Brigham,Ehrhardt & Fox

Financial Management:
Theory and Practice
First EMEA edition

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1
 CHAPTER 6
Risk and Return

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Risk and Return: Basic Concepts

 Basic return concepts (historic; expected)

 Basic risk concepts (historic; expected)

 Stand-alone risk (for an entity)

 Portfolio (market) risk

 Risk and return:

 Individual company (CAPM/SML)
 Portfolio (CML)

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Portfolio theory: Basic Concepts

 Portfolio Theory
 Efficient frontier
 Capital Market Line (CML)

 Capital Asset Pricing Model (CAPM)

 Security Market Line (SML)
 Beta calculation

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Learning Outcomes
At the end of this chapter, you should be
knowledgeable on risk management and be able to
calculate:
Expected return.
Variance.
Standard deviation.
Coefficient of variation; for
Stand-alone and portfolio risk.
Discuss portfolio risk, efficient portfolios and select optimal
portfolios

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Risk and Return

Valuing risky assets - a task fundamental to

financial management

Three-step procedure for valuing a risky asset:

1. Determine the asset’s expected cash flows
2. Determine discount rate that reflects asset’s risk
3. Calculate present value (PV cash inflows - PV outflows)

This is called: Discounted cash flow (DCF) analysis

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Historical vs. Expected Returns

Decisions must be based on expected returns

Many ways to estimate expected returns and calculate risk

A simple but not necessarily correct way is to:

Assume that expected return and risk going forward will

be similar to past values

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7
What is investment risk?
 Investment returns are not known with certainty.

 Investment risk pertains to the probability of earning

a return less than (downside risk) expected. Earning
more than expected (upside risk) is not a risk it is a
bonus.

 The greater the chance of a return far below the

expected return, the greater the risk.

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What are investment returns?

 Investment returns measure the financial results of

an investment.

 Returns may be historical or prospective

(anticipated).

 Returns can be expressed in:

 Money terms.
 Percentage terms.

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An investment costs $1,000 and is sold after 1
year for $1,060.

Euro return:
€ Received - € Invested
€1,060 - €1,000 = €60.

Percentage return:

€ Return/€ Invested
€60/€1,000 = 0.06 = 6%.

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Return on a single asset
Return - The total gain or loss experienced on an
investment over a given period of time.

Expected sales price Purchase price (Old price)

(New Price)

Pt+1 - Pt + Ct+1 Cash Flow

R t+1 =
Pt
An example.... $63 – $60 + $6
Bought for $60/share
R =
$60
Dividend = $6/share $9
= = 15%
Sold for $63/share
$60
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11
Arithmetic Versus Geometric Returns
• Arithmetic return the simple average of annual returns:
best estimate of expected return each year.

(R1 + R2 + R3 + … + Rt ) / t

• Geometric average return the compounded annual

return to an investor who bought and held a stock t
years:

(1+R1 )(1+R2 )(1+R3 )….(1+Rt )]1/t – 1

The difference between arithmetic returns and geometric returns

gets bigger the more volatile the returns are

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Arithmetic Versus Geometric Returns

An example....

Year Return

2015 -10% AAR = 7.00%

2016 +13%

2017 +17% GAR = 6.47%

2018 + 8%

AAR =(-10 + 13 + 17 +8) / 4 = 7.00%

GAR = [(1 + (-0.10)(1 + 0.13)(1 + 0.17)(1 + 0.08)](1/4) - 1 = 6.47%

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The Focus

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Scenarios and Returns for a share - Next Year

Scenario Probability Return

Worst Case 0.10 −14%

Poor Case 0.20 −4%

Most Likely 0.40 6%

Good Case 0.20 16%

Best Case 0.10 26%

1.00

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Discrete Probability Distribution for Scenarios

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Continuous Probability Distribution

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Returns for differing risks

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Expected return
^
r = expected rate of return.

r = 0.10(-14%) + 0.20(-4%)
^

+ 0.40(6%) + 0.20(16%)

+ 0.10(26%) = 6%.

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Stand-Alone Risk: Standard Deviation

 Stand-alone risk is the risk of each asset held by itself.

