CORPORATE

FINANCE

MSC. VU MINH NGOC (MS) - [email protected]

FACULTY OF BANKING & FINANCE – FOREIGN TRADE UNIVERISTY
 ¡ Chapter 1 : Introduction to Financial Management
¡ Chapter 2 : Financial Statement Analysis
CONTENTS ¡ Chapter 3 : Investment Projects & Appraisal Method
¡ Chapter 4 : Risk, Return and CAPM
¡ Chapter 5 : Capital Structure
¡ Chapter 6 : Dividend Policies
CHAPTER 4

RISK, RETURN AND CAPM

 • RISK, RETURN
• TYPES OF RISK AND MEASUREMENT

OUTLINE • PORTFOLIO DIVERSIFICATION

• CAPITAL ASSET PRICING MODEL
(CAPM) AND ITS APPLICATION
 • RISK, RETURN
• TYPES OF RISK AND MEASUREMENT
• PORTFOLIO DIVERSIFICATION
OUTLINE • CAPITAL ASSET PRICING MODEL
(CAPM) AND ITS APPLICATION
RISK & RETURN

1. Rate of Return:
The rate of return (RoR) is a measure
used to evaluate the performance of an
investment over a specified period of
time.
RISK & RETURN
1. Rate of Return:

Historical Return: The return that an asset has already

produced over a specified period of time

Expected Return: The return that an asset is expected to

produce over some future period of time

Required Return: The return that an investor requires an

asset to produce if he/she is to be a future investor in that
asset
RISK & RETURN
1. Rate of Return:

o Historical Return: indicates how much additional money can be earned for every 1 unit of currency
invested. It is calculated by dividing the total return by the initial invested capital.
o Calculating Historical Return:
Ending Value − Beginning Value + Income
Historical Return = x 100
Beginning Value
Where:
• Ending Value: The value of the investment at the end of the period.
• Beginning Value: The value of the investment at the start of the period.
• Income: Any additional income received from the investment during the period (e.g., dividends, interest).
RISK & RETURN
1. Rate of Return:

o Calculating Historical Return:

D + P! − P"
Historical Return = x 100
P"

o Example: Suppose a stock begins the year

with a price of $25 per share and ends with a
price of $35 per share. During the year, it paid
a $2 dividend per share. What are its dividend
yield, capital gains yield, and total return for
the year?
RISK & RETURN
1. Rate of Return:

o Limitations of Historical Return:

• Past Performance is Not Indicative of Future Results: Historical returns provide no guarantee of future
performance.
• Market Changes: Economic conditions, market dynamics, and other factors can change, affecting future
returns.
• Survivorship Bias: Analyzing only those investments that have survived over the period can give an
overly optimistic view of historical performance.
RISK & RETURN
1. Rate of Return:

o Expected Return: The anticipated amount of profit or loss an investor can expect to receive from an
investment. It is an average value of possible returns, weighted by the probabilities of those returns
occurring.
o Calculating Expected Return:
Where:
R ! : Return in scenario i
E R = $(R! x P! )
P! : Probability of scenario i occurring
∑: Summation over all possible scenarios
RISK & RETURN
1. Rate of Return:

o Example: Company A and Company B have the following potential returns and probabilities:

Economy Probability Return rate of A Return rate of B

Recession 0.3 -5% -10%
Normal 0.2 10% 15%
Prosperity 0.5 15% 20%

Ø E R " = ∑(R ! x P! ) = 0.3x-5%+ 0.2x10% + 0.5x15% = 8%

Ø E R # = ∑(R ! x P! ) = 0.3x-10%+ 0.2x15% + 0.5x20% = 10%
RISK & RETURN
1. Rate of Return:

o Limitations of Expected Return:

• Doesn't Account for Risk.
• Assumes Known Probabilities.
• Ignores Timing of Cash Flows.
• May Oversimplify Complex Investments.
• No Guarantee of Actual Performance.
• Subjectivity and Bias.
RISK & RETURN
1. Rate of Return:

o Required Return:
Ø For a Treasury security, what is the required rate of return?
Ø For a Company's securities, what is the required rate of return?
RISK & RETURN
1. Rate of Return:

o Required Return:
o For a Treasury security, what is the required rate of return?

Required rate of return = Risk-free interest rate

o Why?
Ø Treasury securities are considered to have virtually no default risk since they are backed by the
full faith and credit of the government issuing them.
Ø The rate of Treasury securities is commonly regarded as the risk-free interest rate.
RISK & RETURN
1. Rate of Return:

o Required Return:
o For a Company's securities, what is the required rate of return?

