FINA1310 CORPORATE FINANCE

Faculty of Business and Economics

University of Hong Kong

Prof. Shiyang HUANG

Lecture 6: Risk and Return

Stock Valuations: three scenarios
• Constant dividend
• The firm will pay a constant dividend forever
• The price is computed using the perpetuity formula

• Constant dividend growth

• The firm will increase the dividend by a constant percent every
period
• The price is computed using the growing perpetuity model

• Supernormal growth
• Dividend growth is not consistent initially, but settles down to
constant growth eventually
• The price is computed using a multistage model
Course Overview
• Introduction

• Part I: Valuation
• Time Value of Money, Discounted Cash Flow Valuation,
Bond and Stock Valuation.

• Part II: Risk and Return

• Historical Risk and Return Relationships, CAPM.

• Part III: Capital Budgeting

• Real Investment Decisions, Cost of Capital.

• Part IV: Financing Decisions

• Raising Capital, Tradeoff between Equity and Debt.
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

The Importance of Financial Markets
• Financial markets allow companies, governments and
individuals to increase their utility
• Savers have the ability to invest in financial assets so that
they can defer consumption and earn a return to
compensate them for doing so
• Borrowers have better access to the capital that is
available so that they can invest in productive assets
• One question
• How to choose assets/projects?
Asset Choices
• Objective
• Choose one asset or multiple assets?
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

Return Calculation – Dollar Return
• Total Dollar Return
= Income from Investment
+ Capital Gain (Loss) Due to Change in Price

• Example:
• You bought a bond for $950 one year ago. You have
received two coupons of $30 each. You can sell the
bond for $975 today. What is your total dollar return?

• Income = $60
• Capital gain = $25
• Total dollar return = $85
Return Calculation – Percentage Return
• It is generally more intuitive to think in terms of
percentages than dollar returns

• Dividend Yield
= Income / Beginning Price

• Capital Gains Yield

= (Ending Price – Beginning Price) / Beginning Price

• Total Percentage Return

= Dividend Yield + Capital Gains Yield
Return Calculation – Percentage Return
• You bought a stock for $35, and you received
dividends of $1.25. The stock is now selling for $40.

• What is your dollar return?

• What is your percentage return?

Dividend yield = ?
Capital gain yield = ?
Total percentage return = ?
Return Calculation – Percentage Return

• You bought a stock for $35, and you received

dividends of $1.25. The stock is now selling for $40.

• What is your dollar return? $6.25

• What is your percentage return?

Dividend yield = 1.25/35 = 3.57%
Capital gain yield = 5/35 = 14.28%
Total percentage return = 17.86%
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance
• Portfolio Theory
• CAPM

Reading : Chapters 12, 13

Statistical Background
• Sample (Historical) Measures:
𝑇1
𝜇Ƹ 𝑖 ≡ Σ𝑡=1 𝑅𝑖𝑡 (mean)
𝑇
1
𝜎ො𝑖2 ≡ Σ 𝑇 (𝑅𝑖𝑡 − 𝜇Ƹ 𝑖 )2 (variance)
𝑇−1 𝑡=1

𝜎ො𝑖 = 𝜎ො𝑖2 (standard deviation)

Example – Variance and Standard Deviation

Year Actual Averag Deviation from Squared

Return e the Mean Deviation
Return
1 .15 .105 .045 .002025
2 .09 .105 -.015 .000225
3 .06 .105 -.045 .002025
4 .12 .105 .015 .000225
Totals .42 .00 .0045

𝜎ෝ𝑖 2 = .0045 / (4-1) = .0015

𝜎ෝ𝑖 =.03873
Arithmetic vs. Geometric Mean
• Arithmetic average: return earned in an average period
over multiple periods
σ𝑇𝑡=1 𝑟𝑡
𝑟𝑎 =
𝑇
• Geometric average: average compound return per period
over multiple periods
𝑇

