-calculating variance and standard deviation Measuring Risk 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.” Measuring Risk Measuring Risk Measuring Risk Portfolio Risk Portfolio Risk Portfolio Risk Portfolio Risk Portfolio Risk Portfolio Risk Beta and Unique Risk Beta and Unique Risk Beta and Unique Risk Beta and Unique Risk 7- * McGraw Hill/Irwin Copyright ? 2003 by The McGraw-Hill Companies, Inc. All rights reserved Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Chapter 7 McGraw Hill/Irwin Copyright ? 2003 by The McGraw-Hill Companies, Inc. All rights reserved Introduction to Risk, Return, and the Opportunity Cost of Capital The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End 1 6402 2587 64.1 48.9 16.6 Source: Ibbotson Associates Index Year End 1 660 267 6.6 5.0 1.7 Real returns The Value of an Investment of $1 in 1926 Rates of Return 1926-2000 Source: Ibbotson Associates Year Percentage Return Risk premium, % Country Return % # of Years Histogram of Annual Stock Market Returns The variance of a two stock portfolio is the sum of these four boxes Example Suppose you invest 65% of your portfolio in Coca-Cola and 35% in Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%. The ex