Risky CFs
How did you find this fair value? . Discounted the expected cash flow by what the expected return on other assets of "similar" risk This gives you what it would cost to buy similar expected cashflows in the market, which is the fair value The expected return you use is called the opportunity cost of capital (OcC) What you could be earning if you invested in an asset with the same risk Effectively, you're saying: I won't invest in this asset unless it's paying me as much as I could be making elsewhere Therefore, the fair value is just a PV, using The expected cash flow and : The expected rate of return on assets of similar risk
Rules to find the fair value of a risky cash flow: : Calculate the expected cash flow : Find the expected return on assets with "similar" risk
Discount just as with riskless cash flows
What drives prices to fair value
Supply and demand Two ways to get $105 in one year: Buy my asset, pay $. Buy the asset in the marketplace which has the same risk, pay $. If one costs more, people buy the other But cannot create riskfree arbitrage with immediate profit : Nothing to force prices together immediately . Prices will adjust eventually. When? Who knows Contrast with riskfree
Examples
Asset X is expected to pay $200 in ten years. Assets of the same risk are expected to pay 5% per year. What is the OCC? What is the fair value of asset X?
Suppose asset X were expected to pay $10 each year for ten years, first payment at year 1. Rule:
Another example
A bond promises to pay $1000 in five years. However, the company that issued it may go bankrupt. If the company goes bankrupt, the bond will pay nothing. The probability of
is the fair value of the bond? Rule:
Risky Cfs
Rules to find the fair value of a risky cash flow: Calculate the expected cash flow : Find the expected return on assets with "similar" risk Discount just as with riskless cash flows What are the two cat