𝑟𝑔 = (ෑ(1 + 𝑟𝑡 ))1/𝑇 −1
𝑡=1
• The geometric average will be less than the arithmetic
average unless all the returns are equal
• Which is better?
• The arithmetic average is overly optimistic for long horizons
• The geometric average is overly pessimistic for short
horizons
• So, the answer depends on the planning period under
consideration
Example
• What is the arithmetic and geometric average for the
following returns?
• Year 1: 5%
• Year 2: -3%
• Year 3: 12%
Example
• What is the arithmetic and geometric average for the
following returns?
• Year 1: 5%
• Year 2: -3%
• Year 3: 12%

• Arithmetic average=(5-3+12)/3=4.67%

• Geometric average
=[(1+5%)*(1-3%)*(1+12%)]1/3-1
=4.49%
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

Comparison of Asset Classes
Comparison of Asset Classes
(1) U.S. Treasury Bills (Short-Term)
Comparison of Asset Classes
(2) U.S. Treasury Bonds (Long-Term)
Comparison of Asset Classes
(3) Large Company Stocks
Comparison of Asset Classes
(4) Small Company Stocks
Comparison of Asset Classes
Average Returns for Different Asset Classes
Investment Average Return

Large Stocks 12.3%

Small Stocks 17.1%

Long-term Corporate Bonds 6.2%

Long-term Government Bonds 5.8%

U.S. Treasury Bills 3.8%

Inflation 3.1%
Risk Premiums
• The “extra” return earned for taking on risk

• (US) treasury bills are considered to be risk-free

• The risk premium is the return over and above

the risk-free rate

Return = risk free return + risk premium

Average Annual Returns and Risk Premiums
Investment Average Return Risk Premium

Large Stocks (A) 12.3% 8.5%

Small Stocks (B) 17.1% 13.3%

Long-term Corporate Bonds 6.2% 2.4%

(C)
Long-term Government 5.8% 2.0%
Bonds (D)
U.S. Treasury Bills (E) 3.8% 0.0%

Which assets do you choose?

Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

Insert figure 12.13 here
What Makes Market Efficient?
• There are many investors out there doing research
• As new information comes to market, investors analyze the
information and trade based on the information

• If investors stop doing research on stocks, or if they do

research in a behaviorally biased way, then the market will
not be efficient
Common Misconceptions about EMH
• Efficient markets do not mean that you can’t make money

• They do mean that, on average, investors will earn a

return that is appropriate for the risk undertaken and there

is not a bias in prices that can be exploited to earn excess
returns
Market Efficiency Theory Implies …
• No Free Lunch, No Arbitrage
• Prices Fully Reflect All Available Information
• Prices Follow Random Walks
• Trade-Off Between Risk and Expected Return
• Investors Cannot Earn Abnormal, Risk-Adjusted Returns
• Active Management Does Not Add Value
 Three Forms of Market Efficiency
• Market efficiency is about whether/what information gets
incorporated in the price.
• Eugene Fama suggests that information can be organized into
three categories.
• Each category relates to a particular form of market efficiency.
Random Walk Theory
Random Walk Theory
Efficient Market Hypothesis
Weak Form Efficiency
• Prices reflect all past market information such as price and
volume

• If the market is weak form efficient, then investors cannot

earn abnormal returns by trading on market information

• Implies that technical analysis will not lead to abnormal

returns

• Empirical evidence indicates that markets are generally

weak form efficient
Weak Form Efficiency
Weak Form Efficiency
Semistrong Form Efficiency

• Prices reflect all publicly available information including

trading information, annual reports, press releases, etc.

• If the market is semistrong form efficient, then investors

cannot earn abnormal returns by trading on public

information

• Implies that fundamental analysis will not lead to

abnormal returns
Semistrong Form Efficiency
• Semi-strong form efficiency: investors cannot achieve
abnormal returns using publicly available information.

• To empirically test the semi-strong form of market efficiency,

we can look at stock price responses to various corporate
events, such as takeover announcements, dividend
initiations/omissions, earning announcements, and etc.

• We can also test if professional money managers can earn

abnormal returns in the stock market.
Semistrong Form Efficiency

• Let’s first look at takeover announcements.

• In most takeovers, the acquiring firm pays a premium over the

prevailing market price to the target firm.

