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Exam 2 ReviewExam 2 Review
Basic ConceptsBasic Concepts
Fisher EffectFisher Effect
-- (1 + k-- (1 + krfrf) = (1 + k*) (1 + IRP)) = (1 + k*) (1 + IRP) Expected rate of returnExpected rate of return
-- k = P(k-- k = P(k11)*k)*k11 + P(k + P(k22)*k)*k22 + ...+ + ...+ P(kn)*knP(kn)*kn
What is Risk?What is Risk?
Uncertainty in the distribution of Uncertainty in the distribution of possible outcomes.possible outcomes.
How can we measure it?How can we measure it?
-- Standard Deviation-- Standard Deviation
Standard DeviationStandard Deviation
= (k= (kii - k) - k)22 P(k P(kii)) n
i=1
It depends on your tolerance for risk! It depends on your tolerance for risk!
Remember, there’s a tradeoff between Remember, there’s a tradeoff between risk and return.risk and return.
Return
Risk
Combining several securities Combining several securities in a in a portfolioportfolio can actually can actually reduce overall risk reduce overall risk (diversification)(diversification)
How can we reduce risk?How can we reduce risk?
Some risk can be diversified Some risk can be diversified away and some cannot.away and some cannot.
Market riskMarket risk ( (systematic risk)systematic risk) is is nondiversifiable. nondiversifiable. This type of risk This type of risk cannot be diversified away.cannot be diversified away.
Company-unique riskCompany-unique risk (unsystematic (unsystematic risk)risk) is is diversifiablediversifiable. This type of risk . This type of risk can be reduced through can be reduced through diversification.diversification.
This is why we have This is why we have Beta.Beta.
Beta: a measure of market risk.Beta: a measure of market risk. Specifically, beta is a measure of how Specifically, beta is a measure of how
an individual stock’s returns vary an individual stock’s returns vary with market returns.with market returns.
It’s a measure of the It’s a measure of the “sensitivity”“sensitivity” of of an individual stock’s returns to an individual stock’s returns to changes in the market.changes in the market.
A firm that has a A firm that has a beta = 1beta = 1 has has average average market riskmarket risk. The stock is no more or less . The stock is no more or less volatile than the market.volatile than the market.
A firm with a A firm with a beta > 1beta > 1 is is more volatilemore volatile than than the market. the market. (ex: technology firms)(ex: technology firms)
A firm with a A firm with a beta < 1beta < 1 is is less volatileless volatile than than the market.the market. (ex: utilities)(ex: utilities)
The market’s beta is The market’s beta is 11
Portfolio BetaPortfolio Beta
Beta of Portfolio =Beta of Portfolio =
ΣΣ (percent invested in stock j) * (percent invested in stock j) *
(Bate of stock j)(Bate of stock j)
kkjj = k = krfrf + + jj (k (kmm - k - krf rf ))
where:where:
kkjj = the required return on security j, = the required return on security j,
kkrfrf = the risk-free rate of interest, = the risk-free rate of interest,
jj = the beta of security j, and = the beta of security j, and
kkmm = the return on the market index. = the return on the market index.
The CAPM equation:The CAPM equation:
Example: Example: AT&T 6 ½ 36AT&T 6 ½ 36 Par valuePar value = = $1,000$1,000 CouponCoupon = = 6.5%6.5% or par value per year, or par value per year,
or or $65$65 per year ( per year ($32.50$32.50 every six months). every six months). MaturityMaturity = 28 years (matures in 2036) = 28 years (matures in 2036) Issued by AT&T.Issued by AT&T.
0 1 2 … 28
$32.50 $32.50 $32.50 $32.50 $32.50 $32.50+$1000
Types of BondsTypes of Bonds
DebenturesDebentures Subordinated debenturesSubordinated debentures Mortgage bondsMortgage bonds ZerosZeros Junk bondsJunk bonds EurobondEurobond
DefinitionsDefinitions
Bond indenture and ratingBond indenture and rating Current yieldCurrent yield Book value Book value Liquidation value Liquidation value Market value Market value Intrinsic value Intrinsic value
Bond ValuationBond Valuation
Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)
$It $M
(1 + kb)t (1 + kb)nVVbb = + = +
nn
t = 1t = 1
The Financial Pages: The Financial Pages: Corporate BondsCorporate Bonds
CurCur Net Net
Yld Vol Close Yld Vol Close ChgChg
Polaroid 11 Polaroid 11 11//22 13 19.3 395 59 13 19.3 395 59 33//44 ... ...
Five RelationshipsFive Relationships
Value of bond is inversely related to Value of bond is inversely related to changes in the investor’s present changes in the investor’s present required rate of returnrequired rate of return
Market value of bond will be less than Market value of bond will be less than the par value if investor’s required rate the par value if investor’s required rate is above the coupon interest rateis above the coupon interest rate
Five RelationshipsFive Relationships
As maturity date approaches, the As maturity date approaches, the market value of bond approaches its market value of bond approaches its par valuepar value
Long-term bonds have greater interest Long-term bonds have greater interest rate risk than do short-term bonds rate risk than do short-term bonds
Five RelationshipsFive Relationships
The sensitivity of bond’s value to The sensitivity of bond’s value to changing interest rate depends not changing interest rate depends not only on length of time to maturity, but only on length of time to maturity, but also on the pattern of cash flows also on the pattern of cash flows provided by the bondprovided by the bond
Duration (calculation and conclusion)Duration (calculation and conclusion)
Preferred StockPreferred Stock
DefinitionDefinition and features (similarities with and features (similarities with bond and stock, dividend cumulative…)bond and stock, dividend cumulative…)
ValuationValuation
V =Dk
psps
Common StockCommon Stock
Definition and featuresDefinition and features ValuationValuation
1. discounted dividend and selling price of 1. discounted dividend and selling price of the stockthe stock
2. 2.
Vcs =D1
kcs - g
Growth RateGrowth Rate
g = ROE * rg = ROE * r g: the growth rate of the companyg: the growth rate of the company ROE: return on equityROE: return on equity r: the company’s percentage of profit r: the company’s percentage of profit
retainedretained