Required interest rate = Risk-free interest rate + Risk premium

Ø How much risk premium should we demand when purchasing securities of a company?
RISK & RETURN
2. Risk Premium:

o The rate of return on T-Bills is essentially “risk-free”.

o Investing in stocks is risky, so there must be some compensations.
o The risk premium for investing in stocks is the difference between the return on stocks and T-bills.
RISK & RETURN
3. Interest Rate:
o Determinants: Interest rates are influenced by a variety of factors, both macroeconomic and
market-specific.

Central Bank
Policy
Market
Expectations Inflation

Government Interest Economic

Deb rate Growth

Global Supply and

Economic Demand for
Conditions Credit
Risk
Premium
RISK & RETURN
3. Interest rate:

o Interest rate adjusted for inflation:

Interest Rate: the percentage rate that a borrower must pay for borrowing money or that a lender
receives for lending money.
Nominal Interest Rate: not adjusted to reflect inflation or price changes.
Real Interest Rate: adjusted to reflect inflation or the depreciation of currency; typically indicates
the actual value of the benefit that an investment or loan can bring in the context of the global
economic environment.
RISK & RETURN
3. Interest rate:

o Interest rate adjusted for inflation:

o Conceptually:

Nomial interest rate = Real interest rate + Anticipated inflation rate

(i) (R) (r)

o Mathematically:

(1+i) = (1+R) x (1+r)

RISK & RETURN
3. Interest rate:

o Example: Assuming you bought 1 bond with a 6% interest rate one year ago at a price of $1,040,
and today it's being sold at a price of $1,063.
a. Suppose the face value of the bond is $1,000, calculate the total profit after one year of this
investment.
b. Calculate the nominal interest rate of this investment.
c. Assuming the inflation rate for the past year was 3%, calculate the real interest rate of this
investment.
 • RISK, RETURN
• TYPES OF RISK AND MEASUREMENT
• PORTFOLIO DIVERSIFICATION
OUTLINE • CAPITAL ASSET PRICING MODEL
(CAPM) AND ITS APPLICATION
TYPES OF RISK AND MEASUREMENT

Have you
o Example: Company A and Company B have the following potential returns and probabilities:
considered
Economy Probability Return rate of A Return rate of B
RISK?
Recession 0.3 -5% -10%
Normal 0.2 10% 15%
Prosperity 0.5 15% 20%

Ø E R " = ∑(R ! x P! ) = 0.3x-5%+ 0.2x10% + 0.5x15% = 8%

Ø E R # = ∑(R ! x P! ) = 0.3x-10%+ 0.2x15% + 0.5x20% = 10%
Ø Based only on your expected return calculations, which company share would you prefer?
TYPES OF RISK AND MEASUREMENT
1. Definition

o The possibility that an actual return will differ from our expected return
o Uncertainty in the distribution of possible outcomes
o Risk cannot be avoided, it is necessary to:
Ø Measure the risk
Ø Minimize the risk.
TYPES OF RISK AND MEASUREMENT
2. The relationship between return and risk

o Investors always demand a proportional level of risk and return. The higher the investor's risk
tolerance, the greater the expected return.
o If securities have equal levels of risk, investors will invest in securities with the highest returns.
o If securities have equal returns, investors will invest in securities with the lowest risk.
 TYPES OF RISK AND MEASUREMENT
2. The relationship between return and risk
“THE HIGHER THE RISK, THE HIGHER THE EXPECTED RETURN, AND VICE VERSA”
TYPES OF RISK AND MEASUREMENT
3. Types of risk:

o Systematic Risks (market risks or non-diversifiable risks): affect the entire market or a large
segment of the market. These risks are inherent to the entire market and cannot be eliminated
through diversification.
o Unsystematic Risks (specific risks or diversifiable risks): affect a specific company, industry, or
sector. These risks are unique to a particular business or industry and can be mitigated through
diversification.
TYPES OF RISK AND MEASUREMENT
3. Types of risk:

o Example:

•Economic Recessions: Economic downturns •Business Risk: Risks related to a company's

affect most sectors and industries. operations, such as management decisions, product
•Interest Rate Changes: Central bank policies recalls, or labor strikes.
impacting interest rates affect borrowing costs and •Financial Risk: Risks related to a company's
investment returns broadly. financial structure, such as high levels of debt or
•Political Instability: Changes in government liquidity issues.
policies, geopolitical tensions, or political upheaval •Industry Risk: Risks specific to an industry, such
can impact financial markets globally. as changes in technology, regulation, or consumer
•Natural Disasters: Large-scale events like preferences affecting a particular sector.
hurricanes, earthquakes, or pandemics can disrupt
markets.
TYPES OF RISK AND MEASUREMENT
4. Risk measurements:

o Variance: measures the average squared deviation of each data point from the mean of the dataset.
It quantifies how spread out the numbers are in a set.
Ø A higher variance indicates higher volatility and, therefore, higher risk.
o Standard deviation: measures the dispersion of returns for a given security or portfolio. It
indicates the extent to which returns can deviate from the average return.
Ø A higher standard deviation indicates higher volatility and, therefore, higher risk.
TYPES OF RISK AND MEASUREMENT
4. Risk measurements:

o Variance: measures the average squared deviation of each data point from the mean of the dataset.
It quantifies how spread out the numbers are in a set.
Ø A higher variance indicates higher volatility and, therefore, higher risk.
o Calculating variance:
𝝈𝟐 =∑ 𝑷𝒊 [(𝑹𝒊 − E(𝑹𝒊 )]𝟐
o Where:
𝑷𝒊 : the probability of each return 𝑹𝒊
𝑹𝒊 : each possible return.
E(𝑹𝒊 ): expected return
TYPES OF RISK AND MEASUREMENT
4. Risk measurements:

o Standard deviation: measures the dispersion of returns for a given security or portfolio. It
indicates the extent to which returns can deviate from the average return.
Ø A higher standard deviation indicates higher volatility and, therefore, higher risk.
o Calculating standard deviation:
𝝈 = 𝝈𝟐 = ∑ 𝑷𝒊 [(𝑹𝒊 − E(𝑹𝒊 )]𝟐
o Where:
𝑷𝒊 : the probability of each return 𝑹𝒊
𝑹𝒊 : each possible return.
E(𝑹𝒊 ): expected return
TYPES OF RISK AND MEASUREMENT
4. Risk measurements:

o Coefficient of Variation (CV): indicates the amount of risk per unit of expected return.
o Formula:
𝝈
CV =
E(7)
Ø The smaller the coefficient of variation, the better. If two investments have the same coefficient of
variation, the one with the higher expected return is preferable.
TYPES OF RISK AND MEASUREMENT
Example: Calculate Variance and Standard deviation of 2 companies:

Economy Probability Return rate of A Return rate of B

Recession 0.3 -5% -10%
Normal 0.2 10% 15%
Prosperity 0.5 15% 20%
 • RISK, RETURN
• TYPES OF RISK AND MEASUREMENT
• PORTFOLIO DIVERSIFICATION
OUTLINE • CAPITAL ASSET PRICING MODEL
(CAPM) AND ITS APPLICATION
PORTFOLIO DIVERSIFICATION
1. Portfolio:

o A portfolio is a collection of assets.

o An efficient portfolio is:
One that maximizes the return for a given level of risk.
OR
One that minimizes risk for a given level of return.
PORTFOLIO DIVERSIFICATION
1. Portfolio:

o Portfolio returns: Is calculated as a weighted average of returns on the individual assets from which it is
formed.
o Formula:

Where:
rp = Return on a portfolio
wj = Proportion of the portfolio’s total dollar value represented by asset j
rj = Return on asset j
PORTFOLIO DIVERSIFICATION
1. Portfolio:

o Risk Preferences:
§ Risk lover (Risk taker): willing to engage in activities that involve a high degree of uncertainty or
potential for loss, with the expectation that these activities could yield high returns or benefits.
§ Risk averse: Unwilling to incur losses and not interested in the potential profits from volatility. Their
main concern is the guaranteed profit from known business outcomes that are not affected by risk.
§ Risk neutral: Indifferent towards risk, without a clear preference for or against it.
PORTFOLIO DIVERSIFICATION
1. Portfolio:
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

o A portfolio’s risk:
§ The risk of a portfolio is the possibility that the actual return of the portfolio will differ from the
expected return of the portfolio.
o Portfolio’s risk determinants:
§ Asset Allocation: The distribution of investments across different asset classes (such as stocks, bonds,
real estate, and cash) significantly impacts the overall risk.
§ Individual Asset Risk: The inherent risk associated with each investment within the portfolio.
§ Correlation Between Assets: The degree to which assets move in relation to one another.
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

o How to measure a portfolio’s risk:

Ø Covariance
Ø Correlation Coefficient
Ø Portfolio Variance
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Covariance: is a statistical measure that indicates the extent to which two variables change together.

Cov(r" , r# )=∑&!$% p(i) r" i − r" r# i − r#

Where
p! : The probability of scenario i
r" : The return of asset A in scenario i
r# : The return of asset B in scenario i
r" : The average return of asset A
r# : The average return of asset B
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Covariance: is a statistical measure that indicates the extent to which two variables change together.

