1 chapter 10 estimating risk and return mcgraw-hill/irwin copyright © 2012 by the mcgraw-hill...
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Chapter 10Chapter 10 Estimating Risk and Return
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Expected Returns• Expected return is a forward-looking
calculation
• Includes risk measures
10-2
Expected Return
• Multiply each possible return by the probability of that return occurring
10-3
Risk Premiums
• Required return is the return that investors demand for the level of risk taken
• Risk premium is the reward investors require for taking risk
• Market risk premium is the reward for taking unsystematic stock market risk
10-4
The Market Portfolio
• Capital Asset Pricing Model (CAPM)
– Best known capital asset pricing model
– Starts with modern portfolio theory
10-5
Efficient Frontier• The efficient frontier demonstrates the
highest expected return for each level of risk
10-6
Efficient Frontier• Adding a risk-free asset improves return for
each level of risk
10-7
CAPM
• Calculate the Security Market Line for risk/return relationship
• Substituting into line equation results in CAPM
10-8
Beta
• Measures the sensitivity of a stock or portfolio to market risk
– Beta greater than 1 = more risky than market (higher risk premium)
– Beta less than 1 = less risky (lower risk premium)
10-9
Security Market Line
• Shows relationship between risk and return for any stock or portfolio
• Similar to capital market line– Risk is characterized by beta, not standard
deviation
10-10
Security Market Line Uses Beta as Risk Measure
10-11
Portfolio Beta
Weighted average of portfolio stocks’ betas
10-12
Finding Beta
• Two ways
– Can compute with data from company’s and market portfolio returns
– Find in published data from financial outlets
10-13
Capital Market Efficiency
• Efficient markets feature
– Many buyers and sellers
– No high barriers to entry
– Free and available information
– Low trading or transaction costs
10-14
Efficient Market Hypothesis
• States that security prices fully reflect all available information
• Three levels– Weak form
– Semi-strong form
– Strong form
10-15
Weak-form Efficiency
• Current prices reflect all information derived from trading– Includes current and past stock prices and
trading volume
10-16
Semi-strong form Efficiency
• Current prices reflect all available public information– Includes information like financial statements,
news, analysts’ opinions
10-17
Strong-form Efficiency
• Current prices reflect all information– Public
– Privately-held information
10-18
Behavioral Finance
• People behave in “irrational” ways– Both optimism and pessimism can be
extreme
– Overconfidence is tendency to overestimate knowledge and underestimate risk
10-19
Implications for Financial Managers
• Managers must...
– understand the risk/return relationship and implications
– address stockholders’ concerns and requirements
10-20
Constant-Growth Model
• Assumes stock is efficiently priced• Uses dividend and price data and forward
estimate
10-21