[MUSIC] Most of the focus of this lesson has been on analyzing capital investment in real bricks and mortar machinery. Or virtual bricks and motor things like computer software programs that modern businesses need. But there is another side to corporate finance that deals with managing financial capital. And at least one of the important topics in these area has to do with the stock market and constructing portfolios of stocks and other financial assets in an efficient and profitable manner. While this side of corporate finance is quite complex, and well beyond the scope of an introductory microeconomic principles course. And you want to end this lesson by at least introducing you to some of the key ideas underlying optimal stock market portfolio construction. And what I mean by that at a practical level is learning how to invest and speculate in the stock market intelligently rather than as a wild gambler. So, in this module, we will start with a leisurely stroll through one of the most famous models in finance, the capital asset pricing model, which is used to evaluate stock prices. Then, we will talk briefly about the intuition underlying the concept of a stock portfolio that best diversifies your investment risk. [MUSIC] Okay, let's start with this big picture. When we use the net present value approach, the value of proposed investment, like I've shown you how to do in this lesson, we are engaging in an exercise in capital budgeting for our business. The central question we're trying to answer is whether any given investment is worth pursuing. And our measuring yard stick is whether the investment will add value to the firm with its net cash flow contributions. Check this out, for companies that are publicly traded on stock market, we're really asking when we evaluate the desireability of a new capital investment, is whether the proposed investment will increase or decrease the stock price of the company. Let me repeat that, for companies that are publicly traded on stock markets, what we're really asking when we evaluate the desirability of a new capital investment, whether the proposed investment will increase or decrease the stock price of the company. Question number four then is, how does the stock market go about evaluating individual stock and setting stock prices? Based on risks presented by investing in those companies. At least one answer, provided by strategic corporate command, the capital asset pricing model, illustrated in this video. [MUSIC] The capital asset pricing or CAPM model provides a formula that calculates the expected return on a security based on it's level of risk. In practice, the model can be used to determine what the required rate of return on a company stock must be. And therefore the stock price for an investor to add that stock to a well diversified portfolio. Here, in this formula, we see that the expected rate of return, R sub E, on the individual security has two components. First, there is the so-called risk-free rate of return, which is a way of measuring the time value of money. Second, there is a risk premium which equals a term called beta times the difference between the expected return of the broad market and the risk-free rate. Before I explain this model in detail, let's pause the presentation as you take a few minutes to study the various elements of the model. When you're ready, let's work our ways through each of the components. [MUSIC] Okay, let's start with our first term R sub E, this is what investors expect to earn from the individual stock. A plot twist here, of course, is that the actual realized return from the investment may deviate, up or down, from the expected return and that is the essence of risk. In fact, the actually or realized return from an investment may deviate substantially from the expected return for any number of reasons. For example, a biotech firm might see its new wonder drug wind up failing in clinical trials and go bust. Or, on the positive side, the small oil company might find a big new oil reserve and its stock price may boom. Most broadly, the finance profession calls these kinds of bad and good surprises unsystematic or diversifiable risk. Such surprises are unsystematic because they are isolated to companies or portions of industries. Unlike the business cycle risk aka macroeconomic risk, that we shall soon describe when I discuss the beta term in our model. But first, the risk free rate. [MUSIC] In our capital asset pricing model, R sub f is indeed the so-called risk-free rate of return. And the idea here is that an investor will always want to earn at least the minimum possible return that could be had from an investor that has no risk at all. A typical proxy for the risk-free rate is that return offered by a long term bond issued by a stable government like that of the United States. [MUSIC] Now the next term in the capital asset pricing model, the beta, is really interesting. This is a measure of broad business cycle or macroeconomic risk. In fact, this is the risk all companies face to some degree as members of the broader economy. The simple idea here is that if the economic system goes into a recession, most companies will suffer a reduction in sales and profits as demand for their products or services fall. And it is for this reason that business cycle risk or macroeconomic risk is called, in the finance profession, systematic risk. Now here's the interesting thing about the beta. It is explicitly designed to measure the business cycle sensitivity, also known as volatility, of an individual company or a particular industry. In a nutshell, a beta equal to 1 means that the company or industry in question will rise and fall exactly with the broader stock market. However, if the beta is greater than 1, the company or industry in question will move at a faster pace up or down than the broad stock market. To put this in a risk context, if, say, the economy is contracting in a recession, the stock price of a company with a beta greater than 1 will fall more than the broader market. In other words, a beta greater than 1 