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6-2
Stand-alone risk
zPercentage terms.
6-3
6-4
= $100.
Percentage return:
$ Return/$ Invested
$100/$1,000
= 0.10 = 10%.
This presentation uses slides from Brigham et al textbooks.
6-5
6-6
Probability distribution
Stock X
Economy
Prob. T-Bill
HT
Coll
USR
MP
Recession
0.10
8.0% -22.0%
28.0%
10.0% -13.0%
Below avg.
0.20
8.0
-2.0
14.7
-10.0
1.0
Average
0.40
8.0
20.0
0.0
7.0
15.0
Above avg.
0.20
8.0
35.0
-10.0
45.0
29.0
Boom
0.10
8.0
50.0
-20.0
30.0
43.0
Stock Y
-20
15
50
Rate of
return (%)
1.00
This presentation uses slides from Brigham et al textbooks.
6-7
6-8
6-9
6 - 10
^
k = expected rate of return.
k =
k P.
i
^
k
17.4%
15.0
13.8
8.0
1.7
i=1
^
kHT = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
This presentation uses slides from Brigham et al textbooks.
6 - 11
(k
n
i =1
6 - 12
(k
n
i =1
2
k Pi .
HT:
= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.
k Pi .
T-bills = 0.0%.
HT = 20.0%.
Coll = 13.4%.
USR = 18.8%.
M = 15.3%.
6 - 13
Prob.
T-bill
USR
HT
13.8
6 - 14
17.4
Coefficient of variation is an
alternative measure of stand-alone
risk.
This presentation uses slides from Brigham et al textbooks.
6 - 15
Expected
return
17.4%
15.0
13.8
8.0
1.7
6 - 16
Risk,
20.0%
15.3
18.8
0.0
13.4
6 - 17
6 - 18
Portfolio Return, ^
kp
^ is a weighted average:
k
p
n
^
^
kp = wiki.
i=1
^
kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^
^
^
kp is between kHT and kColl.
This presentation uses slides from Brigham et al textbooks.
Alternative Method
Estimated Return
Economy
Recession
Below avg.
Average
Above avg.
Boom
Prob.
0.10
0.20
0.40
0.20
0.10
HT
Coll.
Port.
-22.0%
-2.0
20.0
35.0
50.0
28.0%
14.7
0.0
-10.0
-20.0
3.0%
6.4
10.0
12.5
15.0
^
kp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
(More...)
This presentation uses slides from Brigham et al textbooks.
6 - 19
6 - 20
Two-Stock Portfolios
Two stocks can be combined to form
a riskless portfolio if r = -1.0.
Risk is not reduced at all if the two
stocks have r = +1.0.
In general, stocks have r 0.65, so
risk is lowered but not eliminated.
Investors typically hold many stocks.
What happens when r = 0?
This presentation uses slides from Brigham et al textbooks.
6 - 21
6 - 22
Prob.
Large
2
15
6 - 23
p (%)
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
6 - 24
Stand-alone Market
Diversifiable
= risk
+
.
risk
risk
Company Specific
(Diversifiable) Risk
35
2,000+
# Stocks in Portfolio
This presentation uses slides from Brigham et al textbooks.
Return
6 - 25
Conclusions
6 - 26
6 - 27
6 - 28
6 - 29
Market
25.7%
8.0%
-11.0%
15.0%
32.5%
13.7%
40.0%
10.0%
-10.8%
-13.1%
KWE
40.0%
-15.0%
-15.0%
35.0%
10.0%
30.0%
42.0%
-10.0%
-25.0%
25.0%
6 - 30
kKWE
20%
kM
0%
-40%
-20%
0%
20%
40%
-20%
-40%
R = 0.36
6 - 31
6 - 32
6 - 33
6 - 34
Security
HT
Market
USR
T-bills
Collections
Expected
return
17.4%
15.0
13.8
8.0
1.7
Risk, b
1.29
1.00
0.68
0.00
-0.86
6 - 35
kHT
= 8.0% + (7%)(1.29)
= 8.0% + 9.0%
= 17.0%.
kM
kUSR
kT-bill
kColl
=
=
=
=
8.0% + (7%)(1.00)
8.0% + (7%)(0.68)
8.0% + (7%)(0.00)
8.0% + (7%)(-0.86)
= 15.0%.
= 12.8%.
= 8.0%.
= 2.0%.
6 - 36
HT
17.4%
k
17.0% Undervalued
Market
15.0
15.0
Fairly valued
USR
13.8
12.8
Undervalued
T-bills
8.0
8.0
Fairly valued
Coll
1.7
2.0
Overvalued
6 - 37
HT
kM = 15
kRF = 8
. .
. T-bills
Market
USR
Coll.
-1
6 - 38
Risk, bi
6 - 39
6 - 40
SML2
SML1
18
15
Or use SML:
11
8
kp = kRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.
Original situation
0
This presentation uses slides from Brigham et al textbooks.
kM = 15%
SML1
RPM = 3%
Original situation
2.0
6 - 42
15
1.0
1.5
18
1.0
6 - 41
After increase
in risk aversion
kM = 18%
0.5
I = 3%
New SML
kp = Weighted average k
= 0.5(17%) + 0.5(2%) = 9.5%.
Risk, bi