A1 Business and Technical College Risk Diversification and Returns Paper & Excel Sheet Please download the file down bellow and follow the instructions.I a

A1 Business and Technical College Risk Diversification and Returns Paper & Excel Sheet Please download the file down bellow and follow the instructions.I added a pdf file for more materials.I added a sample video, Note: DO NOT use the same companies in the video. Thank you. CHAPTER 8
RISK AND RATES OF
RETURN
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Learning Outcomes
LO.1 Explain what it means to take risks when
investing.
LO.2 Compute the risk and return of an
investment, and explain how the risk and
return of an investment are related.
LO.3 Identify relevant and irrelevant risk, and
explain how irrelevant risk can be reduced.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
Learning Outcomes (cont.)
LO.4 Describe how to determine the appropriate
reward—that is, rate of return—that investors
should earn for purchasing an investment.
LO.5 Describe actions that investors take when the
return they require to purchase an investment is
different from the return they expect the
investment to produce.
LO.5 Identify different types of risk, and classify each
as relevant or irrelevant with respect to
determining an investment’s required rate of
return.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Defining and Measuring Risk
? Risk is the chance that an unexpected outcome
will occur.
? A probability distribution is a listing of all
possible outcomes with a probability assigned
to each.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Probability Distributions
? It either will rain, or it will not rain; there are
only two possible outcomes.
Outcome
Rain
No Rain
Probability
0.40
= 40%
0.60
= 60%
1.00
100%
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
Probability Distributions
? Martin Products and U. S. Electric
State of the
Economy
Boom
Normal
Recession
Probability of This
State Occurring
0.2
0.5
0.3
1.0
Rate of Return on Stock if
the Economic State Occurs
Martin Prod. U.S. Electric
110%
20%
22
16
–60
10
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
Expected Rate of Return
? Rate of return expected to be realized from an
investment during its life.
? Mean value of the probability distribution of
possible returns.
? Weighted average of the outcomes, where the
weights are the probabilities.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Expected Rate of Return
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
Total Risk (Stand-Alone Risk):
The Standard Deviation (?)
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Standard Deviation (?):
Martin Products
ri – r?
= (3)
(ri – r? )2
(4)
110% – 15% = 95
22 – 15 = 7
–60 – 15 = –75
9,025
49
5,625
ri
r?
(1) – (2)
(5)
(ri – r? )2Pri
(4) x (5) =
0.2 9,025 x 0.2
0.5
49 x 0.5
0.3 5,625 x 0.3
Variance = ?2
(6)
= 1,805.0
=
24.5
= 1,687.5
= 3,517.0
Standard deviation = ? =
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Estimated Standard Deviation, s
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Measuring Risk: Coefficient of
Variation
? Calculated as the standard deviation divided by
the expected return.
? Useful where investments differ in risk and
expected returns.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
Risk Aversion and Required
Returns
? Risk-averse investors require higher rates of
return to invest in higher-risk securities.
? Risk Premium (RP):
?
?
The portion of the expected return that can be
attributed to an investment’s riskiness.
The difference between the expected rate of
return on a given risky asset and that on a less
risky asset.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Risk/Return Relationship
Return
(r)
rHigh
rAvg
r = rRF + RP
rLow
Payment for Risk = Risk Premium = RP
rRF
Risk-Free Return, rRF = r* + Inflation Premium = r* + IP
0
Below Average Risk
Average Risk
Above Average Risk
Risk
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Portfolio Returns
? Expected return on a portfolio,
rˆp
?
The weighted average expected return on the
stocks held in the portfolio.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
Portfolio Returns
? Realized rate of return,
?
The return that is actually earned.
?
Actual return usually differs from expected
return.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Portfolio Risk
? Correlation Coefficient, ?
?
Measures the degree of relationship between two
variables.
?
Positively correlated stocks (? > 0) have rates of
return that move in the same direction.
?
