Measuring a Project’s Market Risk If we are looking at an investment in a share of stock, we could compare

Measuring a Project’s Market Risk If we are looking at an investment in a share of stock, we could compare

the stock’s returns and the returns of the entire market over the same period of time as a way of measuring its market risk. While this is not a perfect measurement, it at least provides an estimate of the sensitivity of that particular stock’s returns as compared to the returns of the market as a whole. But what if we are evaluating the market risk of a new prod- uct? We can’t look at how that new product has affected the firm’s stock return! So what do we do?

Though we can’t look at a project’s returns and see how they relate to the returns on the market as a whole, we can do the next best thing: Estimate the market risk of the stock of another firm whose only line of business is the same as the project’s. If we could find such a company,

1 Because the frequency distribution is a sampling distribution (that is, its based on a sample of observations instead of a probability distribution), its standard deviation

is calculated in a slightly different manner than the standard deviation of possible outcomes. The standard deviation of a frequency distribution is:

= ----------------------------- i ) Standard deviation of frequency distribution f i

Σx 2 ( – x

N1 – where x i is the value of a particular outcome, is the average of the outcomes, x f i is

the number of times the particular outcome is observed (its frequency), and N is the number of trials (e.g., number of times a coin is flipped). The interpretation of this standard deviation is similar to the interpretation of the standard deviation discussed previously.

There are two differences between the standard deviation of the frequency distri- bution and that of the probability distribution: Instead of the probability, the weights are the frequency, and the sum of the weighted outcomes is divided by the number of trials (less one).

LONG-TERM INVESTMENT DECISIONS

we could look at its stock’s market risk and use that as a first step in estimating the project’s market risk.

Let’s use a measure of market risk, referred to as beta and represented by β. β is a measure of the sensitivity of an asset’s returns to change in the returns of the market. β is an elasticity measure: If the return on the mar- ket increases by 1%, we expect the return on an asset with a β of 2.0 to increase by 2%; if the return on the market decreases by 1%, we expect the returns on an asset with a β of 1.5 to decrease by 1.5%, and so on. The β of an asset, therefore, is a measure of the asset’s market risk. To dis- tinguish the beta of an asset from the beta we used for a firm’s stock, we refer to an asset’s beta as β asset and the beta of a firm’s stock as β equity .