The ThomsonNOW Web ste contains an xc file that wll guide you theough the chapter’ caleaations The file for this ‘hapte s 19 Ch03 Tool Kitts and we low along as you read the chapter. In Chapter 2 we presented the key elements of risk and return analysis. There we saw that much of a stock's risk can be elimi nated by diversification, so rational investors should hold portfo- lios of stocks rather than just one stock. We also introduced the Capital Asset Pricing Model (CAPM), which links risk and required rates of return, using a stock's beta coefficient as the relevant measure of risk. In this chapter, we extend these concepts by presenting an in-depth treatment of portfolio concepts and the CAPM, including a more detailed look at how betas are calcu- lated. In addition, we discuss two other asset pricing models, the Arbitrage Pricing Theory model and the Fama-French three- factor model, We also introduce a new but fast-growing field, behavioral finance.[As you read the chapter, consider how you would answer the following questions. You should not necessarily be able to answer the questions before you read the chapter. Rather, you should use them to get a sense of the issues covered in the chapter. After reading the chapter, you should be able to ive at least partial answers to the questions, and you should be able to give better answers after the chapter has been discussed in class. Note, too, that itis often useful, when answering conceptual questions, to use hypothetical data to illustrate your answer. We illustrate the answers with an Excel model that is available on the ThomsonNOW Web site, Accessing the model and working through it is, 2 useful exercise, and it provides insights that are Useful when answering the questions. In general terms, what is the Capital Asset Pricing Model (CAPM)? What assumptions were made when it was derived? Define the terms covariance and correlation coefficient. How are they related to one another, and how do they affect the required rate of return on a stock? Would correlation affect its required rate of return if a stock were held (say, by the company’s founder) in a one-asset portfolio? What is an efficient portfolio? What is the Capital Market Line (CML), how is it related 10 efficient portfolios, and how does it inter- face with an investor's indifference curve to determine the investor's optimal portfolio? Is it possible that two rational investors could agree as to the specifications of the Capital Market Line, but one would hold a portfolio heavily weighted with Treasury securities while the other held only risky stocks bought on margin? What is the Security Market Line (SML)? What information is developed in the Capital Mar- ket Line analysis and then carried over and used to help specify the SML? For practical applications as opposed to theoretical con- siderations, which is more relevant, the CML. or the SML? ‘What is the difference between an historical beta, an adjusted beta, and a fundamental beta? Does it matter which beta is used, and if s0, which is best? Has the validity of the CAPM been confirmed ‘through empirical tests? What is the difference between a diversi able risk and a nondiversifiable risk? Should stock portfolio managers try to eliminate both types of risk? Ifa publicly traded company has a large num- ber of undiversified investors, along with some who are well diversified, can the undiversified investors earn a rate of return high enough to compensate them for the risk they bear? Does this affect the company’s cost of capital? MEASURING PORTFOLIO RISK In the preceding chapter, we examined portfolio risk at an intuitive level. We now describe how portfolio risk is actually measured and dealt with in practice. First, the risk of a portfolio is measured by the standard deviation of its returns. Equa sion 3-1 is used to calculate this standard deviation:! Du BP, Portfolio standard deviation = of, ‘cer ek meses sch 3 the cont of variation or savin coud ao be wd to meas the sk of apo: foo, ut sce prt es (ae appoxinaely normaly dtd ac (2) have sonal sins ee Les these referents are ot necessary ad Hence ae no ed Chapter 3 kan ew: Path = 73In Chapter 1, we told you that managers free cash flows (FCF). This chapter provides should strive to make their firms more valu- additional insights into how to measure a able and that the value of a firm is deter- firm’ risk, | mined by the size, timing, and risk of its “ures || in Operations | | New ecitt,, || Catal || "tino the ith State of the economys#, is the expected rate of return on the portfolio; P is the probability of occurrence Of the ith state of the economy; and there are n eco- nomic states. This equation is exactly the same as the one for the standard deviation of a single asset, except that here the asset is a portfolio of assets (for example, a | | | | Here 4, is the portfolio’s standard deviation; r,; is the return on the portfolio in | mutual fund), | Covariance and the Correlation Coefficient ‘Two key concepts in portfolio analysis are (1) covariance and (2) the correlation coefficient. Covariance is a measure that combines the variance (or volatility) of a stock’s returns with the tendency of those returns to move up or down at the same time other stocks move up or down, For example, the covariance between Stocks A and B tells us whether the returns of the two stocks tend to rise and fall together, and how large those movements tend to be. Equation 3-2 defines the covariance (Cov) between Stocks A and B: TA + Patt Fundamental Cones