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Lecture 1

16655 Lecture Notes - Lecture 1: Relate, Risk Premium, Basis Point

9 pages79 viewsFall 2018

Department
Design, Architecture and Building
Course Code
16655
Professor
Song Shi
Lecture
1

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Workshop 1 Day 1
Finance Theory
1. Modern Portfolio Theory
Based off the concept “don’t put all your eggs in one basket”
The more investments we have, the lower the overall risk we are taking
If I buy one stock, I’m exposed to things that make the ASX200 go up and down, but very exposed to things
that impact on that individual stock unsystematic risk
If I keep adding stocks until I own every stock in the ASX200, and buy them in the same proportions that
make up the ASX200, then I cease to be exposed to all the idiosyncrasies of the individual stocks and
exposed to all the things that drive the broader market (interest rates, politics, fear, greed...) i.e. I’m just left
with systematic risk
Portfolio Return
Portfolio Risk Markowitz Model
Measured by the standard deviation of the expected return of individual stock or portfolio
Not a weighted average of individual stock or asset in the portfolio
*(see slides for example)
Portfolio Efficient Frontier
Efficient Portfolios: The ratio whereby the lowest risk is achieved for a given return
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Portfolio Two-Fund Theorem
Sharpe ratio: The portfolio return less the return from the riskless asset (or the “risk” premium of the
portfolio), divided by the risk of portfolio. Thus it measures the risk adjusted return
E.g.
2. Capital Asset Pricing Model
The CAPM seeks to arrive at a mathematical formula to calculate the expected return of an asset or a
portfolio to returns on a market index
E.g.
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The Risk Free Rate
The rate of return generated on a riskless asset
“Often the government bond rate is used for the risk-free rate”
We assume that government bonds are risk free because governments can mandatorily raise taxes to repay
debt if necessary
For an investment to be risk free its actual return should always be equal to the expected return
The risk free rate must be positive
Why does the risk free rate matter?
o When calculating the PV we use the discount rate. The discount rate is determined by the risk free
rate PLUS a premium to reflect the riskiness of who the person is that is paying you that dollar
Introduction of Basis Points (BPS)
Widely used to measure the interest rate or yield movements in finance
One basis point is calculated as 1/100 of 1%, or 0.01% or 0.0001. Therefore 100 BPS is equal to 1%
E.g. of calculating the discount rate
Beta
Beta is a measure of the volatility of a security or a portfolio in comparison to the market as a whole
Beta seeks to answer the question: “If the market as a whole goes up by 1%, how much will I expect the
value of an individual asset to up or down by?”
o A beta of 1 indicates that the security's price will move with the market, e.g. +1% market movement
to +1% individual movement
o A beta of 0.8 means that the security will be less volatile than the market, e.g. +1% market
movement to +0.8% individual movement
o A beta of 1.2 indicates that the security's price will be more volatile than the market, e.g. +1%
market movement to +1.2% individual movement
o A beta of -0.5 indicates that the security will move in the opposite direction to the market, e.g. +1%
market movement to -0.5% individual movement
To calculate Beta, we use the CAPM formula and work backwards with historical data of the security and the
market
E.g.
So,
o If Beta < 1 the stock is less volatile than the market
o If Beta > 1 the stock is more volatile then the market
o If Beta < 0 then the stock is falling while the market is rising (and vice versa)
Beta is not constant
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