Financial management - Lecture five 2023 New Update

Portfolio theory - -Even with only two stocks we could create lots of different portfolios. different percentages of each stock. -With three stocks we could create many more possible portfolios. Efficient Frontier - The combination of all efficient portfolios. Portfolios are said to be efficient if they offer: -The highest return for a given level of risk -The lowest risk for a given level of return. Rational investors will only ever invest in efficient portfolios. It is very difficult to estimate returns, standard deviations and the correlation coefficients between investments. For large portfolios calculations are extremely complex. Paying for risk - Since investors can eliminate the diversifiable risk element, the only part they are interested in, and will pay a premium to bear, is the systematic risk element. We measure this risk using Beta. A measure of the extent to which the returns on a given stock move with the stock market, which represents an "average stock". The beta of a security can be defined as an index of responsiveness of the changes in returns of the security relative to a change in the stock exchange or market. Changes in a Stock's Beta Coefficient - The risk of a stock is affected by -Composition of its assets -Use of debt financing -Increased competition -Expiration of patents, copyrights, etc. Any change in the required return (from change in or in expected inflation) affects the stock price. Capital Asset Pricing Model (CAPM) - The CAPM is a model that relates the expected return from an investment to the market premium using beta as a measure of risk. The expected return is composed of two parts: -The risk-free rate - usually estimated from the return on government bonds. -A risk premium - for an individual stock depends on the market risk premium and the company beta. Negative beta - It is possible to have an asset with a negative beta. Expected return will be less than Rf or even negative. Gives protection against states with low aggregate wealth. Applications of CAPM - -To calculate the expected levels of return -To deliberately select high risk portfolios -To identify mispriced shares -To measure portfolio performance CAPM Assumptions - 1. investors are risk adverse...