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Pablo Carbonell
June 21, 2013
An Alternative Model for Risk-Adjusted Returns:
Effect of Capital Structure on Returns, Derivative Pricing and Volatility
Last updated 10/20/2013
Abstract
The purpose of this study is to assess how capital structure modifies the probability
distribution of returns in stocks and its consequences on derivative pricing and volatility. Under
the Black-Scholes-Merton model and commonly in financial literature, a lognormal distribution
of returns is assumed for stocks. We show that a lognormal distribution cannot be assumed for
stocks as arbitrage opportunities would arise when comparable assets are traded at different
levels of leverage. Consequently we propose a new distribution of returns to adjust for non-
arbitrage conditions. The goal is not to find a definitive probability distribution, as all pricing
mechanisms would have to be factored in for that objective, but rather to adjust our benchmark
lognormal distribution for considerations on capital structure and study the consequences of such
adjustment. Hence we explore those consequences along four areas. First, we show that under
the proposed distribution we predict a higher frequency of larger market declines along with
increases in volatility as the market falls. Second, we derive an adjusted calculation for the
Black-Scholes equation where leverage is introduced as an additional parameter, and show that
this adjustment constitutes a better fit of market prices given that it reduces the dispersion in
implied volatilities of options. Third, we derive an alternative model to CAPM for stocks, where
we show that leverage pulls stocks downwards in relation to a theoretical average Market
Security Line. Fourth, we assess the properties of the Fama-French portfolios under the light of
our alternative model to CAPM. We verify, after adjusting for differences in leverage, that the
market premiums for small and high book to price stocks are consistent with our model.
Carbonell 2
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Part 1: Capital Structure and Distribution of Returns
Lets consider the scenario of two almost identical companies, and , which own the
same type of assets. These firms keep minimum cash to operate and give back to investors all
excess of it, and do not expand or shrink. For illustration purposes lets assume that they are two
farms next to each other. However, company has no debt, while has its assets partially
financed through debt
0
.
Now, we could assume either that the value of is lower than the value of +
because of tax shields, or that the value of already includes the opportunity value of the assets
debt absorption capacity. The reasoning for the latter is that company could be part of a larger
portfolio: while not levered itself, it would be providing additional debt capacity for the overall
portfolio and correspondingly tax savings would be made somewhere else in the portfolio as a
consequence of . Furthermore, the highest bidder for would include this debt capacity
premium, effectively pricing in the market at such level. Thus we have
0
=
0
+
0
.
If the two firms remain very similar and therefore, their assets interchangeable during
a period of time where interest rates do not change we will observe:
(1.1)
Where is the yield on the debt, and (
has two
prices, opening a window for arbitrage opportunities. In our example of the farms this equation
means that the two farms maintain equal prices.
Carbonell 4
The following graph illustrates a possible path for the adjusted prices of and :
0.00
20.00
40.00
60.00
80.00
100.00
120.00
Fig. 1.1
A E
What follows is that at maximum only one of the two firms can present returns that fit a
lognormal distribution. Lets call
and
+1
=
+1
=
+1
=
+1
+1
[,
2
]
The parameters and
2
are respectively mean and volatility per interval of time, and
is the yield of the debt per interval of time. It follows that:
+1
= (
)
(1.2)
We define R as the returns on E, such that
=
+1
/
) = (
)
(1.3)
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We introduce a change of variable
= (
)/
, we have:
+(1
(1.4)
(
) = (
+(1
) = [ (
+ (
1)
)]
Given that X is [,
2
] we get:
(
) =
( (
+(
1)
) ; , )
(1.5)
Substituting in the CDF for the normal distribution of we get the CDF for :
(
) =
() =
1
2
+
1
2
[
(
+(
1)
)
2
2
]
(1.6)
Deriving over the previous expression we get the probability distribution function of R:
(; , ,
, ) =
1
(
+ 1)2
((
+(
1)
))
2
2
2
(1.7)
We have defined a new distribution probability for the returns R, with
parameters (,
2
,
, ). The parameters and are respectively the drift and volatility of the
underlying asset;
represents the leverage and the yield on the debt. In the specific case
when
0
= 0 we verify that
() = . (,
, ), where = (
+(1)
)
The expected value of R is given by:
() = (
+(1 )
) = (
) +(1 )
=
+
2
2
+(1 )
(1.8)
The variance on is given by:
() = [R
2
] [()]
2
(1.9)
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From equation (1.4) we have that =
+ ( 1)
, where is [,
2
]. To
simplify the notation we set =
, =
, =
, =
.
