Part Five

Risk and Return 379

Chapter 12

Some Lessons from Capital Market History 381

12.1 Returns 382

Dollar Returns 382 Percentage Returns 384

12.2 The Historical Record 386 A First Look 387

A Closer Look 387

12.3 Average Returns: The First Lesson 392 Calculating Average Returns 392 Average Returns: The Historical Record 392 Risk Premiums 394

The First Lesson 395

12.4 The Variability of Returns: The Second Lesson 396

Frequency Distributions and Variability 396

The Historical Variance and Standard Deviation 396

The Historical Record 399

Normal Distribution 399

The Second Lesson 402

Using Capital Market History 402

12.5 Capital Market Efficiency 403

Price Behavior in an Efficient Market 403 The Efficient Markets Hypothesis 404 Some Common Misconceptions about the EMH 405 The Forms of Market Efficiency 407

12.6 Summary and Conclusions 407

Chapter 13

Return, Risk, and the Security Market Line 415

13.1 Expected Returns and Variances 416

Expected Return 416 Calculating the Variance 418

13.2 Portfolios 420 Portfolio Weights 420 Portfolio Expected Returns 420 Portfolio Variance 422

13.3 Announcements, Surprises, and Expected Returns 423

Expected and Unexpected Returns 423 Announcements and News 424

13.4 Risk: Systematic and Unsystematic 425 Systematic and Unsystematic Risk 425

Systematic and Unsystematic Components of Return 426

13.5 Diversification and Portfolio Risk 427

The Effect of Diversification: Another Lesson from

Market History 427 The Principle of Diversification 428 Diversification and Unsystematic Risk 429 Diversification and Systematic Risk 429

13.6 Systematic Risk and Beta 430 The Systematic Risk Principle 430 Measuring Systematic Risk 431 Portfolio Betas 432

13.7 The Security Market Line 433

Beta and the Risk Premium 434 The Reward-to-Risk Ratio 435 The Basic Argument 435 The Fundamental Result 437 The Security Market Line 439 Market Portfolios 439 The Capital Asset Pricing Model 439

13.8 The SML and the Cost of Capital: A Preview 442

The Basic Idea 442 The Cost of Capital 442

13.9 Summary and Conclusions 443

Chapter 14

Options and Corporate Finance 453

14.1 Options: The Basics 454

Puts and Calls 454

Stock Option Quotations 454

Option Payoffs 456

14.2 Fundamentals of Option Valuation 459 Value of a Call Option at Expiration 459

The Upper and Lower Bounds on a Call Option's Value 459 The Upper Bound 460 The Lower Bound 460 A Simple Model: Part I 461 The Basic Approach 462 A More Complicated Case 462 Four Factors Determining Option Values 463

14.3 Valuing a Call Option 464 A Simple Model: Part II 464 The Fifth Factor 465

A Closer Look 466

14.4 Employee Stock Options 467

ESO Features 467 ESO Repricing 468

14.5 Equity as a Call Option on the Firm's Assets 468

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