Chpt010(1).ppt

,Corporate Finance Ross Westerfield Jaffe,Sixth Edition,Chapter Outline,10.1 Individual Securities10.2 Expected Return,Variance,and Covariance10.3 The Return and Risk for Portfolios10.4 The Efficient Set for Two Assets10.5 The Efficient Set for Many Securities10.6 Diversification:An Example10.7 Riskless Borrowing and Lending10.8 Market Equilibrium10.9 Relationship between Risk and Expected Return(CAPM)10.10 Summary and Conclusions,10.1 Individual Securities,The characteristics of individual securities that are of interest are the:Expected ReturnVariance and Standard DeviationCovariance and Correlation,10.2 Expected Return,Variance,and Covariance,Consider the following two risky asset world.There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.2 Expected Return,Variance,and Covariance,10.3 The Return and Risk for Portfolios,Note that stocks have a higher expected return than bonds and higher risk.Let us turn now to the risk-return tradeoff of a portfolio that is 50%invested in bonds and 50%invested in stocks.,10.3 The Return and Risk for Portfolios,The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:,10.3 The Return and Risk for Portfolios,The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:,10.3 The Return and Risk for Portfolios,The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:,10.3 The Return and Risk for Portfolios,The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio.,10.3 The Return and Risk for Portfolios,The variance of the rate of return on the two risky assets portfolio is,where BS is the correlation coefficient between the returns on the stock and bond funds.,10.3 The Return and Risk for Portfolios,Observe the decrease in risk that diversification offers.An equally weighted portfolio(50%in stocks and 50%in bonds)has less risk than stocks or bonds held in isolation.,10.4 The Efficient Set for Two Assets,We can consider other portfolio weights besides 50%in stocks and 50%in bonds,100%bonds,100%stocks,10.4 The Efficient Set for Two Assets,We can consider other portfolio weights besides 50%in stocks and 50%in bonds,100%bonds,100%stocks,10.4 The Efficient Set for Two Assets,100%stocks,100%bonds,Note that some portfolios are“better”than others.They have higher returns for the same level of risk or less.,These compromise the efficient frontier.,Two-Security Portfolios with Various Correlations,100%bonds,return,100%stocks,=0.2,=1.0,=-1.0,Portfolio Risk/Return Two Securities:Correlation Effects,Relationship depends on correlation coefficient-1.0 r+1.0The smaller the correlation,the greater the risk reduction potentialIf r=+1.0,no risk reduction is possible,Portfolio Risk as a Function of the Number of Stocks in the Portfolio,Nondiversifiable risk;Systematic Risk;Market Risk,Diversifiable Risk;Nonsystematic Risk;Firm Specific Risk;Unique Risk,n,In a large portfolio the variance terms are effectively diversified away,but the covariance terms are not.,Thus diversification can eliminate some,but not all of the risk of individual securities.,Portfolio risk,10.5 The Efficient Set for Many Securities,Consider a world with many risky assets;we can still identify the opportunity set of risk-return combinations of various portfolios.,return,P,Individual Assets,10.5 The Efficient Set for Many Securities,Given the opportunity set we can identify the minimum variance portfolio.,return,P,minimum variance portfolio,Individual Assets,10.5 The Efficient Set for Many Securities,The section of the opportunity set above the minimum variance portfolio is the efficient frontier.,return,P,minimum variance portfolio,efficient frontier,Individual Assets,Optimal Risky Portfolio with a Risk-Free Asset,In addition to stocks and bonds,consider a world that also has risk-free securities like T-bills,100%bonds,100%stocks,