530Mod5a

Session 6 - Risk, Return, and the Capital Asset Pricing Model, Chapter 6

All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage South-Western, 2020)

Chapter 6

Things to Absorb

The main focus is on defining and measuring types of risk and return. You need to be able to calculate returns, standard deviations, of individual securities and returns and betas of portfolios. You must be able to compute weighted average returns and portfolio betas. Know that standard deviation is a measure of total risk. Know that beta is a measure of systematic risk and is appropriate when analyzing portfolios. Be able to understand the impact of diversification. You should understand the Capital Asset Pricing Model (CAPM) as it is the predominant theory of the relationship between risk and return. You need to understand CAPM's uses and the inputs used in CAPM calculations. You should read about Behavioral Finance (applications of Psychological principles to financial decision making). Behavioral Finance is an emerging area of finance, but the lessons and math are very complex.  Without a deep understanding of the topic, one should not attempt to apply this to the real world.  You need to be able to understand and apply the concepts of the Efficient Markets Hypothesis and the implications for efficient capital markets.

Things You Do Not Need to Absorb

You are not responsible for the Fama-French three factor model.

Things to Read

All of the chapter except pages 278-281 (Three-factor model).

Things to Do

Make 100 on the quiz. You should be ale to answer all of the end of Questions and Problems 1-3, 5-14. Note, I have used variations of every one of the end of chapter Questions and Problems in recent semester exams.  Continue to work with the Excel Tookkit for this chapter.

Calculator links

Simple and useful instructions for most calculators

Note, that your calculator is probably set to 12 payments per year and 2 decimal places. You need to change this to 1 payment per year and at least 4 decimal places.

  1. Watch the Chapter Introduction and Overview video. The Powerpoints for all of this chapter's videos are located here.
  2. Read pages 243-254.
  3. Watch the Computing  Returns and Standard Deviation (minicase page 291 parts a-d) video.  After this video, you should be able to solve end of chapter problems 5, 6, and 13.
  4. Read pages 254-259.
  5. Watch the Portfolio  Risk, Correlation, and 2-stock portfolio (minicase parts e-g) video.
  6. Read pages 259-270.
  7. Watch the Diversification and Capital Asset Pricing Model and Computing Beta (minicase parts h-j) video. After this video, you should be able to solve end of chapter problems 1-3, 7, 8, and 12. 
  8. Read the remainder of the chapter.
  9. Watch the Computing Beta, Shifts in the Security Market Line, and Computing Portfolio Betas (minicase parts k-p) video.  Watch the Market Efficiency (minicase q and r) video. After this video, you should be able to solve end of chapter problems 9, 10, 11,  and 14.
  10. Before the exam, you should be able to answer the following questions; Self test Questions 1 and 2, All of the end of chapter questions, and All of the problems except number 4. I have used variations on all of the end of chapter problems in past semesters. Remember that the Learning Management websites has solutions to end of chapter problems.
  11. Here are audio solutions, created by Dr. Ronald Best, to several types of Risk and Return problems;
    1. What is the expected return for the following stock? (State your answer in percent with one decimal place.)  In the better economy, with probability of .5, the expected return is 32%. In  the same economy, with probability of .2, the expected return is 17%. In the worse economy, with probability of .3, the expected return is -10%. | Audio Solution
    2. What is the expected return for the following portfolio? (State your answer in percent with two decimal places.) Stock AAA with expected return of 31.2% has a total value of $190,000. Stock BBB with expected return of 24.0% has a total value of $350,000. Stock CCC with expected return of 18.6% has a total value of $200,000. Stock DDD with expected return of 11.9% has a total value of $500,000. | Audio Solution
    3. If the risk-free rate is 4.3%, the expected return on the market is 15.7%, and the expected return on Security J is 21.5%, what is the beta for Security J? (Calculate your answer to two decimal places.) | Audio Solution
    4. You are considering buying a stock with a beta of 0.73. If the risk-free rate of return is 6.9 percent, and the expected return for the market is 12.2 percent, what should the expected rate of return be for this stock? (State your answer as a percentage.) | Audio Solution
    5. If the risk-free rate is 6.9%, the market risk premium is 7.0%, and the expected return on Security J is 29.4%, what is the beta for Security J? (Calculate your answer to two decimal places.) | Audio Solution
    6. You are considering buying a stock with a beta of 2.05. If the risk-free rate of return is 6.9 percent, and the market risk premium is 10.8 percent, what should the expected rate of return be for this stock? (State your answer as a percentage.) | Audio Solution
    7. You are holding a stock that has a beta of 2.4 and is currently in equilibrium. The required return on the stock is 20.4% and the return on a risk-free asset is 8%. What would be the return on the stock if the stock's beta increased to 3.3 while the risk-free rate and market return remained unchanged? (Calculate your answer to two decimal places  and state it as a percentage.) | Audio Solution
    8. The risk-free return is 4.1% and  the market return is 14.0%. What is the expected return for the following portfolio? (State your answer in percent with two decimal places.) Stock AAA with Beta of 3.4 has a total value of $125,000. Stock BBB with Beta of 2.9 has a total value of $330,000. Stock CCC with Beta of 1.3 has a total value of $230,000. Stock DDD with Beta of .9 has a total value of $500,000. | Audio Solution
  12. There is a quiz based on the above material. The name of the quiz is Chapter 6.

Revised August 22, 2020
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