Risk and Return

Professor Allaudeen Hameed

National University of Singapore
Reference:RWJ, Chapters 10, 11, 12, and 13
1

Objectives
Basic tool in corporate finance is the
discounted cash flows models
Discounting risky cash flows requires
some way of measuring the discount rate
(cost of capital)
How do we measure cost of equity and
cost of capital?

Rates of Return
60

40

20

-20
Common Stocks
Long T-Bonds
T-Bills

-40
-60 26

30

35

40

45

50

55

60

65

70

75

80

85

90

95

Source: Stocks, Bonds, Bills, and Inflation 2000 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Historical Returns, 1926-2007

Series

Average
Annual Return

Standard
Deviation

Large Company Stocks

12.3%

20.0%

Small Company Stocks

17.1

32.6

Long-Term Corporate Bonds

6.2

8.4

Long-Term Government Bonds

5.8

9.2

U.S. Treasury Bills

3.8

3.1

Inflation

3.1

4.2
90%

Distribution

0%

+ 90%

Source: Stocks, Bonds, Bills, and Inflation 2008 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

The Risk-Return Tradeoff

18%

Small-Company Stocks
Annual Return Average

16%
14%

Large-Company Stocks

12%
10%
8%
6%

T-Bonds
4%

T-Bills

2%
0%

5%

10%

15%

20%

25%

Annual Return Standard Deviation

30%

35%

Normal Distribution
S&P 500 Return Frequencies
16
16

Normal
approximation
Mean = 12.8%
Std. Dev. = 20.4%

14
12
12

11

10

8
6

Return frequency

12

4
2
1

2
2

0
0

-58% -48% -38% -28% -18%

-8%

2%

12%

22%

32%

42%

52%

62%

Annual returns
Source: Stocks, Bonds, Bills, and Inflation 2000 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Portfolio Returns: Summary

Distribution of returns are characterized by
two measures: expected return and risk.
No universal measure of risk
One measure of portfolio risk is the
spread/dispersion of returns
Variance and standard deviation
If returns are normally distributed, the
distribution is fully described by mean and
standard deviation

Review of Statistics
Expected Return:

Variance

Covariance

K
E ( R) ps Rs
s 1
K
2
ps ( Rs E ( R))2
s 1

K
AB ps ( Rs, A E ( R A ))( Rs, B E ( RB ))
s 1

Correlation Coefficient

AB
AB
A B
8

Sample Statistics
The historical returns on asset classes (like
stocks) can be summarized by describing the
average return

( R1 RT )
R
T
the standard deviation of those returns

( R1 R) 2 ( R2 R) 2 ( RT R) 2
SD VAR
T 1
.
9

Risk and Return Individual Securities

Diversification of risk
Intuition: two sources of risk are
1.firm specific actions that directly affects
the asset price
Firm specific risks: in a portfolio these
risks can average out to zero
diversifiable/non-systematic risk
2. marketwide movements that affects all
prices
Market risks affects all investments in a
portfolio
non-diversifiable or systematic risk

Portfolio Risk as a Function of the

Number of Stocks in the Portfolio

In a large portfolio the variance terms are effectively

diversified away, but the covariance terms are not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.

11

Diversification -Caveat
Diversification reduces portfolio risk is a
fact (as long as correlation is less than 1.0);
but there are disagreements about whether
diversifiable risk is relevant in asset
pricing.
As we increase N,marginal benefits of
portfolio diversification decreases; and
transaction and information costs increases

Definition of Risk When Investors

Hold the Market Portfolio
Total security risk = systematic (nondiversifiable) risk + unsystematic
(diversfiable) risk
Relevant risk = securitys contribution to
well-diversified portfolio risk
The common measure of the risk of a
security in a large portfolio is the beta (b)of
the security.
Beta measures the responsiveness of a
security to movements in the market
portfolio.
Cov( Ri , RM )

bi

( RM )
2

13

Intuition: Marginal Contribution to risk

N
E ( R p ) wi E ( Ri )
i 1
where wi 1.0
N 2 2 N N
2
p wi i wi w j ij
i 1
i 1 j 1
i j
Portfolio variance increasingly depends on covariance
terms as N increases i.e. N variance terms vs N(N-1)
covariance terms
Hence, as each security is added, the marginal
contribution to portfolio risk comes mainly from security
covariance with portfolio

