0:39

As a result a project where,

Â by the way, when I say project, I mean small, big, anything.

Â The whole company is like a project.

Â Project's risk is largely.

Â 1:08

Across assets.

Â Why? Because everything unique

Â to the project is gone.

Â It gotten diversified.

Â Not because of the manager.

Â This is rare but say the important thing the manager think like they invest.

Â The investor is not worried about your project, if they were worried about your

Â project that would be exactly when all their money's in your project.

Â That's not the case.

Â They're worried about your project to the extent that it's related to the market and

Â look at the beauty of this.

Â How are all those relationships captured?

Â 1:44

Ri, which in our case was Apple,

Â alpha plus beta i, market,

Â plus epsilon i.

Â I have replaced in the typical regression y on the left hand side by Ri.

Â 2:44

You know it was just waiting for finance to happen.

Â So quick thing I want to move on now is given all this development,

Â what does it mean?

Â First, risk is defined, I told you, defined.

Â 3:06

How easy, how easily measured, just a regression.

Â I must emphasize, though, that as soon as you round just to the ratio we have to

Â worry about how months of data, typically 60, did the anomaly you are trying to

Â measure, in this case apple, has not changed dramatically.

Â Still looks similar in the past to what your business is, which is orange, right.

Â So things like that.

Â And I'm not going to talk too much about that because that falls in the domain of

Â statistics but you have to do this intelligently.

Â There are statistical biases you have to worry about and so on.

Â So, if I want to measure beta properly, you need to know statistics.

Â And I am skipping that part and moving on to something that is extremely important.

Â Is how do I know use this risk measure, to figure out what.

Â I was interested in risk to figure out the return.

Â Because risk drives return, which then I will use to evaluate orange.

Â And why Apple's return?

Â For two reasons.

Â One again, Apple is comparable and second,

Â at this point, we have seen that debt is equal to 0.

Â So Apple's return on equity which is in this regression will also,

Â the risk of this equation is telling me the risk of the equity of Apple right?

Â That will also determine the return of equity of Apple.

Â But because there's no debt RA and RE for

Â Apple are the same and I'm in business because I am after RA.

Â Okay.

Â So let's see how do I develop that relationship?

Â 6:30

The first part is the average market risk premium.

Â So what you want to figure out is, how much does the market give over and

Â above the risk free rate?

Â Remember the table we saw last week?

Â 6:44

In America, the rate of return on average over the last 70, 80 years,

Â we, in books, tend to use about 7%.

Â I'm very wary of this, because remember, you're going to use this.

Â There's a lot of data backing it, 80 years.

Â But what did I tell you?

Â One of the biggest questions is why has this been so high?

Â So this is a little bit questionable, but used very commonly.

Â Many people do surveys of what it's likely to be in the future.

Â If you put all data together, this has to be a lower number and

Â it's a very powerful number.

Â Because, even if you change it to, say, 5%, what some people suppose,

Â it has a dramatic impact, because a 2% rate of return is a huge amount.

Â So you start off with the risk to create.

Â You add to it the risk premium on the market.

Â 7:34

But the risk premium on the market is not what a project is.

Â What is the risk of your project?

Â It's your beta relative to the market.

Â So these two things multiplied together tells you the risk premium for Apple.

Â So let me give you some, let's move on, and get some intuition for this.

Â Because, I think, this is probably the most used equation other than

Â discounted value of, the stock prices, the discounted value of dividends.

Â Look at this equation linearly.

Â What is it showing?

Â First of all, the graph, what is the risk free asset here?

Â 8:26

And the reason and the thing I like about it is it's very easy to measure.

Â Right?

Â It's the one thing I know about the future is how much will a government bond pay.

Â And why do I feel confident?

Â Because I believe the government will pay.

Â 8:42

This is the risk premium which I will say should be somewhere between 5 and

Â 7% and this is where it's very important to recognize which

Â number you want to use here and textbooks tend to use 7% I believe.

Â It is a good idea to use 5% as well, at a minimum.

Â Because remember, all the answers are not perfectly precise.

Â And what is there?

Â 9:07

This is the risk of comparable equity.

Â Why?

Â It's almost always the risk of the equity, why?

Â Because equity trades, and even if there's debt in your business,

Â 9:28

most countries debt is a private contract between the company and a bank.

Â So it doesn't trade.

Â In America you can get some information on debt as well.

Â But typically if you see a beta anywhere, and

Â we'll see some soon, it's about the equity.

Â Because equity trades and easy to calculate.

Â Now here is ironic,

Â which is more difficult in instrument to think about debt or equity?

Â Debt is a contract, simple to understand.

Â Equity, love and fresh air.

