Finance 325 Chapter 10

The Market Portfolio

CAPM

Example 2: Calculating the Variance (LIN)

(LIN)

Example 3: Expected Returns and Variances (LIN)

(LIN)

Semi-Strong form efficiency

*Current prices reflect all available public information -Includes information like financial statements, news, analysts' opinions -Analyzing a stock using public information, called fundamental analysis, would not be useful in identifying mispriced stocks -Another implication is that stock prices would quickly and accurately reflect any new information relevant to the company

Strong-form efficiency

*Current prices reflect all information -Public -Privately-held information *then even private, insider information would not allow an investor to "beat the market" by trading on this information since it is already incorporated into the stock price

Weak-Form Efficiency

*Current prices reflect all information derived from trading -includes current and past stock prices and trading volume -Technical analysis would be futile --Technical analysis relies on price and volume charts to make predictions about future prices --Then Prices would already reflect this type of information -But other types of stock analysis could produce excess returns

Variance of returns (definition)

- a measure of the dispersion of the distribution of possible returns in the future

Concerns about beta

-Differences in beta estimates can result in different assumptions about the market portfolio or the historical estimation time period. -Companies can change their risk levels over time -Studies have found that a company's beta does a mediocre job of predicting future return --New models have added additional factors to the CAPM, such as firm size and the book-to-market ratio

Behavioral Finance

-People behave in ways that are very likely irrational --Too optimistic, or too pessimistic --may drive prices away from correct price *leaves open the possibility that capital markets may not represent efficient markets if buyers and sellers do not always make rational choices

Security Market Line

-Shows the relationship between risk and return for any stock or portfolio -Similar to Capital Market Line but risk is characterized by beta, not standard deviation

The EMH implies that information is embedded in current stock prices. Which information, and to what extent? (3 categories)

-Weak form -Semi-strong form -Strong form *Current prices reflect all information derived from trading -includes current and past stock prices and trading volume

Expected return

-forward looking calculation -includes risk measures ER = (sum of each return x Probability of that return) = S Sigma i = 1 Pj x Returnj

Portfolio Beta You own $1,000 of City Steel stock that has a beta of 1.50. You also own $5,000 of Rent-N-Co (beta = 1.80) and $4,000 of Lincoln Corporation (beta = .90). What is the beta of your portfolio (closest to)?

1.41

Portfolio Beta: You have a portfolio with a beta of 1.01. what will be the new portfolio beta if you keep 30% of your money in the old portfolio and 70% in a stock with a beta of 1.61?

1.43

Portfolio Beta You own $31,000 of City Steel stock that has a beta of 3.41. You also own $43,000 of Rent-N-Co (beta = 1.86) and $21,600 of Lincoln Corporation (beta = -.74). What is the beta of your portfolio?

1.78

CAPM Required Return: A company has a beta of 0.60. If the market return is expected to be 13% and the risk-free rate is 5.5%, what is the company's required return?

10.00%

Required Return: If the risk-free rate is 9.9% and the market risk premium is 5.8%, what is the required return for the market?

15.7%

Expected Return: A company's current stock price is $85.00 and it is likely to pay a $4.00 dividend next year. Since analysts estimate the company will have a 11% growth rate, what is its expected return?

15.71%

Expected Return: A company's current stock price is $26.20 and it is likely to pay a $1.95 dividend next year. Since analysts estimate the company will ahve a12% growth rate, what is its expected return

19.44%

Under/Over Valued Stock: A manager believes his firm will earn a 16.6% return next year. His firm has a beta of 1.56, the expected return on the market is 14.6% , and the risk-free rate is 4.6%. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued.

20.2%, over-valued

Company Risk Premium: A company has a beta of 4.64. If the market return is expected to be 15.40% and the risk-free rate is 7.70%, what is the company's risk premium?

35.73%

Risk Premium: If the annual return on the S&P 500 index was 14%. The annual T-bill yield during the same period was 6.5% what was the market risk premium during that year?

