Risk, return and capital budgeting
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| Diversification | Strategy designed to reduce risk by spreading the portfolio across many investments. (diversification reduces variability)
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| Unique Risk | Risk factors affecting only that firm. Also called “diversifiable risk.”
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| Market Risk | Economy Economy--wide sources of risk that wide sources of risk that affect the overall stock market. Also called “systematic risk.”
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| Market Portfolio | Portfolio of all assets in the economy. In Practice a broad stock market index is used to represent the market. (e.g., S&P500).
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| Beta | Sensitivity of a stock’s return to the return on the market portfolio.
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| Defensive stocks | Not very sensitive to the market
fluctuations and have low betas (B < 1).
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| Aggressive stocks | Amplify and market movements and have higher betas (B>1). If the market goes up, it is good to be in aggressive stocks; if it goes down, it is better to be defensive stocks.
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| Common stock returns can be from two parts: | 1.The part explained by market returns and the firm’s beta. Fluctuations in this part reflect market risk;
2.The part due to news that is specific to the firm. Fluctuations in this part reflect unique risk.
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| Diversification, unique risk & market risk |
Diversification decreases variability from unique risk, but not from market risk.
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| Portfolio Betas | The beta of your portfolio will be an average of the betas of the securities in the portfolio.
If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0
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| Definition of portfolio betas & how to calculate them | Portfolio beta is an weighted average of the betas of the securities in the portfolio
Beta of portfolio = (fraction of portfolio in first stock * beta of first
stock) +(fraction of portfolio in second stock * beta of second stock) +DD
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| Market Risk Premium | Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.
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| CAPM | CAPM: The expected rates of return demanded by investors depend on:
1. Compensation for the time value of money (the risk-free rate)
2. A risk prem, which depends on beta & the market risk prem
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| Theory of the relationship between risk & return states | that the expected risk premium on any security equals its beta times the market risk premium.
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| Security Market Line |
The graphic rep of the CAPM.
If the project’s return lies above the security market line, then the return is higher than they could get from the capital market, so the project is attractive; otherwise, the project is not attractive &shouldn’t be accept
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| Company & project risk | Company cost of capital is the expected rate of return demanded by investors in a company determined by the average risk of the company’s securities; project cost of capital is the minimum acceptable expected rate of return on a project given its risk.
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| The project cost of capital depends on | The use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.
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