market portfolio
portfolio of all assets in the economy - broad stock market index is used to represent the market
we can asses the impact of macro news by tracking market porfolio
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beta
sensitivity of a stock's return to the return on the market portfolio
the sensitivity of the investment's returns to fluctuations in the market
aggressive stocks have high betas - greater than 1...their returns tend to respond more than one for one to returns on the overall market - the betas of defensive stocks are less than 1
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the average beta of all stocks is 1
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we can break down common stock returns into two parts - the part explained by market returns and the part due to news that is specific to that firm - fluctuations in the first part reflect market risk - the second is specific risk
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some of the most variable stocks have below average betas and vice versa - uh what pg 362
total risk is not the same as market risk basically
think of a mining company with a lot of risks - gold and other worldwide prices - variance in ore grade... they have high firm specific volatility but a low beta - because these variables do not depend on how the market does - like if the economy is in a
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firm specific risk is of no concern to an investor
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portfolio beta =
sum of - fraction of portfolio in stock X beta of stock
market risk premium
difference between market return and return on risk free treasury bills - has been 7.6 over the lase century
= Rm(expected market return) - Rf(treasury rate)
total risk
standard deviation
sd =
beta times sd of market
risk premium =
beta (expected market return - treasury bill rate)
total expected return =
risk free rate (treasury) + risk premium
CAPM - capital asset pricing model
the expected rate of return demanded by investors depends on two things - 1. compensation for TVM and 2. a risk premium which depends on beta and market risk premium
r = rf(risk free rate) + beta X (expected market return - risk free rate)
security market line
relationship between expected return and beta
you can obtain any combination of risk and expected return - this graph shows you this
graphical representation of the CAPM equation
the security market line describes the expected returns and risks from splitting your overall portfolio between risk free securities and the market - setting a standard for other investments - investors will be willing to hold other securities only if the
beta X expected market risk premium
risk premium on investment =
beta X expected market risk premium
discount rate for valuing a proposed capital investment project is the OCC - the expected rate of return the shareholders could achieve investing on their own
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project cost of capital
minimum acceptable expected rate of return on a project given its risk
if the CAPM holds, the security market line defines the opportunity cost of capital. A project's expected rate of return plots above the security market line, then it offers a higher expected rate of return than investors could get on their own at the SAM
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company cost of capital
depends on the average risk of all investments
opportunity cost of capital for investment in the firm as a whole - the company cost of capital is the appropriate discount rate for an average risk investment project undertaken by the firm
high fixed costs
high beta bc a small change in revenue can seriously change earnings
cyclical businesses
revenues and earnings are strongly dependant on the state of the economy - high beta and high cost of capital
businesses that produce essentials
less effected by state economy
low beta and low cost of capital
expected cash flow forcasts should already reflect the probabilities of all possible outcomes - good and bad - if the CF forcasts are prepared properly - the discount rate should reflect only the market risk of the project - it should not be fudged to off
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