 Standard deviation measures the dispersion of possible
outcomes.
 For a single asset:
Stand-alone risk = Standard deviation

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Individual asset - Standard deviation of returns

n 2
  

2
  r  r P
i i
i 1
 

n 2
  
   r  r P .
i 1  i  i

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Standard Deviation of the Share’s Return
During the Next Year

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Expected return and expected risk
Case investment alternatives (Brigham & Erhardt)

Economy Prob. T-Bill Alta Repo Am F. Market

% % % % %
Recession 0.10 8.0 -22.0 28.0 10.0 -13.0

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00
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23
What is unique about the investment opportunities?
 The T-bill will return 8% regardless of the state of
the economy.

 Is the T-bill riskless? Explain.

 Alta moves with the economy, so it is positively

correlated with the economy. This is the typical
situation.

 Repo moves counter to the economy. Such

negative correlation is unusual.

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Expected rate of return of an individual asset.

^
r = expected rate of return.

n

r=  RP i i
I=1

Alta - case
^
rAlta = 0.10(-22%) + 0.20(-2%) + 0.40(20%)

+ 0.20(35%) + 0.10(50%) = 17.4%.

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Expected rate of return individual assets.

^
r
Alta 17.4%
Market 15.0
Am. F 13.8
T-bill 8.0
Repo 1.7
 Alta has the highest rate of return.
 Does that make it best?
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Risk interpreted.
 Standard deviation measures the stand-alone risk of an
investment.

 The larger the standard deviation, the higher the

probability that returns will be far below / above the
expected return.

 Coefficient of variation is an alternative measure of

stand-alone risk.

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27
Expected Return (E(R)) and Risk Choice)

Expected
Security return Risk, 

Alta Inds. 17.4% 20.0%

Market 15.0 15.3

Am. Foam 13.8 18.8

T-bills 8.0 0.0

Repo Men 1.7 13.4

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Coefficient of Variation (CV) =
Standard deviation / Expected return

CVT-BILLS = 00.0% / 8.0% = 0.0

CVAlta Inds = 20.0% / 17.4% = 1.1

CVRepo Men = 13.4% / 1.7% = 7.9

CVAm. Foam = 18.8% / 13.8% = 1.4

CVM = 15.3% / 15.0% = 1.0

CV = Units of standard deviation / unit of return

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E(R) and CV (Choice ?)

Expected Risk: Risk:

Security return  CV

Alta Inds 17.4% 20.0% 1.1

Market 15.0 15.3 1.0

Am. Foam 13.8 18.8 1.4

T-bills 8.0 0.0 0.0

Repo Men 1.7 13.4 7.9

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Expected return for a Portfolio

 Most investors hold multiple asset portfolios

 Key insight of portfolio theory: asset return adds linearly,

but risk is (almost always) reduced in a portfolio

E(Rp) = w1 * E(R1) + w2 * E(R2) + w3 * E(R3) + wN * E(RN)

The expected return of portfolio is the weighted average of

expected returns of the stocks

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Two assets same expected return (10%) but different
distributions

0.5

0.25

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Two-Asset Portfolio Standard Deviation

 p  w1  1  w2  2  2w1 w2 12 1 2
2 2 2 2 2

Standard Deviation   p
2

Correlation between stocks influences portfolio volatility

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The Importance of Covariance

 Risk reduction is achieved in portfolios because

fluctuations in one asset partially off set fluctuations in
the other

 Risk of a portfolio depends crucially on whether the

returns on the portfolio’s components move together or
in opposite directions

 Covariance: Statistical measurement of the co-

movements of two random variables

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How closely do the returns follow one another?

Notice that the returns don’t move in perfect unison:

Sometimes one is up and the other is down.
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Correlation Coefficients And Risk Reduction
For Two-Asset Portfolios
 is -1.0
Expected Return on the Portfolio 25%
-1.0 <  <1.0

20% Asset B
100%

15%

Asset A
10% 100%
 is +1.0

0% 5% 10% 15% 20% 25%

Standard Deviation of Portfolio Returns

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In a 2-Share Portfolio
 r = −1
 2 stocks can be combined to form a riskless portfolio:

σp = 0.
 r = +1
 Risk is not “reduced”

 σ
p is just the weighted average of the 2 stocks’
standard deviations.
 −1 < r < −1
 Risk is reduced but not eliminated.

