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Corporate Chapter 7
Finance
Introduction to Risk, Return,
Seventh Edition
and the Opportunity Cost of
Richard A. Brealey Capital
Stewart C. Myers
Slides by
Matthew Will
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 2
Topics Covered
75 Years of Capital Market History
Measuring Risk
Portfolio Risk
Beta and Unique Risk
Diversification
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 3
S&P
6402
Small Cap 2587
1000 Corp Bonds
Long Bond
T Bill
64.1
48.9
Index
10 16.6
0.1
1925 1940 1955 1970 1985 2000
10 6.6
5.0
1 1.7
0.1
1925 1940 1955 1970 1985 2000
60
Percentage Return
40
20
-20
00
26
30
40
45
50
55
60
65
70
75
85
95
35
80
90
20
Year
Source: Ibbotson Associates
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 6
Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0
Ger
Bel
Swi
Can
Neth
Den
Jap
Aus
USA
It
Spa
Fra
Swe
Ire
UK
Country
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 7
Measuring Risk
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 8
Measuring Risk
Coin Toss Game-calculating variance and standard deviation
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 9
Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
-50 to -40
0 to 10
10 to 20
50 to 60
-40 to -30
-30 to -20
-20 to -10
-10 to 0
20 to 30
30 to 40
40 to 50
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 10
Measuring Risk
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 11
Measuring Risk
Portfolio rate
of return (
=
fraction of portfolio
in first asset )( x
rate of return
on first asset )
(
+
fraction of portfolio
in second asset
x
)(
rate of return
on second asset )
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 12
Measuring Risk
Portfolio standard deviation
0
5 10 15
Number of Securities
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7- 13
Measuring Risk
Portfolio standard deviation
Unique
risk
Market risk
0
5 10 15
Number of Securities
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 14
Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes
Stock 1 Stock 2
x 1x 2σ 12 =
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 =
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2
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7- 15
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-
Cola and 35% in Reebok. The expected dollar
return on your CC is 10% x 65% = 6.5% and on
Reebok it is 20% x 35% = 7.0%. The expected
return on your portfolio is 6.5 + 7.0 = 13.50%.
Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 16
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 17
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 18
Portfolio Risk
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7- 19
Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes
N
1 2 3 4 5 6 N
STOCK
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 20
1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%
Copyright 1996
McGraw by The McGraw-Hill Companies, Inc
Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 21
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 22
σ im
Bi = 2
σm
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights
7- 23
σ im
Bi = 2
σm
Covariance with the
market
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights