UnderstandingRisk.ppt

If an investor holds the market portfolio, the risk of any asset is the risk that it adds to the portfolio. That is what beta measures. The cost of equity is a linear function of the beta of the portfolio. Summarizes the inputs. Note that we are replacing the last component (E(Rm-Rf) with the expected risk premium.. Reemphasize that you need to know the expected returns with certainty for something to be riskless. No default risk and no reinvestment risk. Most people understand the first point, but don’t get the second. If you need an investment where you will know the expected returns with certainty over a 5-year time horizon, what would that investment be? A T.Bill would not work - there is reinvestment risk. Even a 5-year T.Bond would not work, because the coupons will cause the actual return to deviate from the expected return. Thus, you need a 5-year zero coupon T.Bond From a present value standpoint, using different riskfree rates for each cash flow may be overkill, except in those cases where your interest rates are very different for different time horizons (a very upward sloping or downward sloping yield curve) Since corporate finance generally looks at long term decisions, we will for the most part use the long term government bond rate. For a real riskfree rate, an expected real growth rate for the economy should provide a reasonable approximation. If the real growth rate is much lower than the real interest rate, you will have significant deficits - trade or budget - to make up the shortfall. If the real growth rate is much higher than the real interest rate, you will the exact opposite - surpluses. A long term equilibrium can be reached only when the two are equal. Implicit here are two questions - Which investor’s risk premium? What is the average risk investment? I usually find that the median number that I get in the US is 10.7-12.7%, though the distribution is pretty spread out. This translates into a risk premium of 4-6%. The wealthier you are