Essay About Expected Return And Much Risk

Coefficient of Variation
Week 8Coefficient of variation (CV): a standardized measure of dispersion about the expected return, tells how much risk we face per unit of return (chose the one with lowest CV)Correlation coefficient, is a measure of the extent to which two securities’ returns tend to move together[pic 1]Describe the goodness of fit about linear relationship between two variables[pic 2]Portfolio return is the weighted average of the expected returns of the individual assetsRisk attitudesA risk adverse investor tries to maximize his return and minimize his riskA risk neutral investor tries to maximize his return but does not care about the riskA risk seeking investor tries to maximize his return and maximize his riskDiversification: strategy designed to reduce risk by spreading the portfolio across many investors (systematic/unsystematic risk)[pic 3]Week 9Diversification and portfolio riskAs more shares are added, each new share has a smaller risk-reducing impactBy forming portfolios, we can eliminate some of the riskiness of the individual sharesMarkowitz Portfolio Theory (MPT)Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.Investors estimate the risk of the portfolio on the basis of the variability of expected returns.Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.For a given risk level, investors prefer higher returns to lower returns.  Similarly, for a given level of expected returns, investors prefer less risk to more risk.Efficient frontier[pic 4]The section of the opportunity set above the minimum variance portfolio is the efficient frontierCapital Market Line (CML)[pic 5]Introducing a risk0free asset, the opportunity set for investors is expanded and results in a new efficient frontierThe CML represents the efficient set of all portfolios that provides the investor with best possible investment opportunities when a risk-free asset is availableThe important factsRisk-free asset has a standard deviation od zeroThe minimum variance portfolio lies on the boundary of the feasible set at a point where the variance is at a minimumThe optimal portfolio lies on the feasible set and on a tangent from the risk-free assetBeta βA measure of a security’s systematic riskMeasures the responsiveness of a security to movements in the market portfolioIf beta = 0, the expected return if risk-freeIf beta = 1, stock is as risky as the marketIf beta > 1, stock is riskier than the marketIf beta < 1, stock is less risky than the marketSecurity Market Line (SML)[pic 6]Represent CAPM, describe the linear relationship between expected returns for individual securities and systematic riskIn equilibrium, all securities must be priced that their returns lie on the SMLIf inflation rises, it will shift the SML to the leftIf risk aversion increased, it will increase the market premium by the same amountWhat’s the difference between SML and CML?Week 10Cost of capital: the rate of return the firm must earn to maintain its market value and attract investors, estimatedOn an after-tax basisAt a point in timeBased on expected future valuesHolding business and financial risk fixedCost of capital is the RRR on the three main types of financingCost of debt (YTM)Cost of equity Cost of preference sharesCost of debtFind the YTMCovert to an annual cost of debtFind the after-tax cost of debt ki (1 – T)Cost of preference sharesPreference shares generally pay a constant dividend every period forever (perpetuity)kp = D1 / PCost of capitalDividend Growth Model (DGM)Advantage: easy to understand and useDisadvantage:Only applicable to companies currently paying dividendsNot applicable if dividends are not growing at a reasonably constant rateExtremely sensitive to the estimated growth rate (1% increase in g will lead to 1% increase in the cost of capital)Does not explicitly consider riskSML or CAPM Advantages:Explicitly adjusts for systematic riskApplicable to all companiesDisadvantages:Have to estimate the expected market risk premiumHave to estimate betaRelying on the past to predict the future, which is unreliable