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Effect of diversification on portfolio variance
Single stockσ = 35
p Stand-alone risk
Market + Mpy Specific/diversifiable

Portfolio
35% risk

Risk, p
Total
Company Specific/diversifiable risk
Portfolio risk

Part of stand-alone risk (σp) eliminated

by diversification

20% Market risk

Part of stand-alone risk that cannot be
eliminated by diversification

0 10 20 30 40 2,000+
No. Stocks in Portfolio
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Stand-alone risk = Market risk + Diversifiable risk

 Market risk is that part of a security’s stand-alone risk that

cannot be eliminated by diversification.

 Firm-specific, or diversifiable, risk is that part of a

security’s stand-alone risk that can be eliminated by
diversification.

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Conclusions
 As more shares are added, each new share has a smaller
risk-reducing impact on the portfolio.

 sp falls very slowly after about 40 stocks are included. The

lower limit for sp is about 20% = sM .

 By forming well-diversified portfolios, investors can

eliminate about half the risk of owning a single stock.

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Return of alternative investments in different
countries, 1900-2008

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Returns - Bills, Bonds, Stocks 1900 - 2003
Nominal (%) Real (%)
Asset Class Average Best Year Worst Year Average Best Year Worst Year

Bills 4.1 14.7 0.0 1.1 19.7 -15.1

Bonds 5.2 40.4 -9.2 2.3 35.1 -19.4
Stocks 11.7 57.6 -43.9 8.5 56.8 -38

Risk premium = (r – rf)

Stocks and bills = 7.6% (nominal 11.7 – 4.1)
Stocks and bonds = 6.5% (nominal 11.7 – 5.2)

Stocks and bills = 7.4% (real 8.5 – 1.1)

Stocks and bonds = 6.2% (real 8.5 – 2.3)

42

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Risk and Return Fundamentals
Equity risk premium: the difference between equity returns
(r) and returns on safe investments(rf)

Where : Premium = (r – rf)

Implies that stocks are riskier than bonds or bills

Trade-off always arises between expected risk and expected

return

Volatility of stocks relative to bonds / bills depends on the

time horizon over which investment returns are measured

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Systematic Risk and Asset Pricing
• Investors can only expect compensation
for systematic risk:
 Contribution of an asset’s risk to a diversified

portfolio is measured by beta

• The capital asset pricing model (CAPM) relates an

asset’s return to its systematic risk.
 Assumes that rational, risk-averse investors select

efficient portfolios

Beta measures the change in an individual assets’ return

against the change in total market return

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How is market / systemetic risk measured for
individual securities?
 Market risk, which is relevant for stocks held in well-
diversified portfolios, is defined as the contribution of
a security to the overall riskiness of the portfolio.

 It is measured by a stock’s beta coefficient. For

stock i, its beta is:

bi = (riM si) / sM

In addition to measuring a stock’s contribution of risk to

a portfolio, beta also measures the stock’s volatility
relative to the market.
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The Capital Asset Pricing Model (CAPM)

CAPM
CAPMmodel
modelfor
forfirm
firmi i

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Market Risk and CAPM
Expected
Expectedreturnreturn
for firm i the
for firm i the
discount
discountrate rate
applied
applied tovalue
to value
ofofthe
thefirm
firmone risk
one riskfree
free aaportion
portionofof Market
Marketrisk
riskpremium
premium
year from
year from nownow return the market
return the market
risk
riskpremium
premium
ininexpanded
expandedform
form

note
notethat
that isisconstant
constantonly
only
ororCov(r
Cov(ri,ri,rmm))defines
defines
the
therequired
requiredreturnreturn
ofofaashare…
share… asininthe
as the
variance
variancecovariance
covariance
matrix earlier.
matrix earlier.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Asset Pricing Model (CAPM)

Only beta changes from one security to the next. For that
reason, analysts classify the CAPM as a single-factor
model, meaning that just one variable explains differences
in returns across securities.

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Market Risk and Beta

 Most stocks have betas in the range of 0.5 to 1.5.

 Can a stock have a negative beta?

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What are the CAPM assumptions?

 Investors think in terms of a single holding period.

