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    Lecture Evaluating Risk Return

    Uploaded by

    Ali Khan
    Here are the steps to solve this problem using the CAPM model: * Baldwin-Mills beta = 1.25 * Risk-free rate (Rf) = 10% * Expected market return (Rm) = 20% * Expected share price in 1 year = $50 Using the CAPM formula: Expected return on Baldwin-Mills (Ri) = Rf + βi(Rm - Rf) = 10% + 1.25(20% - 10%) = 20% To calculate the current share price: Current price + Expected return = Expected future price x + 20%x = $50 1.2x = $50 x = $

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    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd

    Lecture Evaluating Risk Return

    Uploaded by

    Ali Khan
    170 views15 pages
    Here are the steps to solve this problem using the CAPM model: * Baldwin-Mills beta = 1.25 * Risk-free rate (Rf) = 10% * Expected market return (Rm) = 20% * Expected share price in 1 year = $50 Using the CAPM formula: Expected return on Baldwin-Mills (Ri) = Rf + βi(Rm - Rf) = 10% + 1.25(20% - 10%) = 20% To calculate the current share price: Current price + Expected return = Expected future price x + 20%x = $50 1.2x = $50 x = $

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    Here are the steps to solve this problem using the CAPM model: * Baldwin-Mills beta = 1.25 * Risk-free rate (Rf) = 10% * Expected market return (Rm) = 20% * Expected share price in 1 year = $50 Using the CAPM formula: Expected return on Baldwin-Mills (Ri) = Rf + βi(Rm - Rf) = 10% + 1.25(20% - 10%) = 20% To calculate the current share price: Current price + Expected return = Expected future price x + 20%x = $50 1.2x = $50 x = $

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    170 views15 pages

    Lecture Evaluating Risk Return

    Uploaded by

    Ali Khan
    Here are the steps to solve this problem using the CAPM model: * Baldwin-Mills beta = 1.25 * Risk-free rate (Rf) = 10% * Expected market return (Rm) = 20% * Expected share price in 1 year = $50 Using the CAPM formula: Expected return on Baldwin-Mills (Ri) = Rf + βi(Rm - Rf) = 10% + 1.25(20% - 10%) = 20% To calculate the current share price: Current price + Expected return = Expected future price x + 20%x = $50 1.2x = $50 x = $

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 15

    Evaluating Risk

    Danger (Risk) and Opportunity


    (Expected Return)
    Maximize the Value of the Business
    (Firm)

    The Investment The Financial The Dividend


    Decision Decision Decision
    Invest in assets that Find the right kind of If you cannot find
    earn a return greater debt or your firm and investments that
    than the minimum the right mix of debt make your minimum
    acceptable hurdle and equity to fund acceptable rate,
    rate your operations return the cash to
    owners of your
    The hurdle The The The right business
    How much How you
    rate return optimal kind of cash you choose to
    should reflect should mix of debt can return return
    The riskiness reflect the debt and matches depends on cash to
    of magnitude equity the tenor current and the
    the and the maximizes or your potential owners
    investment timing of firm value assets investment will
    and the mix the cash opportuniti depend on
    of debt and flows as es whether
    equity used well as all they
    to fund it side prefer
    effects dividends
    or
    buybacks
    Probability = 1

    Expected Retur
    Return ns

    Returns on a Risk-free investment


    The greater the deviation of
    the actual returns from
    expected returns, the greater
    the variance hence more
    area under the curve.

    Expected Retur
    Return ns

    Probability Distribution for Risky


    investment
    Low variance investment

    High variance
    investment

    Expected
    Return
    Return Distribution
    Comparison
    Adjusted Closing prices of IBM
    250

    200

    150
    Adj Close

    100

    50

    Returns of IBM
    0.15

    0.1

    Returns
    0.05

    -0.05

    -0.1
    Calculation of Risk using Historical
    Returns-- IBM

    (Price t Price t 1 Dividends t )


    Return t
    Price t 1

    t n
    (R t Average return) 2
    Semi variance
    t 1 n
    Q. Unicom is a regulated utility serving northern Illinois. The
    following table lists the stock prices and dividends on Unicom
    from 1989 to 1998.
    Years Price Dividends
    1989 $36.10 $3.00
    1990 33.60 3.00
    1991 37.80 3.00
    1992 30.90 2.30
    1993 26.80 1.60
    1994 24.80 1.60
    1995 31.60 1.60
    1996 28.50 1.60
    1997 24.25 1.60
    1998 35.60 1.60

    Required: (a) Estimate the average annual return you would have
    made on your investment.
    (b) Estimate the standard variance and variance in annual returns.
    A Breakdown of Risk
    Projects Competition Interest
    may do may be Entire Exchange rates,
    better or Investing
    Firms sector
    weaker Acquirin
    or may
    DiversifyingrateDiversify
    and inflation
    Cannot
    canworse in many stronger
    g be affected
    across political
    ing and news
    affect
    than projectsthan competit
    reduce by action
    sectors risk
    across about
    byexpected anticipated
    ors countrie economy
    s
    Investor Diversifying across Diversifying Diversifying
    s can domestic stocks globally across asset
    mitigate classes
    Firm
    by
    Specific Mark
    et
    Actions or
    risk that Actions/
    affect only risk that
    one firm affect all
    Affects few Affects
    investmen
    firms many firms
    ts
    Limits of Diversification
    Total Risk = Un-diversifiable risk +
    Total Risk (Variance) of Portfolio

    Diversifiable risk
    Total Risk

    Unique risks
    (unsystematic)

    Market risks
    (systematic)

    Number of securities
    Beta () of an Asset
    The Beta of an asset, is a market-sensitivity measure
    It is a measure of the variability of that asset relative to the
    variability of the market as a whole
    Thus it is an index of the systematic risk of an asset.

    Covariance of asset i with market portfolio


    Beta of an asset i
    Variance of the market portfolio

    Covi m
    i
    m2
    Capital Asset Pricing Model
    (CAPM)
    According to CAPM, the expected return on an asset, i, is related to
    the risk of the asset as follows:-

    E ( Ri ) R f i [ E ( Rm ) R f ]
    Where,
    E(Ri) = Expected rate of return on asset i, or the assets RRR

    Rf = Risk-free rate of return

    i = Beta coefficient of stock I

    E(Rm) = Expected return on the market portfolio (S&P 500)


    Q. The Baldwin-Mills Corporation has a beta of 1.25 and pays
    no dividends. The expected market return is 20%, and T-bill
    rate is expected to remain constant at 10%. You expect
    Baldwin-Mills shares to be worth $50 in one year. Using the
    CAPM, find the value of a share today.

    Q. Saldco shares have a beta of 1.2, are currently selling for


    $80 each and pay no dividends. The risk-free rate is 10%, and
    the expected market return is 16%.
    (a) What do you expect Saldco shares to trade for one year
    from today?
    (b) If the expected market return is 20% (rather than 16%),
    what do you expect Saldco shares to trade for one year
    from today?

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