In practice a broad stock market index is used to represent the market.. Measuring Market RiskExample - Turbo Charged Seafood has the following % returns on its stock, relative to the li
Trang 1Risk, Return and Capital Budgeting
Trang 3Measuring Market Risk
Market Portfolio - Portfolio of all assets in the economy
In practice a broad stock market index is used to represent the market.
Beta - Sensitivity of a stock’s return to the return on the market portfolio.
Trang 4Measuring Market Risk
Example - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the
% return on the market portfolio The beta of Turbo Charged Seafood can be derived from this information.
Trang 5Measuring Market Risk
Month Market Return % Turbo Return %
Trang 6Measuring Market Risk
When the market was up 1%, Turbo average % change was +0.8%
When the market was down 1%, Turbo average % change was -0.8%
The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8.
Example - continued
Trang 7Measuring Market Risk
Example - continued
Trang 8Portfolio Betas
Diversification decreases variability from unique risk,
but not from market risk.
The beta of your portfolio will be an average of the
betas of the securities in the portfolio.
If you owned all of the S&P Composite Index stocks,
you would have an average beta of 1.0
Trang 9Stock Betas
.30 Heinz
H.J
.41 ExxonMobil
.46 Pfizer
.51 Mart
Wal
-.76 Boeing
.90 s
McDonald'
.97 GE
1.34 Ford
1.64 er
DellComput
2.49 Amazon
Beta Stock
B
Betas calculated with price data from
January 2001 thru December 2004
Trang 10Risk and Return
Trang 11Risk and Return
Trang 12Measuring Market Risk
Market Risk Premium - Risk premium of market portfolio Difference between market return and return on risk-free Treasury bills
Market Portfolio
Trang 13Measuring Market Risk
CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.
Market risk premium = r - r Risk premium on any asset = r - r
Expected Return = r + B(r - r )
f
Trang 14Measuring Market Risk
Security Market Line - The graphic
representation of the CAPM.
Security Market Line
Trang 15Security Market Line
Trang 16Capital Asset Pricing Model
R = r f + B ( r m - r f )
CAPM
Trang 17Testing the CAPM
Avg Risk Premium 1931-2002
Beta vs Average Risk Premium
Trang 18Testing the CAPM
High-minus low book-to-market
Trang 19Stock Expected Returns
5.1 Heinz
H.J
5.9 ExxonMobil
6.2 Pfizer
6.6 Mart
Wal
-8.3 Boeing
9.3 s
McDonald'
9.8 GE
12.4 Ford
14.5 er
DellComput
20.4 Amazon
Beta Stock
)
(r
E
Trang 20Capital Budgeting & Project Risk
The project cost of capital depends on the use to which
the capital is being put Therefore, it depends on the risk of the project and not the risk of the company
Trang 21Capital Budgeting & Project Risk
Example - Based on the CAPM, ABC Company has a cost of capital of 17% [4 + 1.3(10)] A breakdown of the
company’s investment projects is listed below When evaluating a new dog food production investment, which cost of capital should be used?
1/3 Nuclear Parts Mfr B=2.0
1/3 Computer Hard Drive Mfr B=1.3
1/3 Dog Food Production B=0.6
AVG B of assets = 1.3
Trang 22Capital Budgeting & Project Risk
Example - Based on the CAPM, ABC Company has a cost of capital of 17% (4 + 1.3(10)) A breakdown of the company’s investment projects is listed below
When evaluating a new dog food production investment, which cost of capital should be used?
R = 4 + 0.6 (14 - 4 ) = 10%
10% reflects the opportunity cost of capital on an
investment given the unique risk of the project.