 All investors have identical expectations.
 Investors can borrow / lend money unlimited at the risk-
free rate.
 All assets are perfectly divisible.
 There are no taxes and no transactions costs.
 All investors are price takers, that is, investors’ buying
and selling won’t influence stock prices.
 Quantities of all assets are given and fixed.

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Can an investor holding one stock earn a return
commensurate with its risk?

 No. Rational investors will minimize risk by holding

portfolios.

 They bear only market risk, so prices and returns reflect

this lower risk.

 The one-stock investor bears higher (stand-alone) risk, so

the return is less than that required by the risk.

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Using a regression to estimate beta
 Run a regression with returns on the stock in question
plotted on the Y axis and returns on the market
portfolio plotted on the X axis.

 The slope of the regression line, which measures

relative volatility, is defined as the stock’s beta
coefficient, or b.

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Use the historical stock returns to calculate
the beta for PQU. (Slides Brigham & Erhardt)

Period Market PQU

1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
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78
Calculating Beta for PQU

40%
r PQU

20%

r M

-40% -20% 20% 40%

-20%

-40%

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79
What is beta for PQU?
The regression line, and hence beta, can be found using a
calculator with a regression function or a spreadsheet
program. In this example, b = 0.83.

Calculating beta in practice

 In South Africa analysts use the JSE All Share Index (J

203) to find the market return.
 Analysts typically use four or five years’ of monthly returns
to establish the regression line.
 Some analysts use 52 weeks of weekly returns.
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80
Expected Return versus Market Risk
Expected
Security return Risk, b
Alta 17.4% 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Repo Men 1.7 -0.86

Which of the alternatives is best?

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Expected return and expected risk
Investment alternatives (Brigham & Erhardt)
Economy Prob. T-Bill Alta Repo Am F. MP

Recession 0.10 8.0% -22.0% 28.0% 0.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00

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Altas’ expected beta

50 50 : 43

40
Alta Return

30
Beta = Rise / Run
20 Beta = 13 / 10 = 1.3
10

-30 -20 -10 10 20 30 40 50 Market Return

-10

© 2016-22 : -13
Cengage -20
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Use the SML to calculate each
alternative’s required return.
 The Security Market Line (SML) is part of the Capital
Asset Pricing Model (CAPM).

 SML: ri = rF + (RPM)bi.

 Assume rF = 8%; rM = rM = 15%.

 RPM = (rM - rF) = 15% - 8% = 7%.

RR (1-T)
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Required Rates of Return

rAlta = 8.0% + (7%)(1.30)

= 8.0% + 9.0% = 17.0%.

rM = 8.0% + (7%)(1.00) = 15.0%.

rAm. F. = 8.0% + (7%)(0.68) = 12.8%.
rT-bill = 8.0% + (7%)(0.00) = 8.0%.
rRepo = 8.0% + (7%)(-0.86) = 2.0%.

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Expected versus Required Returns

^
r r
Alta 17.4% 17.0% Undervalued

Market 15.0 15.0 Fairly valued

Am. F. 13.8 12.8 Undervalued

T-bills 8.0 8.0 Fairly valued

Repo 1.7 2.0 Overvalued

Over/Under valued
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Constructing the SML

ri (%) SML: ri = rF + (RPM) bi

ri = 8% + (7%) bi

Alta . Market
.
ra = 17
rM = 15

rRF = 8 . T-bills Am. Foam

Repo
. Risk, bi
-1 0 1 2

SML and Investment Alternatives

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Figure 6.8 The Security Market Line

E(Ri)
A: Undervalued SML
•

•A
Slope of SML = Rm  Rf =
Rm • B • Market Risk Premium (MRP)
•
Rf
• B: Overvalued
•
 i
=1.0
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The Security Market Line: Relating Risk and Required
Return

E(rm ) = 1
Slope
Slope == the the price
price of of
risk.
risk. The
The steeper
steeper itit isis
the
the more
more return
return
rf
required
required toto compensate
compensate
for
forbeta
betarisk
risk

βm = 1

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Risk and Return in the Stock Market

 We assume that you cannot consistently get a higher

return for a given risk than that dictated by the security
market line

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Beta for a portfolio of:50% Alta; 50% Repo

bp = Weighted average

= 0.5(bAlta) + 0.5(bRepo)

= 0.5(1.29) + 0.5(-0.86)

= 0.22.

