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