FNCE10001 Chapter Notes - Chapter 12: Expected Return, Market Risk, Risk Premium
25 May 2018
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Cost of capital = best expected return available in the market on investments with similar risk =
expected return of available investments with the same beta
Construct market portfolio
1.
Determine its expected excess return over risk
-
free interest rate
2.
Estimate stock's beta or sensitivity to market portfolio
3.
The Equity Cost of Capital
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Principles of Finance Page 1
Constructing the market portfolio:
Contains more of largest stocks and less of smallest stocks
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Proportions of each security corresponds to proportion of total market that each security represents
Market value = number of shares of investment outstanding x price of investment per share
Portfolio weights of each security = market value of investment / total market value of all securities
Also an equal
-
ownership portfolio
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equal fraction of total number of shares outstanding of
each security in the portfolio
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Even when market prices change, no need to trade unless number of shares outstanding of
some security changes
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Passive portfolio = a portfolio that requires very little trading to maintain
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Value
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weighted portfolio = a portfolio like the market portfolio, in which each security is held in
proportion to its market capitalisation
Market indexes:
Market index reports value of a particular portfolio of securities
Price
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weighted portfolio = a portfolio that holds an equal number of shares of each stock,
independent of their size
Index funds = funds to invest in portfolios
Exchange
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traded fund (ETF) = security that trades directly on an exchange, represents ownership in a
portfolio stocks
Market proxy = a portfolio whose return practitioners believe closely tracks the true market
portfolio
Market risk premium:
Risk
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free interest rate in CAPM corresponds to risk
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free rate at which investors can borrow and save
Most investors pay higher rate to borrow
Even if loan is essential risk
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free, premium compensates lenders for difference in liquidity compared
with investment in Treasuries
Important to measure historical stock returns over same time horizon as that used for risk
-
free
interest rate
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Old data may have little relevance for investors' expectations of market risk premium today
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One approach is to use historical average excess return of market over risk
-
free interest rate
More investors participate in stock market so risk can be shared more broadly
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Financial innovations such as mutual funds and exchange
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traded funds have greatly reduced
costs of diversifying
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Overall volatility of the market has declined over time
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Market risk premium has declined over time
Expected return of market = dividend yield + expected dividend growth rat
-
Fundamental approach = estimate expected return of market by solving for discount rate consistent
with current level of the index
The Market Portfolio
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Principles of Finance Page 2
Document Summary
Cost of capital = best expected return available in the market on investments with similar risk = expected return of available investments with the same beta. Determine its expected excess return over risk-free interest rate. Estimate stock"s beta or sensitivity to market portfolio. Proportions of each security corresponds to proportion of total market that each security represents. Contains more of largest stocks and less of smallest stocks. Market value = number of shares of investment outstanding x price of investment per share. Portfolio weights of each security = market value of investment / total market value of all securities. Value-weighted portfolio = a portfolio like the market portfolio, in which each security is held in proportion to its market capitalisation. Also an equal-ownership portfolio - equal fraction of total number of shares outstanding of each security in the portfolio. Even when market prices change, no need to trade unless number of shares outstanding of some security changes.
