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Chapter 12

Chapter 12 ECON 2560

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University of Guelph
ECON 2560
Tahsin Mehdi

Chapter 12 ECON 2560 Risk, Return & Capital Budgeting MEASURING MARKET RISK  Changes in interest rates, government spending, monetary policy , oil prices foreign exchange rates & other macroeconomic events affect almost all companies and the returns on almost all stocks Market Portfolio: A portfolio of all assets in the economy. In practice, a broad stock market index (such as the s&p/tsx) is used to represent the market.  Can assess the impact of “macro” news by tracking the rate of return on a market portfolio  Risk depends on exposure to macro events and can be measured by the sensitivity of a stock’s returns to fluctuations in returns on the market portfolio  This sensitivity = beta Measuring Beta  Investors choose from a large number of different securities (common shares, preferred shares, income trust units, etc.)  Some stocks are less effected by market fluctuations  The average beta of a;; stocks is 1.0  There are “defensive” and “aggressive” stocks  Defensive = not very sensitive to market fluctuations (betas less than 1.0)  Sensitive stocks = amplify market movements (betas greater than 1.0) Procedures for measuring real companies’ betas: 1. Observe rates of return, usually monthly, for the stock & the market 2. Plot the observations on a graph 3. Fit a line showing the average return to the stock at different market returns *Beta is the slope of the fitted line Let pjm correlation coefficient for the return on stock j w/ the market Ơ j the standard deviation of the return on stock j Ơ m the standard deviation of the return on the market Beta of stock j = j = P jmƠ j___ Ơ m  Another way to measure the relatedness of changes in one random variable w/ another is covariance  The correlation between 2 variables is their covariance divided by the product of their standard deviations Pjm cov(r,j m / Ơ j m rm= market return rj=2return on the stock Ơ m = variance of the market return Beta of stock j = j = cov(j m ) 2 Ơ m Portfolio Betas  The beta of a portfolio is just the weighted average of the betas of the securities in the portfolio. The weight for each security is its fraction of the portfolio value Beta of portfolio = (fraction of portfolio in 1 stock x beta 1 stock) + (fraction of portfolio in 2 stock x beta of second stock)  Portfolios w/ betas between 0 & 1 tend to move in the same direction as the market BUT not as far RISK & RETURN & CAPITAL ASSET PRICING MODEL (CAPM)  Least risky investment option I treasury bills since return on treasury bills is fixed and unaffected by what happens in the market  Beta of treasury bills is 0 Market Risk Premium (MRP): Risk premium of market portfolio. Expected extra return on the market portfolio relative to the return on risk-free treasury bills.  Challenge is to estimate this  Over past 85 years the avg. Canadian market risk premium has been around 7% Risk premium on any security = security’s beta x expected market risk premium = ß x (r – r ) m f Security’s total expected return = risk free rate + security’s risk premium = r + ßfr – rm) r Capital Asset Pricing Model (CAPM): Theory of the relationship between risk & return that states that the expected risk premium on an security equals its beta times the market risk premium MRP = Expected market risk premium Security’s expected return = r = r +fß (r +mr ) f r +fß x MRP The expected rate of return demanded by investors depends on… 1. Compensation for the time value of money (risk free rate r ) f 2. A risk premium, which depends on beta and the market risk premium  The beta of a security measures the quantity of risk  The market risk premium determines the extra return per unit of risk Why the CAPM makes sense  CAPM assumes that the stock market is dominated by well diversified investors who are
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