Cov(r" , r# )=∑&!$% p(i) r" i − r" r# i − r#

Ø Positive covariance: The returns of asset A and asset B move in the same direction
Ø Negative covariance: The returns of asset A and asset B move in opposite directions
Ø Covariance = 0: The returns of asset A and asset B have no linear relationship with each other
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Correlation Coefficient: Standardized measure that quantifies the strength and direction of the linear
relationship between two variables.
o Formula:
Cov(R 9 , R : )
𝜌9: =
𝜎9 . 𝜎:
Where:
Cov(R " , R # ): is the covariance between A and B.
𝜎9 : is the standard deviation of A
𝜎: :is the standard deviation of B
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Correlation Coefficient: Standardized measure that quantifies the strength and direction of the linear
relationship between two variables.
Ø Interpretation
o Positive values (0 < r ≤ 1): Indicates a positive linear relationship. The variables tend to move in the
same direction.
o Negative values (-1 ≤ r < 0): Indicates a negative linear relationship. The variables tend to move in
opposite directions.
o Value close to 0: Indicates a weak or no linear relationship.
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Portfolio Variance: s a measure of the dispersion of returns for a portfolio of assets.

PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Portfolio Variance: s a measure of the dispersion of returns for a portfolio of assets.

o General formula:
PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Portfolio Variance: s a measure of the dispersion of returns for a portfolio of assets.

o Formula for 2-asset portfolio:

o Formula for 3-asset portfolio:

PORTFOLIO DIVERSIFICATION
2. Portfolio’s Risk Management:

Ø Portfolio Variance: s a measure of the dispersion of returns for a portfolio of assets.

o Example: Consider a portfolio with two assets, A and B: Assume the covariance between the returns of
assets A and B is 0.005. Calculate the variance of this portfolio.
PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Example: Enron’s scandal (2001):

PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Example: Enron’s scandal (2001):

PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Diversify your investment portfolio:

Help reduce unsystematic risk

by investing in a portfolio of
securities with mixed returns.
PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Diversify your investment portfolio:

PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Diversify your investment portfolio:

Perfectly
positively No effect on risk
correlated

Investing in
If securities
two securities are
to reduce risk
Perfectly
Perfect diversification.
negatively
Risk is minimised
correlated
 PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Effects of portfolio diversification:

v The overall risk of a portfolio depends not only on
the risk of each asset in the portfolio, but also on
the relationship between the returns on two assets.
v Basic principle: Don't put all your eggs in one
basket.
Ø Choosing assets with low correlation will help
significantly reduce the risks of the portfolio.
PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:
o Effects of portfolio diversification:
We have data on the risk and expected returns of stocks A and B as follows:
A B
Expected Return (%) 11 25
Standard deviation (%) 15 20
Correlation 0.3

The potential combinations between stocks A and B:

W(A) 100% 80% 60% 40% 20% 0%
W(B) 0% 20% 40% 60% 80% 100%
E(Rp) 11% 13.8% 16.6% 19.4% 22.2% 25%
Std. of the Portfolio 15.0% 13.7% 13.7% 14.9% 17.2% 20%
 PORTFOLIO DIVERSIFICATION
3. Portfolio Diversification:

o Effects of portfolio diversification:

• Diversifying an investment portfolio is critically
important as it reduces the individual risks associated
with each separate investment.
• Diversification does not reduce systemic risk because
this is the risk caused by changes affecting the entire
economy or financial system.
 • RISK, RETURN
• TYPES OF RISK AND MEASUREMENT
• PORTFOLIO DIVERSIFICATION
OUTLINE • CAPITAL ASSET PRICING MODEL
(CAPM) AND ITS APPLICATION
 CAPITAL ASSET PRICING MODEL
o The Capital Asset Pricing Model (CAPM): This model describes the relationship between risk and
expected return.
o Assumptions of the model: Investors hold fully diversified portfolios. Therefore, the risk investors face is
only systematic risk/market risk. Thus, the risk of a well-diversified portfolio depends on the market risk
of the securities in the portfolio.
o Market risk of the securities in the portfolio: is determined by measuring the sensitivity of those
securities to market fluctuations. This sensitivity is called Beta.
 CAPITAL ASSET PRICING MODEL
o CAPM equation:
 CAPITAL ASSET PRICING MODEL
o The Beta in CAPM:

• It's a coefficient that reflects the risk of a stock compared to the overall market risk of stocks in general
(the "market" here refers to the stock market as a whole).
• Formula
 CAPITAL ASSET PRICING MODEL
o Security Market Line (SML): The
Security Market Line (SML) is a
graphical representation of the Capital
Asset Pricing Model (CAPM). It depicts
the relationship between the expected
return and the beta (systematic risk) of
an asset.
• 𝛽 =0, The required rate of return on
securities equals the risk-free rate.
• 𝛽 =1, The required rate of return on
securities equals the market rate of
return.
 CAPITAL ASSET PRICING MODEL
o Example: Suppose the following information about a stock is known:
• It trades on the NYSE and its operations are based in the United States
• Current yield on a U.S. 10-year treasury is 2.5%
• The average excess historical annual return for U.S. stocks is 7.5%
• The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P500 over the last
2 years)
Ø What is the expected return of the security using the CAPM formula?
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