7.50%

Expected Return: compute the expected return given these three economic states, their likelihoods, and the potential returns: Economic State: Fast Growth Slow Growth Recession Probability: .2 .4 .4 Return: 30.5% 6.25% -2.25%

7.7%

Under/Over Valued Stock A manager believes his firm will earn a 10.15 percent return next year. His firm has a beta of 1.31, the expected return on the market is 8.1 percent, and the risk-free rate is 3.1 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued

9.65%, under-valued

A measure of the sensitivity of a stock or portfolio to market risk

Beta

CAPM (equation)

Calculate the Security Market Line for risk/return relationship -substituting into line equation results in CAPM Required return = risk-free rate + Beta x Market risk Premium =Rf + B(Rm-Rf)

Finding Beta

Can compute with data from company's and market portfolio returns -find in published data from financial outlets --Value Line Investment Survey --Hoovers --MSN Money --Yahoo Finance --Zacks

The asset pricing theory based on a beta, a measure of market risk.

Capital Asset Pricing Model

CAPM

Capital Asset Pricing Model -Best known capital asset pricing model -starts with modern portfolio theory

Popular alternative to CAPM is the ____________

Constant growth Model i = D1 / P0 + g = Dividend Yield + Constant Growth

This is the average of the possible returns weighted by the likelihood of those returns occuring

Expected Return

This is the reward for taking systematic stock market risk

Market Risk Premium

Beta

Measures the sensitivity of a stock or portfolio to market risk -Beta > 1, more risky than market (higher risk premium) -Beta < 1, less risky (lower risk premium)

The set of probabilities for all possible occurences

Probability Distribution

Problem1: We expect the market portfolio to earn 12%, and T-bill yields are 4%. Lowes has a beta of 1.2. Calculate Lowes required return

Required Return = 4% + 1.2(12%-4%) = 13.6%

Ex of Beta: We expect the market portfolio to earn 12% and T-bill yields are 5%. Home Depot has a beta of 1.08 calculate Home Depot's required Return.

Required Return = 5% + 1.08 (12%-5%)

This is the reward investors require for taking risk

Risk Premium

This is typically considered the return on U.S. government bonds and bills and equals the real interest plus the expected inflation premium

Risk-Free Rate

Similar to the Capital Market Line except risk is characterized by beta instead of standard deviation

Security Market Line

Efficient Market Hypothesis

States that security prices fully reflect all available information. -At any point in time, the price of any stock or bond reflects the collective wisdom of market participants about the company's prospects

Efficient Frontier

The efficient frontier demonstrates the highest expected return for each level of risk (table) +Adding a risk-free asset improves return for each level of risk

Capital MArket Efficiency

The risk and return relationship rests on the underlying assumption that stock prices are generally "correct" -Efficient Markets Feature --Many buyers and sellers --no high barriers to entry --free and available information --low trading or transaction costs

Portfolio Beta

Weighted average of portfolio stocks' betas Bp = Sum of the beta of each stock x its weight in the portfolio = n Sigma j =1 WjBj

Financial managers and investors must make investment decisions based on their ____________________ about future risk and return

expectations

If you want the change of earning higher returns, it requires that you take on ________________ investment

higher risk

Example of Constant Growth Model: Wal-Mart is expected to pay a $1 dividend this year, and the current price of WMT stock is $48 per share. Analysts believe that Wal-Mart will grow at a constant 12 percent.

i = $1.00/48 +0.12 = 14.1%

Problem 2: Honeywell just paid a $2.50 dividend, and the current price of Honeywell stock is $19 per share. Analysts believe that the company will grow at a constant 8 percent. Calculate the required return on Honeywell stock.

i = D1 / P0 + g = Dividend Yield + Constant Growth i = $2.50(1+0.08)/19 + 0.08 =22.21%

Required Return

is the return that investors demand for the level of risk taken

Market Risk Premium

is the reward for taking systematic, stock market risk

Risk Premium

is the reward investors require for taking risk

Example 1: Calculating the expected return look in notes

look in notes

Managesr also need to know what return their ______________________ so they can meet those expectations

shareholders require

Expected return (definition)

weighted average of the distribution of possible returns in the future