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Lecture Fundamentals of corporate finance - Chapter 13: Return, risk, and the security market line

Chapter 13 explores the economic and managerial implications of this basic idea. After studying this chapter, you should understand: How to calculate expected returns, the impact of diversifi cation, the systematic risk principle, the security market line and the risk-return trade-off. | T13.1 Chapter Outline Chapter 13 Return, Risk, and the Security Market Line Chapter Organization 13.1 Expected Returns and Variances 13.2 Portfolios 13.3 Announcements, Surprises, and Expected Returns 13.4 Risk: Systematic and Unsystematic 13.5 Diversification and Portfolio Risk 13.6 Systematic Risk and Beta 13.7 The Security Market Line 13.8 The SML and the Cost of Capital: A Preview 13.9 Arbitrage Pricing Theory 13.10 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. T13.2 Expected Return and Variance: Basic Ideas The quantification of risk and return is a crucial aspect of modern finance. It is not possible to make “good” (i.e., value-maximizing) financial decisions unless one understands the relationship between risk and return. Rational investors like returns and dislike risk. Consider the following proxies for return and risk: Expected return - weighted average of the distribution of possible returns in the future. Variance of returns - a measure of the dispersion of the distribution of possible returns in the future. How do we calculate these measures? Stay tuned. T13.3 Example: Calculating the Expected Return pi Ri Probability Return in State of Economy of state i state i +1% change in GNP .25 -5% +2% change in GNP .50 15% +3% change in GNP .25 35% T13.3 Example: Calculating the Expected Return (concluded) i (pi Ri) i = 1 -1.25% i = 2 7.50% i = 3 8.75% Expected return = (-1.25 + 7.50 + 8.75) = 15% T13.4 Calculation of Expected Return (Table 13.3) Stock L Stock U (3) (5) (2) Rate of Rate of (1) Probability Return (4) Return (6) State of of State of if State Product if State Product Economy Economy Occurs (2) (3) Occurs (2) (5) Recession .80 -.20 -.16 .30 .24 Boom .20 .70 .14 .10 .02 E(RL) = -2% E(RU) = 26% T13.5 Example: Calculating the Variance pi ri Probability Return in State of Economy of state i state i +1% change in GNP .25 -5% +2% change in GNP .50 15% +3% change in . | T13.1 Chapter Outline Chapter 13 Return, Risk, and the Security Market Line Chapter Organization 13.1 Expected Returns and Variances 13.2 Portfolios 13.3 Announcements, Surprises, and Expected Returns 13.4 Risk: Systematic and Unsystematic 13.5 Diversification and Portfolio Risk 13.6 Systematic Risk and Beta 13.7 The Security Market Line 13.8 The SML and the Cost of Capital: A Preview 13.9 Arbitrage Pricing Theory 13.10 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. T13.2 Expected Return and Variance: Basic Ideas The quantification of risk and return is a crucial aspect of modern finance. It is not possible to make “good” (i.e., value-maximizing) financial decisions unless one understands the relationship between risk and return. Rational investors like returns and dislike risk. Consider the following proxies for return and risk: Expected return - weighted average of the distribution of possible returns in .