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Thursday, October 6, 2011 Key Slides from Class

Thursday, October 6, 2011 Key Slides from Class . Reducing Risk by Diversifying -- “The Setup” --. There are 5 companies: Amazingly Awesome Automotive ( AAA ) Bodaciously Beautiful Blooms ( BBB ) Crazy Cool Clothes ( CCC ) Delightfully Delicious Donuts ( DDD )

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Thursday, October 6, 2011 Key Slides from Class

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  1. Thursday, October 6, 2011 Key Slides from Class

  2. Reducing Risk by Diversifying -- “The Setup” -- • There are 5 companies: • Amazingly Awesome Automotive ( AAA ) • Bodaciously Beautiful Blooms ( BBB ) • Crazy Cool Clothes ( CCC ) • Delightfully Delicious Donuts ( DDD ) • Exceptionally Excellent Electricity ( EEE ) • We have $1500 to invest. 2 scenarios: • (1) We invest all $1500 in one company… • (2) … or, we invest 1/5 (ie, $300) in each • of the 5 companies

  3. Reducing Risk by Diversifying -- “The Setup” -- • About the companies… • Each has a share price of $30, and it remains • constant (ie, the only return is “dividends”). • Each company pays out all its annual earnings • in dividends. • The annual dividend amount is random • for each company. • Each has dividend possibilities of $1, $2, • $3, $4, $5, $6. • Each possible dividend result has an equal • probability of occurring. What is the correlation among the companies’ dividends -- positive, negative, or neutral?

  4. Reducing Risk by Diversifying -- The “Math” Results: Summary -- Section 001

  5. Reducing Risk by Diversifying -- The “Math” Results: Detail -- Section 001 Lower than the lowest Standard Deviation and lowest Coefficient of Variation of any of the individual companies. Therefore, LOWER RISK by either measure!

  6. Reducing Risk by Diversifying -- The “Math” Results: Summary -- Section 002

  7. Reducing Risk by Diversifying -- The “Math” Results: Detail -- Section 002 Lower than the lowest Standard Deviation and lowest Coefficient of Variation of any of the individual companies. Therefore, LOWER RISK by either measure!

  8. “Efficient Market” … “Market in which prices adjust quickly after the arrival of new information… … and the price change reflects the economic value of the information, on average.”

  9. Efficient Market Characteristics Efficient Market (1) (2) (3) News Reflected Rapidly In Price Info Flows Occur Randomly Many Participants COMMENTS ON “EFFICIENT MARKETS”: * “Efficient market” = the market accurately reflects the economic value of the information on average. * Only unexpected news causes prices to change dramatically. * IT IS EXTREMELY DIFFICULT TO CONSISTENTLY FIND SECURITIES THAT ARE NOT PRICED PROPERLY -- SO, HOW CAN ONE “BEAT THE MARKET”?

  10. Efficient Market Characteristics -- A Bedtime Story --- Lubbock Avalanche-Journal October 24, 2010: • Arena Pharmaceutical Inc. said FDA rejected their drug lorcaserin. It would have been the first prescription weight-loss drug approved in more than a decade. • On September 16, 2010, an FDA panel denied the drug in a 9 – 5 vote, because of a concern about tumors in test rats. • After the drug was not approved, shares of Arena “plunged” 47%, to $1.99. • San Diego based Arena currently has no drugs on the U.S. market.

  11. “Capital Asset Pricing Model” Remember “Systematic” vs. “Unsystematic” Risk? Unsystematic Risk Total Risk Portfolio Risk Systematic Risk About 30 # of Securities in Portfolio The Capital Asset Pricing Model ( CAPM ) “states that the expected return on an asset (or security) depends ONLY on its level of Systematic Risk”.

  12. Market Portfolio ( Beta = 1) “Capital Asset Pricing Model” * The “Market Portfolio” (MP) contains all risky assets, such that Unsystematic Risk is eliminated. The only risk remaining is the Systematic Risk of each asset. * The risk of the MP is assigned a Beta = 1. * If an asset’s return is more volatile than the MP, it is riskier, and has a Beta > 1. * If an asset’s return is less volatile than the MP, it is less risky, and has a Beta < 1. Asset Beta > 1 Asset Beta < 1 Return 0% Time

  13. Reasons for You Not Tiling Your Floor (Or Picking Your Own Investment Securities) (1) Don’t have the Knowledge and Skills… (2) Don’t have the Tools… (3) Don’t have the Time… (4) Don’t have the Interest… (5) Don’t have the Confidence… DON’T let this keep you from getting your floor tiled, or from investing!

  14. CHAPTER 10 Bonds & Stocks

  15. Business Sources of Funds Investors (Individuals, institutions, etc.) (3) Stocks (equity / own’p) (2) Bonds (debt / loans) $ $ Business Funds External $ (1) Retained Earnings Internal From 1995 – 2005, 88% of securities sold to the public were Bonds.

  16. Elements of “Bonds” Typically, $1000 BOND CERTIFICATE: o Par (“face”) value = issue price (also, value returned at maturity) o Maturity Date = term of the bond o Coupon Payments = interest income (usually 2 / yr) o Name of owner (if registered) o Signatures of certain company officers “Indenture” = contract = defines specifics & restrictions: * Allowable asset sales * Allowable levels of debt * Dividend payment restrictions * Audited financial statements * Etc. “Rating” = reflects quality of Bond

  17. Bond Certificate -- Example Coupon (Interest) Rate Maturity (Term) Registered Owner Par Value Signatures

  18. Par Value Coupon (Interest) Rate Maturity (Term) Signatures

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