• Takeover announcements are therefore associated with

increases in the stock prices of target firms.
• – Keown and Pinkerton (1981) study abnormal returns before and after
takeover attempts for 194 firms.
• – They show that this information is quickly incorporated into target
prices by the end of the trading day.
Semistrong Form Efficiency
• The following graph shows the price response of 194 targets to
takeover announcements.
• Interestingly, prices start increasing even before the announcements
(possibly due to market anticipation).
Semistrong Form Efficiency
• Another interesting piece of evidence that is generally
consistent with the semi-strong form of market efficiency
comes from the studies on U.S. mutual funds.

• – A mutual fund is an investment company that raises money

from (typically) small investors, and then invests its capital in
various securities, such as bonds and stocks.
• – The basic prediction of semi-strong form market efficiency is
that it should be difficult for mutual fund managers to earn
abnormal returns.
Semistrong Form Efficiency
• Carhart (1997) shows that mutual funds fail to provide
positive abnormal returns after controlling for risk.
Market underreaction to customer news
from Cohen and Frazzini (2008)
Strong Form Efficiency
• Prices reflect all information, including public and
private (insider information)
• If the market is strong form efficient, then investors
could not earn abnormal returns regardless of the
information they possessed
• Empirical evidence indicates that markets are NOT
strong form efficient and that insiders could earn
abnormal returns
Learning Insider Trading
• Whenever insiders (CEOs, CFOs, Presidents, Board
Chairs, and accountants) buy or sell the stocks of their
companies, they need to report to SEC.
• Mutual fund managers track the reporting of insider trading
• They tend to track a specific set of firms
• These behaviors are persistent
• Do active mutual funds benefit from learning insider
trading?
• Yes! The average tracked stock that an institution buys generates
annualized alphas of over 12% relative to the purchase of an
average non-tracked stock.
• Both semi-strong and strong form MTH are rejected.
• If lots of funds track insiders, what will happen?
Is the Market Really Efficient?
• There is some empirical evidence suggesting that
financial markets incorporate public information quickly.
• – S&P 500 index returns follow a random walk;
• – Stock prices respond to various corporate announcements
quickly
• –...
• The weak and semi-strong forms of market efficiency
may hold to some extent.
• The strong form of market efficiency is unlikely to hold.
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

Expected Returns
• Expected returns are based on the probabilities of
possible outcomes
• In this context, “expected” means average if the
process is repeated many times
• The “expected” return does not even have to be a
possible return

E ( R) = p1 R1 + p2 R2

n
E ( R) =  pi Ri
i =1

where pi = probability of state i occurring

Ri = return when state i occurs
Variance and Standard Deviation
• Variance and standard deviation measure the
volatility of returns
• Using unequal probabilities for the entire range
of possibilities
• Weighted average of squared deviations
For example,

σ 2 = p1 ( R1 − E ( R)) 2 + p2 ( R2 − E ( R)) 2

n
σ =  pi ( Ri − E ( R )) 2
2

i =1
Expected Returns
• Suppose you have predicted the following returns for
stocks C and T in three possible states of the
economy. What are the expected returns?

State Probability Stock C Stock T

Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% 1%
Expected Returns
• Suppose you have predicted the following returns for
stocks C and T in three possible states of the
economy. What are the expected returns?

State Probability Stock C Stock T

Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% 1%

ReturnC = .3(15) + .5(10) + .2(2) = 9.9%

ReturnT = .3(25) + .5(20) + .2(1) = 17.7%

 How to compute expected return and
variance for stock C?
Probability
(Return-
Probability *(Return-
State Probability Return Expected
* Return Expected
return) ^2
return) ^2
Boom 30% 15% 4.50% 0.260% 0.08%
Normal 50% 10% 5.00% 0.000% 0.00%
Recession 20% 2% 0.40% 0.624% 0.12%
Expected
return 9.90%
Variance 0.2029%
Example: Variance and Standard Deviation
• Consider the previous example. What are the variance
and standard deviation for each stock?
Stock C
2 = .3(15%-9.9%)2 + .5(10%-9.9%)2 + .2(2%-9.9%)2
=0.2029%
 = 4.50%
Stock T
2 = .3(25%-17.7%)2 + .5(20%-17.7%)2 + .2(1%-17.7%)2
= 0.7441%
 = 8.63%
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading : Chapters 12, 13