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Required return of the Alta / Repo portfolio?

rp = Weighted average r

= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

rp = rF + (RPM) bp

= 8.0% + 7%(0.22) = 9.5%.

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The Security Market Line
 Plots the relationship between expected return and
betas
 In equilibrium, all assets lie on this line
 If stock lies above the line
 Expected return is too high
 Investors bid up price until expected return
falls
 If stock lies below the line
 Expected return is too low
 Investors sell stock, driving down price until
expected return rises

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Required Return for Blandy

 Inputs:
 r
RF = 4% (given)
 E(rm – rf) = 5% (given)
 βi = 0.60 (estimated)

 ri = rRF + bi (E(rm – rf) )

ri = 4% + 0.60(5%) = 7%

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69
Using a Regression to Estimate Beta

 Run a regression with returns on the stock plotted on the

Y-axis and returns on the market portfolio plotted on the
X-axis.

 The slope of the regression line is equal to the stock’s

beta coefficient.

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Excel: Plot Trendline Right on Chart

yy==Blandy’s
Blandy’sreturns
returns
xx==market
marketreturns
returns
0.6027
0.6027==beta
beta

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Web Sites for Beta
 http://finance.yahoo.com
 Enter the ticker symbol for a “Stock Quote”, such
as IBM or Dell, then click GO.
 When the quote comes up, select Key Statistics
from panel on left.
 www.valueline.com
 Enter a ticker symbol at the top of the page.

 Most stocks have betas in the range of 0.5 to

1.5.

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Feasible and Efficient Portfolios

 The feasible set of portfolios represents all portfolios

that can be constructed from a given set of stocks.
 An efficient portfolio is one that offers:
 the most return for a given level of risk, or
 the least risk for a give level of return.
 The collection of efficient portfolios is called the
efficient set or efficient frontier.

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Feasible and efficient portfolios (risky assets)
(Brigham & Erhardt)

Efficient Set
Expected Portfolio Return, rp

Feasible Set

Risk, 
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Optimal Portfolios for individuals (Brigham &
Erhardt)
Expected
Return, rp IB I
2 B
1

Optimal Portfolio
IA Investor B
2
IA
1

Optimal Portfolio
Investor A

Risk p
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What is indifference curves

 Indifference curves reflect an investor’s attitude

toward risk as reflected in his or her risk/return
tradeoff function. They differ among investors
because of differences in risk aversion.

 An investor’s optimal portfolio is defined by the

tangency point between the efficient set and the
investor’s indifference curve.

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Portfolios of Risky and Risk-Free Assets

The Capital Market Line (CML):

New Efficient Set

.
Z
B

^
M
.
Expected Return, rp

rM

rRF
A .
 M Risk, p
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Portfolios of Risky and Risk-Free Assets

The Capital Market Line (CML):

New Efficient Set

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Finding the Optimal Risky Portfolio
 If investors can borrow and lend at the risk-free rate,
then from the entire feasible set of risky portfolios, one
portfolio will emerge that maximizes the return
investors can expect for a given standard deviation.

 To determine the composition of the optimal portfolio,

you need to know the expected return and standard
deviation for every risky asset, as well as the
covariance between every pair of assets.

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The Capital Market Line (CML) Equation

Intercept
Slope
Risk
measure
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What is the Capital Market Line?
 The Capital Market Line (CML) is all linear combinations
of the risk-free asset and Portfolio M (market portfolio).
 The line connecting Rf to the market portfolio is called
the Capital Market Line (CML)
 CML quantifies the relationship between the expected
return and standard deviation for portfolios consisting
of the risk-free asset and the market portfolio, using
 Portfolios below the CML are inferior.
 The CML defines the new efficient set.
 All investors will choose a portfolio on the CML.

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Risk and Return in the Stock Market

 So how well does the Stock Market value shares?



 see Efficient Markets Hypothesis

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Have we met our goals

Are we knowledgeable on risk and risk management

And are we able to calculate:

Expected return;
Variance;
Standard deviation;
Coefficient of variation;
For both stand-alone and portfolio risk.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Have met our goals

Are we able to:

Discuss portfolio risk, efficient portfolios and select an

optimal portfolios

Determine market risk for individual companies

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