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Chapter 12

# Chapter 12 ECON 2560

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University of Guelph

Economics

ECON 2560

Tahsin Mehdi

Summer

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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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