B2 Notes
• Investors are risk averse and are worried about the confidence interval of returns they might face
when buying a risky investment
• They use standard deviation of returns σr as a measure of the size of a confidence interval
(usually use 95% interval)
• The larger the σr, the less confident they are in the return and thus the more they will expect to
earn; they will want to make sure they get a higher return
• P0 =∑(CFi /(1+r)i
) formula shows how future cash flows are discounted
• P0 =∑(CFi-DDi) formula shows the dollar discount applied to cash flows
•Superior investments plot above the fair market line; they are underpriced (too much return)
and have high returns and low volatility which is what a firm wants
• The effect of underpriced investment: high return will drive prices down which will then drive
the return down closer to fair return
•When (r, σr) is plotted below the line, the investment is inferior and the return is low compared
to the market and the volatility is high which is bad for an investment
• Low return for inferior investment will drive price up which will then drive return up
• Since we know that σr can only be used to measure risk and finding return for diversified
portfolios, we must find a way to find return for individual stocks, projects, and bonds
• Here is where β comes in
• Refer to pg . 5 graph:
• When an investor has a particular amount of money to invest, they could invest it in a market
stock fund (M) which is diversified and follows the market return
• If the investor decides to borrow money and invest the borrowed money in addition to the money
they already had then we call this levering up, and their investment would fall on point L, the
Levered Stock Fund
•The use of leverage (borrowed money) increases both risk and return of your investment;
notice point L is higher on the graph
• Why should we lever up? It generates positive growth over time and can help save up for
retirement
• Macro news drives rewarded risk(market wide); micro news drives unrewarded risk (firm wide)
• Any investment that plots on the fair return line or above is rewarded risk
• The unrewarded risk for an investment can be determined by finding where that investment is
plotted (below the line) and where it corresponds to the fair return line
• Unrewarded risk: micro news events that create some volatility but do not provide any long-run
reward or extra return (i.e. a firm’s CEO dies)
• Rewarded risk= macro news
• For an individual stock, it is not the amount of volatility that is important, it is the amount of one
particular source of volatility that is important
• As your volatility increase, we expect the return of that investment to also increase; however due
to firm focused news, this doesn’t always happen. When return does not increase when it should,
this is the unrewarded risk
•A passive investor should be diversified instead of focused!
• Investment returns: (P1-P0)/P0
• Price changes because news events change investors’ perceptions of future cash flows
• P1 is expected to be= P0(1+r)
• Financial News: only the surprise part of an event will cause prices to change in the market; if
something happens that was already expected or anticipated, it doesn’t matter.
• Macro News (Market-Wide News): ONLY news that moves the market; driven by beta; this
is the surprising or unexpected portion of a news event; ex: interest rates, consumer
confidence, political turmoil
• Micro News (Firm Focused News): only affects firms; will avg out to 0 impact on the
market; ex: product failure