Â [LAUGH] Very tough, but

Â on the other hand risk of these to capture because of training.

Â Don't forget the importance of market.

Â Okay, so what does this say?

Â That the return that is expected, and please recognize

Â 10:12

all r's in this are expected, because it is about the future.

Â You are going to use them from the past data except for

Â rf because you know it about the future and assure the government will pay.

Â Please remember the expected is very important you are trying to

Â project to the future what may happen, that's why I gave you an emphasis on.

Â Don't use 7% for all for r and minus rf so easily, because it's questionable.

Â 11:10

Right?

Â What's the risk of the risk free asset?

Â So rf, its beta f has to be 0, by definition.

Â Why?

Â Because a government bond, remember I told you what the risk was?

Â Was 0 simply because I believed I will get 1,000 regardless of the state of

Â the world, the face value of 1,000.

Â So bf is 0.

Â So, I pick up the treasury build rates.

Â Suppose it's 4%.

Â Tell me which point I will have to find on the graph.

Â 4%.

Â I botched here and I know beta is 0.

Â There's another guy whose beta I know.

Â And what is that?

Â 12:12

Sol I have two points, one is this and

Â one is this, and I draw this red line right through.

Â You see how simple this is, and that's the simplicity I was talking about.

Â One little equation.

Â 12:26

So let me ask you this, what should be the return on a risk free asset?

Â Suppose I found another project which I believed had no risk.

Â Unlikely, but let's find it.

Â What should its return be?

Â Well if its risk is 0,

Â I plug in 0 here, this whole thing cancels, I'm left with a risk free rate.

Â Does that make sense?

Â 12:49

Absolute sense.

Â Let me give you one more intuition.

Â Let me ask you.

Â What is the risk of a portfolio, or sorry, let's not talk about a portfolio.

Â What is the risk of a project whose riskiness is the same as the market?

Â That is, the project moves one and one with the market, 1% up, 1% down.

Â Its beta is what?

Â 13:25

Because what happens when you plug 1?

Â Rf and rf cancel.

Â Isn't this cool?

Â What it is saying?

Â It's saying you can predict what's going to happen for

Â two points and they all both make sense.

Â If your projects almost risk free, your discount rate should be risk free right.

Â Think about this,

Â if your project is bananas your discounter should reflect banana.

Â 14:56

That's the premium in the market place that you [INAUDIBLE].

Â Is this measurable?

Â Sure.

Â If the first two are measurable I can go historically and

Â look at the difference over 80 years, or over earlier markets and so on.

Â And this could be 7% or 5% or many people believe maybe even less.

Â 15:18

And this is the biggest research area.

Â One of the biggest research areas in finance,

Â is why has the risk premium been so high?

Â In the US, more importantly, will it be the same in the future.

Â 15:47

The intuitive and simple idea is that people are risk averse.

Â They therefore hold portfolios.

Â If they hold portfolios the risk of

Â one thing will depend on its relationship with a bunch of other things.

Â That one thing in our case is Apple because we are trying to evaluate orange

Â comparable.

Â And what is everything else?

Â The whole marketplace.

Â 16:11

Simple measure of risk, why?

Â Because not only is the idea simple, the measure of risk is very simple.

Â How do we measure it?

Â We have done it at length, I'm just highlighting everything.

Â You measure it by taking returns on Apple, a comparable for us, and

Â running a regression on markets.

Â 16:39

I think this is even, so the idea is simple, the measure of risk is simple,

Â but the relationship between risk and return is just so simple and

Â intuitive, and that is what we talked about in CAPM.

Â It's linear, and

Â easy to measure.

Â Very easy to measure.

Â I mean I'm getting a little carried away here, but I understand.

Â Why? Because I can't think of anything

Â that could have been simpler than that and easily measurable, of course.

Â Is it perfect?

Â Answer is no.

Â 17:22

Lot of research has shown, not surprisingly, that not all assets

Â fit this perfect relationship between when you measure the beta and

Â you measure the return.

Â Beta doesn't capture all the riskiness.

Â And that's not surprising, is it?

Â [LAUGH] For example, if I told you you can measure love.

Â Would you find one simple linear relationship if you did there's something

Â missing, am I right?

Â But the awesomeness of this is conceptually it's so

Â clean, and practically measuring is so clean too.

Â But don't expect it to do wonders every time, okay?

Â In a more detailed class,

Â we measure different ways of measuring risk and return.

Â But the profound simple fact is this.

Â If you hold a diversified portfolio,

Â you should just be looking at common elements across securities, not specific.

Â And that basic idea carries through all future developments.

Â I wanted to highlight that.

Â Don't expect it to be perfect.

Â But it's profoundly close to perfect.

Â