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Lecture 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 11-1 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. 11-2 Equity Rates of Return: A Review Percentage Return = Capital Gain + Dividend Initial Share Price Dividend Yield = Capital Gain Yield = Dividend Initial Share Price Capital Gain Initial Share Price 11-3 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? Percentage Return $18.29 $15.13 $.46 23.93% $15.13 $.46 Dividend Yield = 3.04% $15.13 $15.13 Capital Gain Yield $18.29 20.89% $15.13 11-4 Real Rates of Return Recall the relationship between real rates and nominal rates: 1 real rate of return = 1 + nominal rate of return 1 + inflation rate 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%? 11-5 Capital Market History: Market Indexes • Market Index - Measure of the investment performance of the overall market. • Dow Jones Industrial Average (The Dow) • Standard & Poor’s Composite Index (S&P 500) Other Market Indexes? 11-6 Total Returns for Different Asset Classes The Value of an Investment of $1 in 1900 11-7 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. 11-8 Risk Premium: Example Interest Rate on Normal Risk Expected Market Return = + Treasury Bills Premium 1981: 21.6% = 14% + 7.6% 2008: = 2.2% + 7.6% 9.8% 11-9 Returns and Risk How are the expected returns and the risk of a security related? 11-10 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. Also a measure of volatility. 11-11 Variance and Standard Deviation: Example Coin Toss Game: calculating variance and standard deviation (assume a mean of 10) (1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 0 0 - 20 - 30 900 Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2% 11-12 Histogram of Returns What is the relationship between the volatility of these securities and their expected returns? 11-13 Historical Risk (1900-2010) 11-14 Risk and Diversification Diversification Strategy designed to reduce risk by spreading a 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.” 11-15 Diversification: Building a Portfolio A portfolio’s rate of return is the weighted sum of each asset’s rate of return. Two Asset Case: fraction of portfolio rate of return Portfolio Rate of Return = x in first asset on first asset fraction of portfolio rate of return + x in second asset on second asset 11-16 Building a Portfolio: Example Consider the following portfolio: Stock Weight Rate of Return IBM wIBM 50% rIBM 8.3% Starbucks wSBUX 25% rSBUX 12.5% Walmart wW 25% rW 4.7% What is the portfolio rate of return? Portfolio Rate of Return = wIBM rIBM wSBUX rSBUX wW rW (50% 8.3%) 25% 12.5% 25% 4.7% 8.45% 11-17 Do stock prices move together? What effect does diversification have on a portfolio’s total risk, unique risk and market risk? 11-18 Risk and Diversification 11-19 Thinking 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 11-20