We introduce a change of variables = (1 )
, and calculate [R
2
]:
[R
2
] = [(
+ )
2
] = [
2
2
+2
+
2
] =
2
[
2
] +2[
] +
2
Applying properties of the lognormal distribution:
[
2
] =
2
2+2
2
+2
+
2
2
+
2
(1.10)
We calculate [()]
2
, using a previous result from (1.8):
[()]
2
= [
+
2
2
+]
2
=
2
2+
2
+2
+
2
2
+
2
(1.11)
Substituting (1.10) and (1.11) into (1.9):
() =
2
2+
2
(
2
1)
(1.12)
The standard deviation on is thus given by:
() =
+
2
/2
2
1
(1.13)
Carbonell 7
The following graph illustrates the p.d.f. of (,
2
,
It follows that:
= = ( +) +( +)
(2.1)
Where [0,1]. Let
= (
) we get:
= [
+
1
2
2
2
2
] +
We define the portfolio with -1 derivative, and
Consequently:
=
= (
1
2
2
2
2
)
The term cancels out, thus the portfolio is riskless and yields the risk-free rate :
=
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Substituting in the previous equations:
(
+
1
2
2
2
2
) = (
)
So that:
+
1
2
2
2
=
(2.2)
The equation above is an adjusted version of the Black-Scholes-Merton general
differential equation, where
, 0)
Replacing
for
we get:
= max (
, 0)
We verify in the equation that a call option on with strike is equivalent to a call
option on with strike price
= +
, where
=
0
= (
0
+
0
)(
1
)
( +
0
)(
1
)
1 =
(
0
+
0
+
0
) +(
2
/2)
(2.3)
In this equation the parameter is the standard deviation of (
0
).
Carbonell 11
Part 3: Experimental Results with Adjusted Black-Scholes formula
In this section we assess how well the proposed model fits actual implied volatilities on
S&P 500. To do so, first we need to estimate the leverage parameter for the aggregate of
companies in the index. Our initial assumption is that the underlying productive assets present
lognormal returns. We define these underlying assets as the following:
A = Cash balance needed to operate + Non-cash net working capital + Fixed assets and intangibles
To estimate the value of the unlevered assets, we start with market capitalization, add the
liabilities tied to those assets, and subtract excess cash. We decide to include along with long
term debt other long term liabilities, given that the market value of equity is discounting these
liabilities from the underlying assets. To estimate excess cash we assume that on average, an
unlevered operation needs to have access to cash to cover three months of SG&A expenses. Thus
we define overall net debt as follows:
Net Debt = Debt Excess Cash
Where:
Debt = Current/Short Term Debt + Long Term Debt + Other Long Term Liabilities
Excess Cash = Cash and Equivalents + Short Term Investments S&GA * 3/12
Carbonell 12
The following table shows aggregate financial data from stocks in S&P 500:
Fig. 2.1
Portfolio Overall
# Tickers 500
Market Cap 14,978,890,000
Interest Expense 199,699,175
Short/Current Debt 1,997,490,702
Long Term Debt 4,298,836,037
Other Non-Current Liabilities 4,904,666,364
Cash and Equivalents 4,615,930,453
Short Term Investments 519,325,825
SG&A 2,015,029,063
Source: Financial statements from Yahoo! Finance, 06/21/2013.
The result of our calculation places Net Debt at 6,569,494,091 or 44% of market
capitalization with prices as of June 21
st
2013.
To assess implied volatilities we look at prices for call options on the ETF ticker SPY for
December 2014 and 2015. We assume a Risk-free rate of 0.5% for all maturities, dividend yield
of 1.9%, and an average interest on net debt of 1.65% which corresponds to 5-year AAA.
Current price of SPY is $159.59, thus
0
becomes $69.99.
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Figures 2.1a and 2.1b show the implied volatilities of options using respectively the
standard and adjusted calculations of Black-Scholes:
0
0.2
0.4
0.6
0.8
1
1.2
0 50 100 150 200 250 300
I
m
p
l
i
e
d
V
o
l
a
t
i
l
i
t
y
Stri ke Pri ce
Fig. 2.1a - Standard Black-Scholes
2014 2015
0
0.2
0.4
0.6
0.8
1
1.2
0 50 100 150 200 250 300
I
m
p
l
i
e
d
V
o
l
a
t
i
l
i
t
y
Stri ke Pri ce
Fig. 2.1b - Adjusted Black-Scholes
2014 2015
However we may still be underestimating the full effect of leverage. There are situations
still not accounted for, such as operational leases, which are one type of financial commitment
that does not appear on balance sheets. If we plug a value of = 2 we get a flatter fit for prices:
0
0.2
0.4
0.6
0.8
1
1.2
0 50 100 150 200 250 300
I
m
p
l
i
e
d
V
o
l
a
t
i
l
i
t
y
Stri ke Pri ce
Fig. 2.1a - Standard Black-Scholes
2014 2015
0
0.2
0.4
0.6
0.8
1
1.2
0 50 100 150 200 250 300
I
m
p
l
i
e
d
V
o
l
a
t
i
l
i
t
y
Stri ke Pri ce
Fig. 2.2b - Adjusted Black-Scholes, Lambda=2
2014 2015
Carbonell 14
Comparing graphs 2.1a with 2.1b, 2.2b we see that our adjusted calculation for Black-
Scholes reduces the dispersion in implied volatilities, and is therefore a better fit for real prices.
