Corporate Finance MP124

Week 8
Duy Linh Do
Email : [email protected]
This Week
• Risk and Return
• Evaluate historical risk and returns
• Expected returns and risk
• Portfolios
• Systematic and unsystematic risk
• Beta and the SML
Introduction: Return

• An investment is a commitment of funds for a period in order to derive a future

cash flow.
• This should be a reward for
• time the funds are committed
• uncertainty involved and
• Inflation
• A question we want to answer is:
• “If you invest in an asset what is a fair return?”
• Is it 5%, 10%, 15%???
Introduction: Risk

• What other considerations?

• Example:
• Your rich grandparent dies leaving you $1,000,000. You now have to decide how to
invest these funds WISELY!
• You consult a financial planner who suggests you have two choices. Invest in:
• Einsteinium Exploration Ltd or
• 10 yr government bonds
• Both investments are returning 6.5%
• Which would be the better investment?
Percentage Returns

• It is generally more intuitive to think in terms of percentages than dollar returns

• Capital gains yield = (ending price – beginning price)
beginning price
• Income yield = Income / beginning price
• Total percentage return = Capital gains yield + Income Yield
Example 1
• 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?
• Dollar return = 1.25 + (40 – 35) = $6.25
• What is your percentage return?
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Dividend yield = 1.25 / 35 = 3.57%
• Total percentage return = 14.29% + 3.57% = 17.86%
Question

• The return from owning a share in Coles-Myer is composed of all of the

following except:

a) Interest
b) Dividend yield
c) Capital gain or loss
d) both b and c
Nominal and Real Returns

• The data in the previous figures were nominal returns. (They included a
component to compensate for inflation.)
• Real returns look at buying power or change in real buying power. (eg. Today’s
dollars)
• The nominal return is related to the real return by the Fisher effect:
• (1 + R) = (1 + r) * (1 + h)
Where
R = nominal rate of return
r = real rate of return
h = the inflation rate
Example 2

• Coca Cola’s share price at the start of the year 2003 was $145. The
share price at the end of the year was $186.50. Inflation during the
year was 6.80%. The risk-free rate of return is 10.70%.
• What is the percentage return?
• R = (186.50 - 145) / 145 = 28.62%
• What is the real return?
• r = (1.2862) / (1.068) - 1 = 20.43%
• What is the risk premium for Coca Cola?
• Risk premium = 28.62% - 10.7% = 17.92% (nominal)
Risk

• Risk is thought of as the uncertainty regarding the expected rate of

return from an investment or the variability of returns
• Uncertainty = Risk
• Variability of return is the risk element
• Investment more risky when range of possible returns are large
• or the more uncertain an investor is regarding the actual return
• ie 5% to 15% is less risky than -10% to 40%
Historical Risk

• Standard deviation = s = s2

where:
r is the average or expected return
ri is the actual return for observation i
• Larger the standard deviation the greater the dispersion of returns
• greater the risk
• Perfect certainty
• standard deviation = 0
Example – Variance and Standard Deviation

Year Actual Average Deviation from Squared

Return Return the Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .42 .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

Normal Distribution & probability
• Probability of having a return above or below the average/mean
• depends on standard deviation
• Normal distribution probability of having a return within
• one standard deviation is 68%
• two standard deviations is 95%
• Note:
• No assurance distribution is normal
Probability Distribution
Expected Returns

• An investor is more interested in what might happen to their investment in the

future than what has happened in the past (ie. history).
• Expected returns are based on the probabilities of possible outcomes
• Calculated as:

E(R) = S Pi Ri
Example 1
• Suppose you have predicted the following returns for stocks C and T in three
possible states of nature. What are the expected returns?
• State Probability C T
• Boom 0.3 0.15 0.25
• Normal 0.5 0.10 0.20
• Recession 0.02 0.01
___
0.2
• E(rC) = .3(.15) + .5(.10) + .2(.02) = 9.99%
• E(RT) = .3(.25) + .5(.20) + .2(.01) = 17.7%
Variance and Standard Deviation

• Variance and standard deviation still measure the volatility of returns

• Weighted average of squared deviations

• Calculated as:

s=
Question

• The less variable a security’s returns, the _________ the risk.

a) higher
b) more important
c) lower
d) none of the above
Example 2

• Consider the previous example. What are the variance and standard deviation
for each stock?
• Stock C
• 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
• = .002029
•  = .045
• Stock T
• 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
• = .007441
•  = .0863
Portfolios

• Investors hold a portfolio of assets that places them on the highest level of
return for a given level of risk.
• A portfolio is a collection of assets
• An asset’s risk and return is important in how it affects 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 Return
• Expected rate of return for a portfolio is:
• weighted average of expected rates of return for each
individual asset in the portfolio.
• Weight is the % of that asset in the portfolio.
• E(rP) =  Wi * E(ri)
• Wi = is % of asset i held in the portfolio
• E(ri) = is the expected return of asset i
• Risk of the portfolio depends upon the way the return on
each asset within a portfolio inter-relate or co-vary
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?
• $2000 of AMP AMP: 2/15 = 0.1333
• $3000 of BHP BHP: 3/15 = 0.20
• $4000 of CBA CBA: 4/15 = 0.2667
• $6000 of DJS DJS: 6/15 = 0.40
Portfolio Expected Returns

• The expected return of a portfolio is the weighted average of

the expected returns for each asset in the portfolio

E ( RP )   w.E ( Ri )

