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X = XiP Xi
i=1
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Var X Xi X P Xi
i=1
2
x
x Xi X P Xi
i=1
n
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P(X)
0.0625
0.2500
0.3750
0.2500
0.0625
1.0000
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X
CV
X
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Risk Aversion
Risk aversion means investors prefer
lower risk when expected returns are
equal
When expected returns are not equal the
choice of investment depends on the
investor's tolerance for risk
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Consider
Worst cases and Best cases
How variable is each return around its mean
Does a picture (next slide) help?
Which would you choose
Is it likely that Harolds choice would be
influenced by his age and/or wealth?
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Business-Specific Risk
Movement caused by things that influence particular
firms and/or industries: labor unrest, weather,
technology, key executives
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Portfolios
A portfolio is the collection of investment
assets held by an investor
Portfolios have their own risks and returns
A portfolios return is simply the weighted
average of the returns of the stocks in it
Easy to calculate
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Portfolios
Goal of the Investor/Portfolio Owner is to
capture the high average returns of stocks
while avoiding as much of their risk as
possible
Done by constructing diversified
portfolios
Investors are concerned only with how
stocks impact portfolio performance,
not with stand-alone risk
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k Conroy = 7.2%
The new return can be estimated as
kConroy = 14% - 7.2% = 6.8%
Using Beta
The Capital Asset Pricing Model CAPM)
CAPM attempts to explain how stock prices are set
CAPM's Approach
People won't invest in a stock unless its
expected return is at least equal to their
required return for that stock
CAPM attempts to quantify how required
returns are determined
The stocks value (price) is estimated based on
CAPMs required return for that stock
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Using Beta
The Capital Asset Pricing Model (CAPM)
Rates of Return, The Risk-Free Rate and
Risk Premiums
The current return on the market is kM
The risk-free rate (kRF)
no chance of receiving less than expected
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k X k RF k M k RF b X
14243
Market Risk
Premium
1 4 4 2 4 43
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D0 1 g
kg
$1.5 1.07
.14 .07
$22.93
g
$1.5
1.09
0
P0
$26.37
Substituting this kand
9%
growth
in the Gordon
g
.152 .09
model yields:
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