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Analytical Methods for Lawyers: Understanding Finance Risk and Discount Rates with CAPM

Dive into the world of finance risk and discount rates using the Capital Asset Pricing Model (CAPM). Learn how to value assets, assess risk, and make informed investment decisions. Explore the complexities of market pricing, ECMH, and the role of beta coefficient. Discover why beta may not always be the best measure of risk.

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Analytical Methods for Lawyers: Understanding Finance Risk and Discount Rates with CAPM

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  1. Analytical Methodsfor Lawyers (Finance) Risk Discount rate Capital Asset Pricing Model (CAPM) (last updated 20 Apr 09)

  2. Merton on risk

  3. What is the value of $1000?

  4. What is the value of $1000? Nominal? When? Risk?

  5. Value a business spreadsheet

  6. What is risk? How do markets “price” risk? What is ECMH? What is CAPM?

  7. ECMH Ronald Gilson (Stanford) Reinier Kraakman (Harvard) Market Information Price Can you beat the market?

  8. Brownian motion (Louis Bachelier)

  9. One hundred thousand lemings can’t all be wrong

  10. How does the market value risk and return?

  11. Which investment would you choose?

  12. Which investment would you choose?

  13. Return Risk

  14. What is beta? The Beta coefficient is a key parameter in CAPM. It measures the part of the asset's statistical variance that cannot be mitigated by portfolio diversification, and thus is correlated with the return of assets in the portfolio.

  15. Stock A Stock B Compare returns to market average

  16. Stock A Stock B Market average Market average

  17. Stock A Stock B Slope = 1.7 Slope = 0.6 Market average Market average

  18. Risk vs. Return Return (%) Stock A = 1.7 Mkt = 1.0 Stock B = 0.6 Risk (measured as beta)

  19. Risk vs. Return Return Return (%) Stock A = 1.7 Mkt = 1.0 Stock B = 0.6 Risk (measured as beta)

  20. Capital Asset Pricing Model rm Return (%) Mkt = 1.0 rf Risk (measured as beta)

  21. Capital Asset Pricing Model E(r) = rf + b(rm- rf ) E(r) rm Return (%) E(r) Beta = 1.7 Mkt = 1.0 rf Beta = 0.6 Risk (measured as beta)

  22. Solve for beta …

  23. Assume: rm = 11.7% / rf = 3.2% E(r) = rf + b(rm- rf ) E(r) = 3.2% + 0.6*(11.7% – 3.2%) E(r) = 3.2% + 0.6*(8.5%) E(r) = 3.2% + 5.1% = 8.3% Return (%) rm= 11.7% E(r) Mkt = 1.0 rf = 3.2% Beta = 0.6 Risk (measured as beta)

  24. Assume: rm = 11.7% / rf = 3.2% E(r) = rf + b(rm- rf ) E(r) = 3.2% + 1.7*(11.7% – 3.2%) E(r) = 3.2% + 1.7*(8.5%) E(r) = 3.2% + 13.45% = 16.65% Return (%) E(r) rm= 11.7% Beta = 1.7 Mkt = 1.0 rf = 3.2% Risk (measured as beta)

  25. Study after study has found that beta isn't a good measure of risk … It’s better to be vaguely right, than precisely wrong …

  26. END

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