This module identifies the general determinants of common share prices. It begins by describing the relationships between the current price of a security, the expected rate of return on the security, and the required rate of return on the security. You will apply statistical measures of mean and variability to measure risk and return of individual securities and a portfolio of securities. The module also describes how risk is included in determining the required rate of return. You will calculate a risk premium for common shares. Finally, you will learn the Capital Asset Pricing Model (CAPM) approach to risk assessment and how risk is reduced through diversification.

Module 4

Security valuation: Risk-adjusted discount rates

Explain the general determinants of common share prices.

The factors that determine common share prices are expected return risk

Expected returns will increase as risk increases.

The expected return of a share is determined as follows:

where D1 and P1 are expected dividend and expected future stock price.

Thus, there is an inverse relation between current share price and expected return.

1)

0

11

P

PDE(r

Define the relationships between current share price, P0, expected rate of return E(r), and required rate of return (r).

… continued

The expected rate of return on a stock is the rate of return that investors anticipate receiving based on the dividends and future share price they expect.

The required rate of return on a stock is the lowest expected rate of return a stock can have and still induce investors to hold the stock.

The relationship between expected return and required return develops through a three-step process:

1. Investors identify the risk of a stock.

2. Investors determine the required rate of return (based on its risk).

3. Investors adjust the current price to set the expected rate of return equal to the required rate of return.

… continued

Define risk of an equity security for one-stock and multi-stock portfolios.

Risk is the uncertainty about returns from investing in a financial asset.

The risk of an investment is measured by the variance, or standard deviation, of possible returns.

The risk of a portfolio is measured by the variance, or standard deviation, of the portfolio returns.

… continued

Holding a portfolio of stocks reduces risk when the returns of the stocks in the portfolio are not perfectly correlated.

Standard deviation is not the appropriate measure of risk for individual common stocks held as a part of a portfolio because it ignores how the stock’s returns vary with other stocks.

Variance, , is defined as follows:

Standard deviation, , is defined as follows:

The correlation coefficient, , between two stocks, A and B, is

BA

B,Acov

Compute the statistical measures of variability: variance, standard deviation, and correlation.

2

r~all

22 r~prr~

2

The required rate of return reflects the fact that investors are risk averse and must be paid a premium to hold a risky investment.

The required return on equity is the sum of two components: the risk-free return rf

a risk premium given by A change in interest rates such as the T-bill return rf

will change the required return on equity.

fm rr

Explain how risk measures for equity securities are used to arrive at a required rate of return.

The risk premium on the market portfolio is . The risk premium required to hold an individual stock is

Beta ( ) is the relevant measure of systematic risk for that stock assuming diversification. It measures the change in the stock’s return for a given change in the return on the market.

A stock’s is the slope of the regression line of the most recent 60 monthly returns of a stock and the market index (such as the TSE 300).

Calculate the risk premium for common shares.

.fm rrβ

fm rr

…continued

Three factors affect the risk premium on common stock: business risk operating leverage financial leverage

Both operating and financial leverage magnify business risk and the risk of common stock; thus, is magnified by operating and financial risk.

The efficient frontier for portfolios of various securities shows the maximum expected return for a given level of risk or vice versa, the minimum risk for a given return.

The equation for the capital asset pricing model is

fmfe rrrr

Explain the Capital Asset Pricing Model (CAPM) approach to risk assessment and the concept of risk reduction through diversification.

Presentation complete!