1) If you are thinking of investing in a stock, what things would you investigate? CF Risk News (company, industry, economy)

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1 BUA321 Chapter 8 Class notes 1) If you are thinking of investing in a stock, what things would you investigate? CF Risk News (company, industry, economy) 2) What is inside trading? Trading on info that no one else has. Who has this info? Why is it a problem? 3) What does this mean: There is no such thing as a free lunch? All benefits and services have a price tag. Think of options in a car. If a security has a benefit to the owner, what happens to their return? Price? What about the issuing company? 4) Calculate the holding period return for TAP. Dividends totaled $3.90. TAP closing prices Date Close 4/1/ /22/

2 a. What is the difference between Return and HPR? Which is more important? Return does not assume any compounding or the time value of money. HPR implies that calculation with compounding Your invest grew from $10 to $15. Return = 50% But what if it took 10 years? 4.14% Which is better? 5) What does history tell us about stock returns? How many negative returns are there compared to positive? Double digit? What does this mean for you? 6) How would you describe Risk? Uncertainty Volatility Changing Future Unexpected

7) If you purchased a stock for $37 last year and this year it is worth $45. What was the return? 8) Complete the following table: i. Enter your company s current price. ii.

3 7) If you purchased a stock for $37 last year and this year it is worth $45. What was the return? 8) Complete the following table: i. Enter your company s current price. ii. Choose a percent change for each condition. (what do you think the return will be for this consumer based company?) iii. Calculate predicted price and return iv. Assign a probability (teacher assigns this) $ price Change % price Predicted price Probability Next year Good economy 15% Average Economy 5% Bad Economy -4% 9) Calculate the statistics for this asset.(use standalone risk) Include the predicted prices to get the expected price. What is the HPR? Record the return information below.

4 10) Repeat the process above with the following two stocks. Record the statistics of these two stocks below. Create 3 portfolios per the table. Stock 2 Stock 3-9% 8% 15% 4% 20% 2% Asset Expected return Standard Deviation CV Port1 1 (.65) 2 (.35) Port2 2 (.45) 3 (.55) Port3 1 (.80) 3 (.20) Port4 1 (.45) 2 (.25) 3 (.30)

11) Combine 2 assets into a portfolio. Insert the picture of the efficient frontier of the portfolio. i. What is an efficient portfolio You cannot find a portfolio with a larger return at a given level of risk.

12) What can you say about the information in the following tables: Higher returns have higher risk Small companies have highest returns and highest risk Where do you think medium

5 11) Combine 2 assets into a portfolio. Insert the picture of the efficient frontier of the portfolio. i. What is an efficient portfolio You cannot find a portfolio with a larger return at a given level of risk. Maximize returns given risk. This is a group of the best possible investments? Which one would you like. Provide the bullet curve and derive the efficient frontier. 12) What can you say about the information in the following tables: Higher returns have higher risk Small companies have highest returns and highest risk Where do you think medium sized stocks would be? 13) What is meant by Do Not Put All Your Eggs in One Basket Describe the concept of 100 baskets What is the chance that all the baskets get stepped on?

describe? How two things seem to act alike. Positive / negative Maximum +1.0 minimum -1.

6 14) Calculate the return on the following portfolio: (use portfolio beta and return worksheet) Asset $ invested Return A 5,000 9% B 7,000 12% C 1,000 6% D 10,000 19% E 1,500 4% F 2,000 7% G 7,000 10% 15) What does correlation describe? How two things seem to act alike. Positive / negative Maximum +1.0 minimum ) What does CAPM describe? The relationship between the returns of a stock and the returns of a stock market? Market risk Straight line relationship

7 17) What things create diversifiable risk? Non-diversifiable risk? Total risk = diversifiable risk + non-diversifiable risk Company specific market risk Lawsuits, strikes inflation, economic conditions What is the formula for risk? (standard deviation) How does correlation reflect the above formula? 18) What is beta? Measure of sensitivity Measures market risk SML? 19) What is the beta of the following portfolio? (use portfolio beta and return) Asset $ invested Return A 5,000 9% 1.25 B 7,000 12% 1.75 C 1,000 6%.54 D 10,000 19% 2.79 E 1,500 4%.32 F 2,000 7%.75 G 7,000 10% 1.95

20) Use the beta of the above portfolio to calculate the expected return of a portfolio. Use the 30 year Treasury yield for the risk free rate and 12% for the average return of the market.

8 20) Use the beta of the above portfolio to calculate the expected return of a portfolio. Use the 30 year Treasury yield for the risk free rate and 12% for the average return of the market. What is market risk premium? 21) Group activity (group of 3) i. Complete the following exercise Use the same market and RF returns i. You are given $100,000 to invest in your groups stocks ii. Find the betas for your companies and input into the portfolio beta and return worksheet iii. Decide how much to invest in each asset iv. Calculate the expected returns and betas for this portfolio Numbers investors should know.

9 Offline Homework (38 points) BUA321 Chapter 08 Web exercise 1) calculate the statistics for the following investments: stand alone risk(12) event Pr r x r y r z very good good Avg Bad Very Bad Asset X Asset Y Asset Z E( R) Variance Standard deviation CV

10 2) For the above assets, create the portfolios below (use stand alone risk) (12) a) 40% X, 35% Y, 25% Z b) 60% X, 40% Y c) 35% Y, 65% Z Portfolio a Portfolio b Portfolio c E( R) Variance Standard deviation CV ) Calculate the portfolio statistics for the following assets: (use portfolio risk and return) (21) weight return variance beta XYZ DEF HIJ correlation XYZ DEF HIJ XYZ DEF HIJ 1.0

11 Portfolio A (.35,.25,.40) Portfolio B (.45,.25,.30) Portfolio C (.10,.75,.15) E( R) Variance Standard deviation Beta CV ) If the risk free rate of return is 3.75% and the stock market averages 12%, what is the expected return on the portfolios using the SML? A 21.24% B 19.76% C 20.75%

CHAPTER 8 Risk and Rates of Return

CHAPTER 8 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM The basic goal of the firm is to: maximize shareholder wealth! 1 Investment returns The rate of return on an investment