The following chart further illustrates how dispersion in implied volatilities is reduced:
Fig. 2.3
Option Method Strike=50 Strike=260 Ratio
December 2014 Standard B.S. 0.76 0.15 1 : 4.94
Adjusted, D=70 (44% of S) 0.39 0.11 1 : 3.50
Adjusted, D=159.59 (100% of S) 0.24 0.08 1 : 2.86
Option Method Strike=30 Strike=250 Ratio
December 2015 Standard B.S. 1.01 0.16 1 : 6.50
Adjusted, D=70 (44% of S) 0.43 0.11 1 : 3.87
Adjusted, D=159.59 (100% of S) 0.25 0.08 1 : 3.06
The fact that the implied volatility lines are not completely flattened means that this
distribution leaves room for other causes of accelerated market declines, whether systemic (such
as stochastic volatility and interest rates), or non-systemic (such as market drops that are due to
external shocks or single discrete events).
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Part 4: An alternative to CAPM
Let
, where
represents the
markets aggregate capital structure as defined previously. The stock price is
.
The unlevered assets
and
Lets consider a portfolio with -1 shares of
and
shares of
. The
value of is given by:
=
It follows that:
=
)
= (
) +
)
Now, the terms and follow the same distribution [0,1] and are positively
correlated. They do not cancel out directly, but tend to do so in a portfolio that has many
for
different stocks:
lim
=1
= 0
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In other words, the terms and are diversified away. Thus becomes a risk-free
portfolio. Consequently, this risk-free portfolio should yield the risk-free rate:
=
Combining the previous equations:
= (
)
Dividing by
) +
(4.1)
Notice how this equation is similar to CAPM, yet here the parameters belong to our
distribution (, , , ). To compare this model against CAPM we need first to express the
expected return and standard deviation in CAPMs terms, where return is defined as
0
1.
The expected return on the stock for = 1 is the expected value of ( 1).
From equation (1.8):
( 1) = () 1 =
+
2
2
+(1 )
1
(4.2)
From equation (1.13):
( 1) = () =
+
2
/2
2
1
(4.3)
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Using equations (4.1), (4.2) and (4.3), the following table (4.9) illustrates expected
returns and volatility expressed in CAPMs terms. We show the results for values of
=
0.1,
= 0.2, = 0.03,
= 0.05.
Table 5.9
. The
assumption from CAPM that conflicts with our model is that an investor seeks to optimize the
tradeoff between the expected return ( 1) and volatility ( 1). This is not the case
in our model, where tradeoffs between
and
Stock
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Under CAPM we would expect only one value for the slope across stocks. Graphically,
increasing the slope makes the expected return escape CAPMs line upwards. The value of the
slope in CAPM is given by definition as:
=
( 1) (
1)
( 1)
(5.2)
Using equations (4.3), (4.8) and (5.2) we calculate the slope for the points in table 4.9:
Table 5.3
2
,
1 (
1)
+
2
/2
2
1
(5.3)
Rearranging, and substituting using equation (4.1):
=
1
2
1
+
(1 )
)++
2
/2
2
1
(5.4)
Deriving over :
2
2
(
2
1
(5.5)
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The sign of the derivative on in equation (5.5) is given by the sign of (
), where
is the risk-free rate and is the interest rate on net debt. Unless the firm piles cash in excess at
no or very little interest, will be higher than the risk-free rate, and thus the derivative will be
negative. Yet normally we would expect companies to place excess cash in short term securities
that yield at least the risk-free rate. As this derivative is negative, it means that decreasing
leverage increases the slope , making the stock escape the CAPMs security line upwards.
If a firm could borrow at the risk-free rate the derivative of would cancel, in that case
the slope would not depend on leverage. To illustrate why changes when the risk-free rate
and the yield of debt are different, lets imagine that we are managing a levered company. We
have $100 that we can use for either invest in risk-free to add to our treasury, or pay off some of
our debt. An outsider would prefer risk-free debt than lending to us; but from our perspective, we
could consider both as risk-free investments as neither will add volatility to our holding. Yet
paying off the debt offers a return instead of . Consequently, doing so would improve our
position in terms of the tradeoff between risk and expected returns, measured respectively as
standard deviation and expected value of ( 1).
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Part 6: Experimental results with the Fama-French portfolios
The Fama-French three-factor model provides an example of portfolios that escape the
CAPMs Security Market Line. Empirical results show that portfolios with higher book-to-price
value or smaller companies present higher average returns. The notation for the Fama-French
model is as follows:
=
+
3
(
) +
. +
. +
The graphical interpretation of this formula is that stocks with SMB or HML
characteristic will show a higher slope , as defined in equation 5.2.
In the following experiment we download the financial statements and historical prices of
the stocks in S&P 500 and in Russell 2000, and estimate the slope for the four quadrants of
Small/Big and High/Low.
For each stock, the return on the underlying assets
in given by:
=
+1
=
+1
+
+1
(6.1)
For small intervals of time, we can assume:
+1
(6.2)
Rearranging equation 6.10 and substituting using 6.11 and 1.2 we get:
+1
(6.3)
The return