means both more volatility and greater risk for that company than investing in the broad market. In fact industries with betas greater than one are said to be cyclical industries and examples include autos, and housing, and restaurants and steel. And as a stock market investor, you certainly don't want to have your portfolio entirely in cyclical industries when a recession hits. That's where non-cyclical, or so-called defensive industries come into play. These lower volatility and less risky defensive industries have betas less than 1. That is, their stock prices rise and fall at a slower rate than the broad market. And examples include industries like food, pharmaceuticals and health care. The underlying intuition here, is that while consumers can easily cut back on new purchases of cars and houses during a recession. They still must eat and have their medicines, and get medical care. [MUSIC] This is the final part of the so-called risk-freemium in the capital asset pricing model. There is the term that is multiplied by the beta. This term is the difference between the expected broad market return and the risk-free rate. And the key idea here is this, by multiplying beta times this risk from the broad market, we are able to determine the risk of the individual stock or security relative to this broad market. [MUSIC] Okay, let us do a quick example. Suppose we are evaluating a highly cyclical stock using the capital asset pricing model. And we assume a risk-free rate of 5%, a beta of 2 for the company stock, and an expected market rate of return of 10%. What is the expected return on this highly cyclical stock needed, to add this to our portfolio? Let's pause now as you work this problem out. The answer, of course, is 15%, which, by the math of the capital asset pricing model, is simply this. The risk-free rate is 5%. And we must add this to the beta of 2 times the difference between an expected broad market return of 10% and the risk-free rate assumed to be 5%. In this math does indeed give us 15%. And of course, you should see from this example that if the beta is less than 1, the expected return will be lower. And that is, of course, because the level of risk is lower. [MUSIC] Now, you may have noted a bit earlier that I said that the unsystematic risk of a company or industry is also called diversifiable risk. And to end this lesson, I want to talk in broad terms about how the capital asset pricing model allows us to think about diversifying risk. The central idea behind risk diversification is based on the statistical concept of correlation. For example, if the profits of two companies tend to rise and fall together, those profits are said to be positively correlated. And if, however, the profits of two companies tend to move in the opposite direction, that's negative correlation. So, here's a question for you, do you think the profits of a suntan lotion company on the one hand and an umbrella company on the other hand, would be positively or negatively correlated? Think about that now as we pause the presentation because this question gets to the very essences of managing risk through diversification. [MUSIC] Well, the idea here is that the profits of the suntan lotion versus the umbrella company are likely to be negatively correlated because of weather conditions. In particular, if the weather in any given year is unseasonably sunny, the suntan lotion company will see its profit soar while the umbrella company is likely to suffer heavy losses. If, however, it's a very rainy year, the situation reverses. With that simple idea, we capture the essence of both stock market speculation and diversifying the stock portfolio. And here is the deal, by way this example. [MUSIC] Suppose you are a big time stock market speculator looking to earn the highest profit in an investment for your high-flying hedge fund. In this case, your weather forecast for the next coming years are a lot of sun and very little rain. So, you invest all your funds in a suntan lotion company. Now if your forecast turns out to be right, you will earn a big fat return on your investment. But if your forecast is wrong and it runs out to be very rainy year, you will lose big, and that's the essence of risk. [MUSIC] So, now, let's take of the same situation, but in this case, you no longer work for a hedge fund with a big appetite for risk. Instead, you are an investment manager for a massive pension fund that is very risk averse and just wants to earn a reasonable return without risking a big loss of capital. So even if your forecast is for a very sunny year, how are you likely to invest, assuming your only choices are the suntan lotion company or the umbrella company? Let's pause now as we think this through. [MUSIC] Well, in this case, the smart speculation may well be to invest equally in both the suntan lotion and umbrella companies. In this way, you effectively hedge your risk. In particular, the statistical negative correlation between the suntan lotion and umbrella companies will ensure that you won't lose big if your weather forecast is wrong. But, of course, such diversification and hedging of risk also means you won't earn as much as you might have if you put all your money on the suntan lotion company and your weather forecast turned out to be correct. This is indeed the essence of risk, and here's the key point. When any given stock market investment boils down simply to a wild guess, or even a forecast with a high probably of failure. It becomes a risky gamble rather than an intelligent speculation. And that's not a smart thing to do with your money. [MUSIC] At any rate, in this module, I'm giving you just a small taste of a really important topic. In our next lesson, we will move on to a discussion of two additional critical factors of production, labor and capital. In the meantime, maybe it's time for you to start watching the stock market every day, and begin learning about how the news drives the stock market, and vice versa. It's pretty interesting. And it can also be very profitable, only if you speculate intelligently. [MUSIC]
