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Chapter 10 Introduction to Risk, Return and the Opportunity Cost of Capital

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Chapter 10 Introduction to Risk, Return and the Opportunity Cost of Capital

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    1. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -1 Chapter 10 Introduction to Risk, Return and the Opportunity Cost of Capital Prepared by Shahriar Hasan Thompson Rivers University

    2. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -2 Chapter Outline Rates of Return: A Review Eighty Two Years of Capital Market History Measuring Risk Risk and Diversification Thinking about Risk

    3. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -3 10.1 Rates of Return: A Review Measuring Rate of Return The total return on an investment is made up of: Income (dividend or interest payments). Capital gains (or losses). Percentage Return = Capital Gain + Dividend Initial share Price

    4. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -4 Rates of Return: A Review

    5. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -5 Rates of Return: A Review An Example: A Canadian Pacific Railway (CP) share had a value of $61.40 at the beginning of 2007. By the end of the year, the price went up to $64.22. In addition, during the year, CP paid a $0.90 dividend per share. % return = (64.22 – 61.40) + 0.90 = 6.06% 61.40 Dividend yield = 0.90/61.40 = 1.47% Capital gain yield = 2.82/61.40 = 4.59% 1.47% + 4.59% = 6.06%

    6. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -6 10.2 Eighty Two Years of Capital Market History Market index: A measure of the investment performance of the overall market S&P/TSX Composite Index - Index of the investment performance of a portfolio of the major stocks listed on the Toronto Stock Exchange. Dow Jones Industrial Average - Value of a portfolio holding one share in each of 30 large industrial (blue chip) firms.

    7. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -7 Eighty Two Years of Capital Market History The Historical Record: If a $1 investment was made in 1925, by the end of 2007, what would it become under different kind of investment styles.

    8. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -8 Eighty Two Years of Capital Market History Average returns of T-bills, Government bonds and common stocks (1926 – 2007):

    9. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -9 Eighty Two Years of Capital Market History The historical record shows that investors have received a risk premium for holding risky assets. In general, we can say: Rate of return on = Rate of return on + Market risk any security T-bills premium. Market risk premium has been in the neighbourhood of 7%. Thus, in 2008, we can expect a market return of 2.4% + 7% = 9.4% The same for 1981 was 27%.

    10. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -10 10.3 Measuring Risk Volatility of returns is what is considered as risk. Volatility is measured by: Variance: The average value of squared deviations from the mean. Standard Deviation The square root of the variance.

    11. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -11 Measuring Risk Coin Toss game 2 coins are flipped For each head, you get 20% For each tail, you lose 10% Possible outcomes: HH: 20+20=40 HT:20-10= 10 TH:-10+20=10 TT:-10-10=-20 Since the possibility of these outcomes are 25% for each, we can say that the expected return is = (0.25x40%) + (0.25x10%) + (0.25x10%) + (0.25x-20%) = 10%

    12. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -12 Measuring Risk Calculating the standard deviation of the coin toss game:

    13. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -13 Measuring Risk Standard deviation for various investment classes (1926-2007):

    14. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -14 Measuring Risk Standard Deviation for Various Securities Notice the risk-return trade-off: T-bills have the lowest average rate of return, and the lowest level of volatility. Stocks have the highest average rate of return and the highest level of volatility. Bonds are in the middle.

    15. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -15 10.4 Risk and Diversification Diversification: Strategy designed to reduce risk by spreading the portfolio across many investments. This is possible because assets possess two kinds of risks: Unique risk: Risk factors affecting only that firm. Also called diversifiable or non-systematic risk. Market risk: Economy-wide sources of risk that affect the overall stock market. Also called systematic or non-diversifiable risk. Total Risk = Unique risk + Market risk

    16. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -16 Risk and Diversification Asset vs. portfolio risk. Here is an example. From the choices below, which one would you pick?

    17. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -17 Risk and Diversification Instead of an individual asset, we could construct a portfolio of these two assets. The return from that portfolio will be:

    18. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -18 Risk and Diversification A portfolio comprising of 75% of its value in the auto stock and 25% in the gold stock will have the following characteristics. Notice the drop in the amount of risk.

    19. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -19 Risk and Diversification Diversification reduces risk because the assets in the portfolio do not move in exact harmony with each other. When one stock is doing poorly, the other is doing well, helping to offset the negative impact on return of the stock with the poorer performance. The reduction in risk of the portfolio depends of the correlation coefficient between the assets. Correlation coefficient is a standardized measure of co-movement of the assets. Its value is always between +1 and -1.

    20. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -20 Risk and Diversification Correlation Coefficient ? > 0 ? positive correlation ? variables move in the same direction. ? < 0 ? negative correlation ? variables move in the opposite direction. ? = 0 ? no correlation If you hold two stocks with a correlation coefficient less than 1, then the risk of the portfolio can be reduced below the risk of holding either stock by itself. Adding stocks to the portfolio, decreases the risk of the portfolio.

    21. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -21 Risk and Diversification

    22. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -22 Risk and Diversification Portfolio Risk: The risk of a portfolio depends on the weights assigned to the assets, their individual risks and the correlation co-efficient(s) between them. sp = vx2Ss2S + x2Gs2G + 2xSxGsSsG?SG

    23. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -23 Risk and Diversification Market risk versus Unique risk: You cannot eliminate all risk from a portfolio by adding securities. Typically, once you get beyond 15 stocks, adding more stocks does very little to reduce the risk of the portfolio. The risk that cannot be diversified away is called market risk. For a reasonably well diversified portfolio, only market risk matters.

    24. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -24 10.5 Thinking About Risk 3 Key Messages about Risk: Some risks look big and dangerous but are really diversifiable. Unique risk can be minimized by creating a diversified portfolio. Market risks are macro risks Example: changes in interest rates, industrial production, inflation, exchange rates and energy cost. Risk can be measured

    25. © 2009 McGraw-Hill Ryerson Limited Chapter 10 -25 Summary of Chapter 10 Standard deviation and variance are measures of risk. Diversification reduces risk because stocks do not move in exact lock step, meaning that poor performance by one stock can be offset by strong performance by another. Correlation coefficient is a measure of how two variables move with respect to each other. Risk which can be eliminated by diversification is known as unique risk. Risk which cannot be eliminated by diversification is called market risk. For a well-diversified portfolio, only market risk matters.

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