FINM1001 Lecture Notes - Lecture 16: Capital Asset Pricing Model, Net Present Value, Standard Deviation

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whitegoat396

30 May 2018

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● Share Returns

○ Normally distributed

■ Copy her notes

○ Investor preferences

■ Investors are risk averse

■ Investors are greedy thus wants to be more wealthy than less

○ Portfolio Theory

■ Diversification benefits

● Max return and minimise risk <- HOW? By combining assets in the

portfolio and assets must be considered.

● 2 asset case: formula insert

● Portfolio standard deviation

● Minimum variance portfolio: insert formula

● Diversify the portfolio (Pf)

○ Invest across industries

○ Different regions or countries

○ Different asset classes/financial instruments

○ Economies

● Risk free asset:

○ Government bonds -> notes and bonds (country

dependent)

○ Term deposit/bank deposit -> bank dependent

○ Cash

● Beta is a measure of sensitivity between the asset i and the

market

● If beta = 0 then E(Ri) = rf + B[E(Rm) - rf] = rf. Can assume risk free

assume if b=0 since CAPM formula

● If B > 1 asset i is more volatile than the market E(Ri) > E(Rm)

● B = 1 -> E(Ri) = rf + B[E(rm) - rf] = rf + 1[E(Rm) - rf] = E(Rm)

● NPV = sum of the incremental cash flows/(1+rp)t - I

○ rp is determined by CAPM

● Projects we are looking in might be of a different risk class to what

the firms are currently operating in. Using CAPM for a discount

NPV -> we are assessing the company at the company’s level and

we are generating a discount rate based on the company’s

operations. If the level of risk is equal to the company’s level then

we can use CAPM however if the company is looking at a project

that is more risky or less risky than the firm is currently operating,

it is not appropriate to use the discount rate we calculated for the

firm thus we have to adjust the discount rate to reflect the different

risk class. If the risk is higher than the company’s then the beta

will be higher than the firm.

● If B of a new project is in a riskier asset class e.g. 50% more risky

than current operations = Bn = Bo (1+x%). Less risky = Bo (1-x%)

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Document Summary

Investors are greedy thus wants to be more wealthy than less. By combining assets in the portfolio and assets must be considered. Government bonds -> notes and bonds (country dependent) Beta is a measure of sensitivity between the asset i and the market. If beta = 0 then e(ri) = rf + b[e(rm) - rf] = rf. Can assume risk free assume if b=0 since capm formula. If b > 1 asset i is more volatile than the market e(ri) > e(rm) B = 1 -> e(ri) = rf + b[e(rm) - rf] = rf + 1[e(rm) - rf] = e(rm) Npv = sum of the incremental cash flows/(1+rp)t - i rp is determined by capm. Projects we are looking in might be of a different risk class to what the firms are currently operating in. Npv -> we are assessing the company at the company"s level and we are generating a discount rate based on the company"s operations.

Related Questions

You are a risk-averse investor who is considering investing in one of two economies. The expected return and volatility of all stocks in both economies are the same. In the first economy, all stocks move together—in good times all prices rise together, and in bad times they all fall together. In the second economy, stock returns are independent -----one stock increasing in price has no effect on the prices of other stocks. Which economy would you choose to invest in? Explain. (Select the best choice below.)

A. A risk-averse investor would choose the economy in which stocks move together because the uncertainty is much morepredictable, and you have to predict only one thing.

B. A risk-averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together.

C. A risk-averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio.

D. A risk-averse investor is indifferent in both cases because he or she faces unpredictable risk.

lemonbadger60

Q2: You own a portfolio that has $700 invested in Stock A and $2,400 invested in Stock B. If the expected returns on these stocks are 11 percent and 18 percent, respectively.

Required:

a) What is the expected return on the portfolio?
b) Why is some risk diversifiable? Why are some risks non-diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?
c) Can the risk of a portfolio be reduced to zero by increasing the number of stocks in the portfolio? Explain.
d) If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.

silverlion830

Evaluating risk and return

Stock X has a 9.5% expected return, a beta coefficient of 0.8, and a 40% standard deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 25.0% standard deviation. The risk-free rate is 6%, and the market risk premium is 5%.

Calculate each stock's coefficient of variation. Round your answers to two decimal places. Do not round intermediate calculations.
CVx =
CVy =

Which stock is riskier for a diversified investor?

For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher beta is more risky. Stock Y has the higher beta so it is more risky than Stock X.

For diversified investors the relevant risk is measured by standard deviation of expected returns. Therefore, the stock with the higher standard deviation of expected returns is more risky. Stock X has the higher standard deviation so it is more risky than Stock Y.

For diversified investors the relevant risk is measured by beta. Therefore, the stock with the lower beta is more risky. Stock X has the lower beta so it is more risky than Stock Y.

For diversified investors the relevant risk is measured by standard deviation of expected returns. Therefore, the stock with the lower standard deviation of expected returns is more risky. Stock Y has the lower standard deviation so it is more risky than Stock X.

For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher beta is less risky. Stock Y has the higher beta so it is less risky than Stock X.

-Select-IIIIIIIVVItem 3

Calculate each stock's required rate of return. Round your answers to two decimal places.
rx = %
ry = %

On the basis of the two stocks' expected and required returns, which stock would be more attractive to a diversified investor?
-Select-Stock XStock YItem 6

Calculate the required return of a portfolio that has $4,500 invested in Stock X and $9,000 invested in Stock Y. Do not round intermediate calculations. Round your answer to two decimal places.
rp = %

If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return?
-Select-Stock XStock Y

FINM1001 Lecture Notes - Lecture 16: Capital Asset Pricing Model, Net Present Value, Standard Deviation

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