CF

473.32

10

Winter 2014

Questions

1. What cash flows should I consider?

2. How does the market set r?

3. How should I set r?

2. Market r

1957-2002

6.42

3.40

2.13

risk

premium

%

13.31small stocks

r

10.29common stocks

9.01 long bonds

6.89treasury bills

1970-2002

inflation 4.35 %

2. Market rReal-World Bonds

perceived risk = required return

flexibility = required return

exactly the same rules for any investment

2. Market rExpected return from market

Expected return from Treasury Bills considered risk-free

Risk premium “extra” return earned for taking on risk

emr

fr

femp rrr

2. Market r

risk

return

rfinflation

t-bills

averagerisk

average return

rp

rem

2. Market r

risk

return

rfinflation

t-bills

SML

averagerisk

average returnlower return

lowerrisk

higher return

higherrisk

2. Market r

risk

return

rf

SML

βem

rem

2. Market r

risk

return

rf

SML

βi

rei

ifemfei rrrr

CAPM

i

fei rr

risk-to-reward ratio

risk

return

rf

Is this true?

2. Market rIs this true?

Efficient Market Hypothesis• prices already reflect all known info

measure collective belief of all investors

• new info unknowable random

• when new info comes prices adjust

» quickly

» correctly if investors over-react or under-react

» they do so randomly

new info research news

2. Market rIs this true?

Efficient Market Hypothesis• can only be true if

investors

» have diversified portfolios

» want highest return for lowest risk

» incorrect predictions are random market is

» transparent

» free

» unlimited

Is this almost true?

Is this true enough?

2. Market rIf

Efficient Market Hypothesis is true• DOESN’T MEAN

can’t make money in stock market

• DOES MEAN no “abnormal” or “excess” returns return proportional to risk NPV of all market investments = 0 research (a.k.a. info)

» useful to match market

» can’t be used to beat market

2. Market r

Efficient Market Hypothesis flavours• weak form efficient

all past price behaviour included

• semi-strong form efficient weak form + all public info included

• strong form efficient semi-strong + all private info included too

• Weak Form Efficiency

prices reflect all past market info• price & volume

if true• trading on market info not useful

• technical analysis not useful

• market timing not useful

• some investment advice is

empirical evidence• generally confirmed?

• Semi-strong Form Efficiency

prices reflect all public info• trading info

• annual reports

• press releases, etc.

if true • value-investing not useful

• other investment advice may be useful

empirical evidence• some, but not all

• Strong Form Efficiency

prices reflect all info• public & private

if true• then info not valuable

• then no advantage to insider trading

empirical evidence • nope

• insiders can earn abnormal returns

Risk

0

2

4

6

-25 -15 -5 5 15 25 35 45

% return

# years

risk = volatility = surprise

2. Market rreturn

rf

SML

βi

rei

ifemfei rrrr

CAPM

i

fei rr

risk-to-reward ratio

risk

volatility

unpredictability

“swing”

β

Riskrisk = volatility = surprise

return

time

β = 1

β > 1

ifemfei βrrrr

β

sensitivity to market swings unpredictability riskiness

in a rational market investors should be rewarded more for buying

more volatile stocks

Market Reward for Riskrisk = volatility = surprise

risk =

surprises affecting the whole market

surprises affecting only one stock(or small group of stocks)

eliminated by diversifying

market will NOT reward you for this

+ unsystematic risksystematic risk

β

Market Reward for Risk

price

revenuesreturn

%.$

.$10

0020

002

risk

return

rf

Security Market Line

β=1

rem

What happens to stocks that are “out of line”?

%.$

.$20

0010

002

%.$

.$5

0010

500

%10$10.00

$1.00

%.$

.$10

005

500

Portfolios

changing hats let’s pretend we’re a financial planner

Portfolios

a collection of stocks mix of

• high risk

• med risk

• low risk

all• publicly traded

• known β s

Portfolios

yx

20%25%

reyrex

What will our portfolio’s return be?only 2 stocks

50%50%weight

eyyexxep rwrwr

20.50.25.50. epr

225.epr 22.5%

Portfolios

yx

50%

50%

chance

10%70%+ good year

30%-20%- bad year

20%25%average

reyrex

What will out portfolio’s return be?only 2 stocks

50%50%weight

eyyexxeyyexxep rwcrwcrwcrwcr

225.0epr

22212211 ebebeaeaep rwcrwcrwcrwcr

Portfolio Volatility

yx

50%

50%

chance

10%70%+ good year

30%-20%- bad year

20%25%average

reyrex

What’s the Standard Deviation of each stock?

50%50%weight

22

exexexexx rrcrrcσ 22

eyeyeyeyy rrcrrc

Pause?

Ch 13 Q 4

have $10,000

2 stocks

How much of each stock to earn 12.2%

05.0

032.0xw

stock earns

X 14%

Y 9%

eyyexxep rwrwr

09.014.0122.0 yx ww

09.0114.0122.0 xx ww

09.009.014.0122.0 xx ww

09.014.009.0122.0 xx ww

05.0032.0 xw

64.0xw

)000,10($64.0xv

400,6$xv

Ch 13 Q 13

4 stocks

What is of portfolio?

stock weight Q 25% 0.60

R 20% 1.70

S 15% 1.15

T 40% 1.34

TTSSRRQQp wwww

34.135.015.115.070.120.060.025.0 p

20.1p

Ch 13 Q 14

3 investments

What is 2?

investments weight stock 1 v1 1/3 1.9

stock 2 v2 1/3 ?

risk-free v3 1/3

portfolio:

332211 wwwp

03

1

3

190.1

3

100.1 2

10.12

33

90.100.1 2

290.100.3

90.100.32 0.0

1.0

Ch 13 Q 20asset expected retun betaw 17% 1.4rf rate 4