BUSINESS AND FAITH INTEGRATION
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Lecture_Note_Chapter_11-Introduction_to_Risk_Return_and_the_Opportunity_Cost_of_Capital1.docxBUSI 530
Chapter 11: Introduction to Risk, Return, and the Opportunity Cost of Capital
Chapter 11 Learning Objectives
1. Estimate the opportunity cost of capital for an “average-risk” project.
2. Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.
3. Understand why diversification reduces risk.
4. Distinguish between specific risk, which can be diversified away, and market risk, which cannot.
Risk and Return
Risk and Return are related.
How?
This chapter will focus on risk and return and their relationship to the opportunity cost of capital.
Chapter 11 Outline
· Rates of Return: A Review
· Dividends and Capital Gains
· Real Rates of Return
· A Century of Capital Market History
· Market Indexes
· Measuring Risk
· Risk & Diversification
· Thinking About Risk
Equity Rates of Return: A Review
Dividend - Periodic cash distribution to shareholders.
Capital Gain - The difference between the sell price and the buy price of a security.
Rates of Return: Example
Example: You purchase shares of GE stock at $15.13 on December 31, 2009. You sell them exactly one year later for $18.29. During this time GE paid $.46 in dividends per share. Ignoring transaction costs, what is your rate of return, dividend yield and capital gain yield?
Real Rates of Return
Recall the relationship between real rates and nominal rates:
Example: Suppose inflation from December 2009 to December 2010 was 1.5%. What was GE stock’s real rate of return, if its nominal rate of return was 23.93%?
Rate of Return – Total income and capital appreciation per period per dollar invested.
Inflation – Rate at which prices as a whole are increasing.
Capital Market history: Market Indexes
· Market Index – Measure of the investment performance of the overall market.
· Dow Jones Industrial Average – Index of the investment performance of a portfolio of 30 “bluechip” stocks.
· S&P Composite Index – Index of the investment performance of a portfolio of 500 large stocks. Also called the S&P 500.
Total Returns for Different Asset Classes
The Value of an Investment of $1 in 1900
Notes: The y-axis is in log-dollars.
· Equities = Diversified Portfolio of Common Stocks
· Bonds = Treasury bonds issued by the U.S. government with average maturity of 10 years
· Bills = Treasury bills issued by the U.S. government with maturity of 3-months.
What Drives the Difference in Total Returns?
Maturity Premium – Extra average return from investing in long- versus short-term
Treasury securities.
Risk Premium – Expected return in excess of risk-free return as compensation for risk
Risk Premium: Example
Returns and Risk
How are the expected returns and risk of a security related?
Measuring Risk
What is risk?
How can it be measured?
Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation – Square root of variance. A measure of volatility.
Variance and Standard Deviation: Example
Coin Toss Game: calculating variance and standard deviation
(assume a mean of 10)
Histogram of Returns
What is the relationship between the volatility of these securities and their expected returns?
Historical Risk
(1900-2010)
Risk and Diversification
· 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.”
Diversification: Building a Portfolio
A portfolio’s rate of return is the weighted sum of each asset’s rate of return.
Two Asset Case:
Building a Portfolio: Example
Consider the following portfolio:
|
Stock |
Weight |
Rate of Return |
|
IBM |
|
|
|
Starbucks |
|
|
|
Wal-Mart |
|
|
What is the portfolio rate of return?
Do stock prices move together?
What effect does diversification have on a portfolio’s total risk, unique risk and market 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.”
Risk and Diversification
Think About Risk
· Message 1
· Some Risks Look Big and Dangerous but Really Are Diversifiable
· Message 2
· Market Risks Are Macro Risks
· Message 3
· Risk Can Be Measured
Page 1 of 7
Dividend
Initial Share Price
Dividend Yield =
Capital Gain
Initial Share Price
Capital Gain Yield =
$18.29$15.13$.46
$15.13
23.93%
Percentage Return
-++
=
=
$.46
Dividend Yield =3.04%
$15.13
=
$18.29$15.13
$15.13
20.89%
Capital Gain Yield
-
==
1 + nominal rate of return
1 + inflation rate
1real rate of return =
+
Interest Rate onNormal Risk
Expected Market Return=+
Treasury BillsPremium
1981: 21.6%=14%+7.6%
2008: 9.8%=2.2%+7.6%
(1)
(2)
(3)
Percent Ra
te of Retu
rn
Deviation
from Mean
Squared De
viation
+
40
+
30
900
+
10
0
0
+
10
0
0
-
20
-
30
900
Variance
=
average of
squared d
eviations
=
1800
/
4
=
450
Standard d
eviation
=
square of
root varia
nce
=
450
=
21.2%
fraction of portfoliorate of return
Portfolio Rate of Return=x
in first asseton first asset
fraction of portfoliorate of return
+x
in second asseton second asset
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50%
IBM
w
=
8.3%
IBM
r
=
25%
SBUX
w
=
12.5%
SBUX
r
=
25%
W
w
=
4.7%
W
r
=
(
)
(
)
(
)
(
)
(
)
Portfolio Rate of Return =
(50%8.3%)25%12.5%25%4.7%
8.45%
IBMIBMSBUXSBUXWW
wrwrwr
´+´+´
=´+´+´
=
Capital Gain + Dividend
Initial Share Price
Percentage Return =