Negatively correlated stocks (? < 0) have rates of return that move in opposite directions. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Portfolio Risk ? Risk Reduction ? ? ? ? Combining stocks that are not perfectly correlated will reduce the portfolio risk through diversification. The riskiness of a portfolio is reduced as the number of stocks in the portfolio increases. The smaller the positive correlation, the lower the risk. The greater the negative correlation, the lower the risk. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Portfolio Risk Portfolio Risk, ?P (%) 30 . . 25 . 20 Diversifiable Risk Related to Company-Specific Events (Unsystematic Risk) . . Total Risk 15 10 Minimum Attainable Risk in a Portfolio of Average Stocks Nondiversifiable Risk Related to Market/Economic Fluctuations (Systematic Risk) 5 0 1 10 20 30 40 All NYSE Stocks © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Firm-Specific Risk versus Market Risk ? Firm-Specific Risk: ? That part of a security’s risk associated with random outcomes generated by events, or behaviors, specific to the firm. ? Firm-specific risk can be eliminated through proper diversification. ? Also called diversifiable risk or unsystematic risk. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 Firm-Specific Risk versus Market Risk ? Market Risk: ? ? That part of a security’s risk that cannot be eliminated through diversification because it is associated with economic, or market factors that systematically affect all firms. Also called nondiversifiable risk or systematic risk. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Firm-Specific Risk versus Market Risk ? Relevant risk = market risk: ? ? The risk associated with a security that cannot be diversified away This risk reflects a security’s contribution to the total risk of a portfolio. ? Irrelevant risk = firm-specific risk: ? The risk associated with a security that can be diversified away. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 The Concept of Beta ? Beta Coefficient, ?: ? A measure of the extent to which the returns on a given stock move with the stock market, which represents an “average” stock. ? The entire market is extremely well diversified (theoretically perfectly diversified), because it includes all investments. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 The Concept of Beta (cont.) ? ? = 0.5: stock is only half as volatile, or risky, as the average stock. ? ? = 1.0: stock has the same risk as the average stock (same as the market). ? ? = 2.0: stock is twice as risky as the average stock. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Portfolio Beta Coefficients ? The beta of any set of securities is the weighted average of the individual securities’ betas © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Risk Premium for a Stock Risk premium for Stock j = RPj = RPM x ?j = (rM – rRF)?j RPM = Market (average stock) risk premium rM = Market (average stock) return rRF = Risk-free rate of return © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 The Required Rate of Return for a Stock, rj Required return = Risk-free return + Premium for risk rj = rRF + RPj = rRF + (RPM)?j = rRF + (rM – rRF) ?j © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Capital Asset Pricing Model (CAPM) ? A model used to determine the required return on an asset, which is based on the proposition that any asset’s required rate of return should equal the risk-free return plus a risk premium that reflects the asset’s nondiversifiable risk. Risk premium for Required return = Risk-free return + systematic risk rj = rRF + (rM – rRF) ?j © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 Security Market Line (SML): ? A graph of the CAPM ? The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Required Rate of Return (%) Security Market Line (SML) SML: ri = rRF + (rM – rRF)?i . rHigh = 17 Relatively Risky Stock’s Risk Premium: 12% . rM = rA = 11 . rLow = 8 rRF = 5 Safe Stock Risk Premium: 3% Market (Average Stock) Risk Premium: 6% Risk-Free Rate: 5% 0 0.5 1.0 1.5 2.0 Relevant Risk, ?j © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 The Impact of Inflation ? rRF is the price of money to a riskless borrower. ? The nominal rate consists of: ? ? a real (inflation-free) rate of return, and an inflation premium (IP) ? An increase in expected inflation would increase the risk-free rate. ? The SML would experience a parallel, upward shift. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 Changes in Risk Aversion ? The slope of the SML reflects the extent to which investors are averse to risk. ? An increase in risk aversion increases the risk premium, which increases the slope of the SML. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 Changes in a Stock’s Beta Coefficient ? The Beta risk of a stock is affected by: ? ? ? ? composition of its assets use of debt financing increased competition expiration of patents ? Any change in the required return (from change in beta or in expected inflation) affects the stock price. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Stock Market Equilibrium ? The condition under which the expected return on a security, r, is just equal to its required return, r? ? Actual market price equals its intrinsic value as estimated by the average investor, which leads to price stability; otherwise, buying or selling in the market makes the appropriate adjustment. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 Changes in Equilibrium Stock Prices ? Stock prices are not constant due to changes in: ? ? ? ? ? Risk-free rate, rRF, Market risk premium, rM – rRF, Stock’s beta coefficient, bs, Stock’s expected growth rate, g, and Changes in expected dividends, D?. t © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35 Physical Assets Versus Securities ? Riskiness of real assets is only relevant in terms of its effect on the stock’s risk. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 Word of Caution ? CAPM ? ? ? ? Based on expected conditions Only have historical data As conditions change, future volatility might differ from past volatility Estimates are subject to error © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 Different Types of Risk ? Systemic Risks ? Interest rates ? Inflation ? Maturity ? Liquidity ? Exchange rate ? Political © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38 Different Types of Risk (cont.) ? Unsystemic Risks ? Business ? Financial ? Default ? Combined Risks ? ? Total Corporate © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39 CHAPTER 10 PROJECT CASH FLOWS AND RISK © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Learning Outcomes LO.1 Describe the relevant cash flows th... Purchase answer to see full attachment