 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 3: Expected Returns

• Consider the portfolio weights computed previously. If the individual shares have
the following expected returns, what is the expected return for the portfolio?
• AMP: 19.65%
• BHP: 8.96%
• CBA: 9.67%
• DJS: 8.13%
• E(RP) = .133(19.65) + .2(8.96) + .167(9.67) + .4(8.13) = 9.27%
Portfolio Risk
• Relevant measure of risk is standard deviation of the portfolio
• Investors are risk averse
• Portfolio risk definition does not change
• To determine the risk of a portfolio, need;
• measure of risk of each asset in the portfolio
• measure of covariance or correlation between each asset
• proportion invested in each asset in portfolio, W
Portfolio Risk Cont…
• P=(W2A2A+ 2WAWBAB +W2B2B )

• Where
• W percentage of the portfolio in stock A or B
• 2 is variance of stock A or B
• AB is covariance of stocks A B
Covariance
• Extent to which two investments move together
• generally above or below their expected return at the same
time
• For two assets covariance is
• COV (RARB) = AB = (RA-E(rA))(RB-E(rB))
• Covariance is an absolute measure
• can range from - to +
• Covariance of an investment with itself is its variance
• Note: Calculation not examinable
Correlation
• Relative measure of the relationship between two variables
• standardises the magnitude of co-variance into an understandable statistic
• AB=CORR(RARB)=COV (RARB) /(A*  B)
• coefficient lies between -1 and +1
• If the two investments move completely together then AB=1
• And we say that A and B are perfectly positively correlated
• Note: Calculation not examinable
Portfolio Variance
• Compute the portfolio return for each state:
R P = w1 R 1 + w2 R 2 + … + wm R m
• Compute the expected portfolio return using the same formula as for an
individual asset
• Compute the portfolio variance and standard deviation using the same formulas
as for an individual asset
Example 4

• A portfolio has two assets L and S with equal amounts being

invested in L and S
• The following expectations of returns are
• MARKET Pi RL RS RP
• Rising 1/3 12% 24% 18%
• Stable 1/3 10% 20% 15%
• Falling 1/3 8% 16% 12%
• Expected return 10% 20% 15%
• Standard Deviation 1.63 3.27 2.45
Example 4 Cont…

• If has used the weights of each stock to calculate the expected return and
variance, then
• E(RP) = 10(.5) + 20(.5) = 15%
• P = 1.63(.5) + 3.27(.5) = 2.45
• Same result as portfolio calculation
• SPECIAL CASE
• stocks are perfectly correlated
Example 5

• MARKET RL RS RP
• Rising 12% 16% 14%
• Stable 10% 20% 15%
• Falling 8% 24% 16%
• E(r) 10% 20% 15%
• Std Dev. 1.63 3.27 0.81
• Using weighting of stock for calculating
standard deviation would give 2.45 not 0.81
• Using weighting of standard deviation in a
portfolio will provide an incorrect answer
Question

• In a two security portfolio, a zero covariance between the two assets

implies
a) correlation of zero between two assets
b) standard deviation of the portfolio is less than the weighted
average of the individual standard deviations
c) both a and b are true
d) none of the above
Expected versus Unexpected Returns

• Actual returns are generally not equal to expected returns

• There is the expected component and the unexpected component
• Actual return = E(r) + Unexpected returns
• Unexpected return is due to NEW information
• This could be positive or negative
• At any point in time, the unexpected return can be either positive or negative
• Over time, the average of the unexpected component is zero
Returns Cont…

• Unexpected return = systematic portion + unsystematic portion

• Therefore, total return can be expressed as follows:
• Total Return = expected return + systematic portion + unsystematic
portion
Unexpected  Risks

• Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation, interest rates, etc.
• Unsystematic Risk
• Risk factors that affect a limited number of assets
• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part shortages, etc.
Diversification

• Portfolio diversification is the investment in several different asset classes or

sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 internet company shares, you are not diversified
• However, if you own 50 shares that span 20 different industries, then you are
diversified
The Principle of Diversification

• Diversification can substantially reduce the variability of returns without an

equivalent reduction in expected returns
• This reduction in risk arises because worse than expected returns from one asset
are offset by better than expected returns from another
• However, there is a minimum level of risk that cannot be diversified away and
that is the systematic portion
Portfolio and Risk
Systematic Risk Principle

• There is a reward for bearing risk

• There is not a reward for bearing risk unnecessarily
• The expected return on a risky asset depends only on that asset’s systematic risk
since unsystematic risk can be diversified away
Measuring Systematic Risk
• How do we measure systematic risk?
• We use the beta coefficient to measure systematic risk
• What does beta tell us?
• A beta of 1 implies the asset has the same systematic
risk as the overall market
• A beta < 1 implies the asset has less systematic risk
than the overall market
• A beta > 1 implies the asset has more systematic risk
than the overall market
Total versus Systematic Risk
• Consider the following information:
Std. Deviation Beta
• Security C 20% 1.25
• Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher expected return?
Beta and the Risk Premium
• Remember that the risk premium = expected return – risk-free rate
• The higher the beta, the greater the risk premium
• Can we define the relationship between the risk premium and beta so that we
can estimate the expected return?
• YES!
SML and Equilibrium
Security Market Line
• The security market line (SML) is the representation of
market equilibrium
• The slope of the SML is the reward-to-risk ratio: (E(RM) –
Rf) / M
• But since the beta for the market is ALWAYS equal to one,
the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium