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Principles of

Corporate Chapter 7
Finance
Introduction to Risk, Return,
Seventh Edition
and the Opportunity Cost of
Richard A. Brealey Capital
Stewart C. Myers

Slides by
Matthew Will

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7- 2

Topics Covered
 75 Years of Capital Market History
 Measuring Risk
 Portfolio Risk
 Beta and Unique Risk
 Diversification

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7- 3

The Value of an Investment of $1 in 1926

S&P
6402
Small Cap 2587
1000 Corp Bonds
Long Bond
T Bill
64.1
48.9
Index

10 16.6

0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End


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7- 4

The Value of an Investment of $1 in 1926

S&P Real returns


Small Cap
1000
Corp Bonds 660
Long Bond
T Bill 267
Index

10 6.6
5.0
1 1.7

0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End


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7- 5

Rates of Return 1926-2000

60
Percentage Return

40

20

-20

-40 Common Stocks


Long T-Bonds
-60 T-Bills

00
26

30

40

45

50

55

60

65

70

75

85

95
35

80

90

20
Year
Source: Ibbotson Associates
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7- 6

Average Market Risk Premia (1999-2000)

Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0

Ger
Bel

Swi
Can

Neth
Den

Jap
Aus
USA

It
Spa

Fra
Swe
Ire
UK

Country

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Measuring Risk

Variance - Average value of squared deviations from


mean. A measure of volatility.

Standard Deviation - Average value of squared


deviations from mean. A measure of volatility.

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Measuring Risk
Coin Toss Game-calculating variance and standard deviation

(1) (2) (3)


Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%

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7- 9

Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
-50 to -40

0 to 10

10 to 20

50 to 60
-40 to -30

-30 to -20

-20 to -10

-10 to 0

20 to 30

30 to 40

40 to 50

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Measuring Risk

Diversification - Strategy designed to reduce risk by


spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”

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7- 11

Measuring Risk

Portfolio rate
of return (
=
fraction of portfolio
in first asset )( x
rate of return
on first asset )
(
+
fraction of portfolio
in second asset
x
)(
rate of return
on second asset )

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7- 12

Measuring Risk
Portfolio standard deviation

0
5 10 15
Number of Securities
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Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
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7- 14

Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes

Stock 1 Stock 2
x 1x 2σ 12 =
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 =
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2

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Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-
Cola and 35% in Reebok. The expected dollar
return on your CC is 10% x 65% = 6.5% and on
Reebok it is 20% x 35% = 7.0%. The expected
return on your portfolio is 6.5 + 7.0 = 13.50%.
Assume a correlation coefficient of 1.

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Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.

Coca - Cola Reebok


x 1 x 2 ρ12 σ 1σ 2 = .65 × .35
Coca - Cola x 12 σ12 = (.65) 2 × (31.5) 2
× 1 × 31.5 × 58.5
x 1 x 2 ρ12 σ 1σ 2 = .65 × .35
Reebok x 22 σ 22 = (.35) 2 × (58.5) 2
× 1 × 31.5 × 58.5

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7- 17

Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 1.

Portfolio Valriance = [(.65) 2 x(31.5) 2 ]


+ [(.35) 2 x(58.5) 2 ]
+ 2(.65x.35x1x31.5x58.5) = 1,006.1

Standard Deviation = 1,006.1 = 31.7 %

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7- 18

Portfolio Risk

Expected Portfolio Return = (x 1 r1 ) + ( x 2 r2 )

Portfolio Variance = x 12σ 12 + x 22σ 22 + 2( x 1x 2ρ 12σ 1σ 2 )

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7- 19

Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
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7- 20

Beta and Unique Risk

1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% +10% Expected


market
-10% return

Copyright 1996
McGraw by The McGraw-Hill Companies, Inc
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Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the


economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.

Beta - Sensitivity of a stock’s return to the


return on the market portfolio.

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7- 22

Beta and Unique Risk

σ im
Bi = 2
σm

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7- 23

Beta and Unique Risk

σ im
Bi = 2
σm
Covariance with the
market

Variance of the market

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