14

Relationship between Risk and Expected

Return (Capital Asset Pricing Model
(CAPM))
Expected return on an individual security:

R i RF i ( R M RF )
Market Risk Premium

This applies to individual securities held within welldiversified portfolios.

Expected Return on the Market:

R M RF Market Risk Premium

15

Expected
return

Relationship Between Risk &

Expected Return
Ri RF i ( R M RF )

13.5%
3%
i 1.5

RF 3%

1.5

R M 10%

R i 3% 1.5 (10% 3%) 13.5%

16

Summary
In a world where investors hold combinations of
riskless asset and market portfolio, risk is measured
relative to market portfolio.
Risk of any portfolio is the risk it adds to the
market portfolio
risk is proportional to covariance term :
standardising covariance
beta
What is the beta of:
market portfolio
riskier than market
riskless security?

Estimation of Beta
Theoretically, the calculation of beta is
straightforward:

Cov( Ri , RM ) iM i M

2
Var ( RM )
M
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market index
is used to represent the market.
Beta - Sensitivity of a stocks return to the return on
the market portfolio

18

Determinants of Beta
1. Business Risk
Cyclicity of Revenues
Retailers/auto firms pro-cyclical (high
beta)
Utilities/transport less dependent on
business cycle (low beta)
Cyclical does not mean volatile
High std dev stocks need not have
high beta (e.g. movie studios hit
or flop)
19

Determinants of Beta
2. Operating Leverage
The degree of operating leverage measures
how sensitive a firm (or project) is to its fixed
costs.
Operating leverage increases as fixed costs
rise and variable costs fall.
Operating leverage magnifies the effect of
cyclicity on beta.
The degree of operating leverage is given by:

Change in EBIT
Sales
DOL

EBIT
Change in Sales
20

2. Operating Leverage

Total
costs
Fixed costs

EBIT

Sales

Fixed costs

Sales Volume

Operating leverage increases as fixed costs rise

and variable costs fall.
21

3. Financial Leverage and Beta

Operating leverage refers to the sensitivity
to the firms fixed costs of production.
Financial leverage is the sensitivity of a
firms fixed costs of financing.

22

Beta and Leverage

If the beta of the debt is non-zero, then
betas of the firms equity is given by:
Equity

B
Unlevered firm (1 TC )( Unlevered firm Debt )
SL

B = MV of Debt
SL = MV of Levered Equity
TC = corporate tax rate
Financial leverage increases the equity
beta.

23

Financial Leverage and Beta: Example

Consider Grand Sport, Inc., which is
currently all-equity and has a beta of 0.90.
The firm has decided to lever up to a capital
structure of 1 part debt to 1 part equity.
Since the firm will remain in the same
industry, its asset (unlevered) beta should
remain 0.90.
However, assuming a zero beta for its debt,
and zero tax rate, its equity beta would
become twice as large:
Equity

Debt
0.90 1 1 1.80
Asset 1
Equity
1

24

Stability of Beta
Most analysts argue that betas are
generally stable for firms remaining in
the same industry use industry
betas
Thats not to say that a firms beta
cant change.
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage

25

Main sources of capital

Equity Capital
Retained Earnings
New equity
Debt Capital
Existing debt capacity vs new debt
Bank borrowing
Issue bonds

26

Cost of Debt
Cost of debt borrowing depends on:
Interest rate levels
Default risk of firm
e.g. Bond ratings
Tax rates
Tax advantage of debt
Hybrid securities
e.g. Convertibles
27

The Cost of Capital with Debt

The Weighted Average Cost of Capital is given
by:

rWACC

S
B

rS
rB (1 TC )
S B
S B

rs = cost of equity
rB = cost of debt
S = market value of equity
B = market value of debt
TC = corporate tax rate
Why do we multiply the last term by (1- TC)?
28

Estimating International Papers

WACC
First, we estimate the cost of
equity and the cost of debt.
Estimate an equity beta, then
estimate the cost of equity.

We can often estimate the cost

of debt by observing the YTM of
the firms debt.
Second, we determine the WACC
by weighting these two costs
appropriately.
29

Estimating IPs Cost of Capital

The industry average beta is 0.82;

the risk free rate is 8% and the
market risk premium is 9.2%.
Thus the cost of equity capital is
re RF i ( R M RF )
8% 0.82 9.2%
15.54%
30

Estimating IPs Cost of Capital

The yield on the companys debt
is 8% and the firm is in the 37%
marginal tax rate.
The debt to value ratio is 32%
S
B
rW ACC
rS
rB (1 TC )
S B
S B
0.68 15.54% 0.32 8% (1 .37)
12.18%

12.18 percent is Internationals cost of capital. It should be

used to discount any project where one believes that the
projects risk is equal to the risk of the firm as a whole, and the
project has the same leverage as the firm as a whole.
31

Reducing the Cost of Capital

What is Liquidity?
Liquidity, Expected Returns and
the Cost of Capital
What the Corporation Can Do

32

What is Liquidity?
The idea that the expected return on a
stock and the firms cost of capital are
positively related to risk is
fundamental.
Recently a number of academics have
argued that the expected return on a
stock and the firms cost of capital are
negatively related to the liquidity of
the firms shares as well.
The trading costs of holding a firms
shares include brokerage fees, the bidask spread and market impact costs.
33

Liquidity, Expected Returns and the

Cost of Capital
The cost of trading an illiquid
stock reduces the total return
that an investor receives.
Investors thus will demand a high
expected return when investing
in stocks with high trading costs.
This high expected return implies
a high cost of capital to the firm.
34

Liquidity and the Cost of Capital

Liquidity
An increase in liquidity, i.e. a reduction in trading costs,
lowers a firms cost of capital.
35

What the Corporation Can Do

The corporation has an incentive to

lower trading costs since this would
result in a lower cost of capital.
A stock split would increase the
liquidity of the shares.
This idea is a new one and empirical
evidence is not yet in.

36

What the Corporation Can Do

Companies can also facilitate stock
purchases through the Internet.
Direct stock purchase plans and
dividend reinvestment plans handled
on-line allow small investors the
opportunity to buy securities cheaply.
The companies can also disclose
more information. Especially to
security analysts, to narrow the gap
between informed and uninformed
traders. This should reduce spreads.
37

The Arbitrage Pricing Model

Logic : investors are rewarded for taking nondiversifiable risks
Firm-specific risks are diversifiable and hence, not
priced
Expected return depends on systematic factors or
unanticipated factor shocks (surprise)
Multiple sources of systematic risks (m)
Example: Uncertainty about general economic
outlook
unanticipated changes in GNP, inflation, (real)
interest rates changes, changes in default risk,
etc

38

Risk: Systematic and Unsystematic

We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:

Total risk; U

R R U
becomes
R Rm

Nonsystematic Risk;

where
m is the systematic risk

Systematic Risk; m

is the unsystematic risk

n

39

Systematic Risk and Betas

For example, suppose we have identified
three systematic risks on which we want to
focus:
1. Inflation
2. GDP growth
3.The dollar-euro spot exchange rate, S($,)
Assume returns follow this process:

R Rm

R R I FI GDP FGDP S FS
I is the inflation beta
GDP is the GDP beta
S is the spot exchange rate beta
is the unsystematic risk

40

Arbitrage Pricing Model

E ( R) R f b I ( RI R f ) bGDP ( RGDP R f )
b S ( RS R f )

41

42