Portfolios
• A portfolio is a collection of assets

• An asset’s risk and return are important in how they

affect the risk and return of the portfolio

• The risk-return trade-off for a portfolio is measured by

the portfolio expected return and standard deviation,
just as with individual assets
Portfolio Theory – Portfolio Weights
• A portfolio is simply a specific combination of securities,
usually defined by portfolio weights that sum up to 1
𝑤 = {𝑤1 , 𝑤2 , … 𝑤𝑛 }
𝑁𝑖 𝑃𝑖
𝑤𝑖 =
𝑁1 𝑃1 + ⋯ + 𝑁𝑛 𝑃𝑛
1 = 𝑤1 + 𝑤2 + ⋯ + 𝑤𝑛

• Weights can be positive or negative

Portfolio Theory – Mean and Variance of

Portfolio Mean

𝑅𝑝 = 𝑤1 𝑅1 + 𝑤2 𝑅2 + ⋯ + 𝑤𝑛 𝑅𝑛
𝐸 𝑅𝑝 = 𝑤1 𝜇1 + 𝑤2 𝜇2 + ⋯ + 𝑤𝑛 𝜇𝑛 = 𝜇𝑝

• Expected return of a portfolio is the weighted average

expected returns of assets in the portfolio

• You can also find the expected return by finding the

portfolio return in each possible state and computing the
expected value as we did with individual securities
Example: Portfolio Weights
• Suppose you have $15,000 to invest and you have
purchased securities in the following amounts. What
are your portfolio weights in each security?

Stock Value Weight

DCLK $2000 13%

KO $3000 20%
INTC $4000 27%
KEI $6000 40%
Total $15000 100%
Example: Expected Portfolio Returns
• Consider the portfolio weights computed previously. If
the individual stocks have the following expected
returns, what is the expected return for the portfolio?

Expected Weight*Expected
Stock Value Weight
Return return
DCLK 2000 13% 19.69% 2.63%
KO 3000 20% 5.25% 1.05%
INTC 4000 27% 16.65% 4.44%
KEI 6000 40% 18.24% 7.30%
Total 15000 100% 15.41%

➢ E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24) = 15.41%

Portfolio Theory – Mean and Variance
Portfolio Mean

𝑅𝑝 = 𝑤1 𝑅1 + 𝑤2 𝑅2 + ⋯ + 𝑤𝑛 𝑅𝑛
𝐸 𝑅𝑝 = 𝑤1 𝜇1 + 𝑤2 𝜇2 + ⋯ + 𝑤𝑛 𝜇𝑛 = 𝜇𝑝

• How to calculate the variance of a portfolio?

Portfolio Variance
• Step 1: Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Step 2: Compute the expected portfolio return using
the same formula as for an individual asset
• Step 3: Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset
Example: Portfolio Variance
• Consider the following information
Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom .4 30% -5% 0.5*30%+0.5*(-5%)=12.5%
Bust .6 -10% 25% 0.5*(-10%)+0.5*25%=7.5%

• What are the expected return and standard deviation for the portfolio?

State P R P*R [R- E(R)] ^2 P*[R- E(R)] ^2

Boom 40% 12.5% 5.00% 0.09% 0.036%
Bust 60% 7.5% 4.50% 0.04% 0.024%
E(R) 9.50%
Variance 0.06%
Expected return =0 .4(12.5) + 0.6(7.5) = 9.5%
Variance of portfolio = 0.4(12.5-9.5)2 + 0.6(7.5-9.5)2 = 0.06%
Standard deviation = 2.45%
Key Takeaways
• Calculation of Return
• Statistical Background
• Historical Patterns of Return
• Market Efficiency Theory
• Expected Return and Variance
• Portfolio Mean and Variance

Reading for Next Time: Chapters 13, 9, 2, 10