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10th Edition

Topics Covered

Capital Market History Measuring Risk Portfolio Risk and Diversification Beta and Unique Risk Diversification and Value Additivity

One way to estimate the cost of capital is to find securities that have the same risk as the project and then estimate the expected rate of return on these securities. Cost of Capital rate of return that investors expected to earn if they invest in equally risky securities. We start our analysis by looking at the rates of return earned in the past from different investments, concentrating on the extra return that investors have received for investing is risky rather than safe securities.

We then show how to measure the risk of a portfolio by calculating its standard deviation and we look again at the past history to find out how risky it is to invest in the stock market. Then, we explore diversification. the concept of

Security return from either stock or bonds, comes in two forms: dividend or interest payments plus any capital gain or loss. The annual percentage return or investment is : Percentage return = capital gain + dividend initial share price This is a nominal return, reflecting how much more money one has at the end of the year if you invest today. The same percentage return or total return is the sum of the dividend yield and capital gain yield.

Rates of Return

Percentage Return =

Capital Gain + Dividend Initial Share Price

Dividend Yield =

Rates of Return

The real rate of return (ror) is the nominal rate adjusted for the inflation rate in the period or the additional purchasing power one has with the investment return: 1 + real ror = (1+nominal ror) (1+inflation rate) The real rate of return tells you how much more you will be able to buy with your money at the end of the year.

Rates of Return

Suppose you bought the stock of General Electric (GE) at the beginning of 2004 when its price was $31.12 a share. By the end of the year the value of that investment had appreciated to $36.59. In addition, in 2004 GE paid a dividend of $0.82 a share. 1. What is the percentage return on your investment? 2. What is your dividend yield? 3. What is your capital gain yield? 4. What is your real rate of return if in 2004 the inflation was only 3.3 percent.

Rates of Return

Suppose you were lucky enough to buy the stock of Nike at the beginning of 1996 when its price was $71.125 share. By the end of the year the value of that investment had appreciated to $120. In addition in1996, Nike paid a dividend of $0.65 a share. 1. What is the percentage return on your investment? 2. What is your dividend yield? 3. What is your capital gain yield? 4. What is your real rate of return if in 1996 the inflation was only 3.3 percent.

Financial analyst are blessed with an enormous quantity of data. There are comprehensive databases of prices of stocks, bonds, options and commodities as well as huge amounts of data for securities in other countries. Focus on a study by Dimson, March and Staunton that measures the historical performance of three portfolio of U.S. securities: 1. A portfolio of treasury bills (US government debt securities maturing in less than a year. 2. A portfolio of U.S government bonds 3. A portfolio of U.S. common stock These investments offer different degrees of risk.

Treasury bills are about as safe an investment you can make. There is no risk of default and their short maturity means that prices of treasury bills are relatively stable. As for long-term government bonds, the investor acquires an asset whose price fluctuates as interest rates vary. Bond prices fall when interest rates rise and rise when interest rates fall. An investor who shifts from bonds to common stock shares in all the ups and downs of the issuing companies.

When you invest in a stock, you dont know what return you will earn. But by looking at the history of security returns, you can get some idea of the returns that investors might reasonably expect from different types of securities and for the risk that they face. Investors can choose from an enormous number of different securities.

Market Indexes

Financial analyst cant track every stock so we rely on market indexes. Market Index measures the investment performance of the overall market. Several market indexes measure the investment performance of the overall market.

Market Indexes

The Dow Jones Industrial Average is an equal share index of thirty industrial stocks. It is an index of important but few firms, independently of how many shares of each company has outstanding. The Standard & Poors Composite Index is a share-weighted index of 500 firms, covering about 70% of the value of stocks traded. Compared to the Dow, the S&P 500 is a broader index and is adjusted for the relative number of shares available to investors. The Wilshire 5,000, the Nikkei Index (Tokyo), and the Financial Times Index (London) are just a few other market performance indices.

Market Indexes

Dow Jones Industrial Average (The Dow)

Value of a portfolio holding one share in each of 30 large industrial firms.

Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.

Review

Basically we should check the historical record to give an idea of typical performance of different investments. Portfolio collection of assets. Treasury bills, Treasury bonds and common stock are some type of portfolio.

T-Bills safest investment because they are issued by the government. Long-term bonds certain to be repaid. Gave slightly higher returns that T-Bills. Common stock riskiest. No promise that you will be repaid.

Review

The difference is called Maturity Premium. Maturity Premium extra average return from investing in long-versus short-term Treasury securities. Risk Premium - expected return in excess of risk free return as compensation for risk. Historical record shows that investors demand and receive a risk premium for holding risky assets. Average returns on high risk assets are higher than those on low-risk assets.

Review

Managers must estimate current and future opportunity rates of return for investment evaluation. Estimating the opportunity rate begins with a study of historical rates of return on varying risk investments. The level of risk and required rate of return (ror) are directly related. Investors require higher rates of return for increased risk.

Rates of Return

Variation around a central tendency or mean may be presented visually by constructing a histogram as shown on this slide, and studying the dispersion or spread of possible outcomes. Another method is calculating a measure of variation used as a proxy for measuring risk, such as the variance or standard deviation. Risk relates to the variability of future returns.

Rates of Return

Common Stocks (1900-2001)

60 40

Return (%)

1901 1909 1917 1925 1933 1941 1949 1957 1965 1973 1981 1989 1997 Year

Measuring Risk

Investment risk depends on the dispersion or spread of possible outcomes. Financial Managers need a numerical measure of dispersion. The standard measures are :

Variance Standard deviation

This suggest that some measure of dispersion will provide a reasonable measure of risk and dispersion is precisely what is measured by variance and standard deviation.

Measuring Risk

Two standard measures of risk: Variance - Average value of squared deviations from mean. Standard Deviation Square root of variance, I.e. square root of average value of squared deviations from mean.

Measuring Risk

Calculating historical average investment returns and the variability of those returns, the comparison of average returns and volatility indicates that historical risk and return are directly related. Higher risk is associated with higher average returns. One might assume that historical returns and variability (long period) would extend into the future for estimating investor-required or opportunity rates of return. Investors will expect a higher rate of return, risk premium over the T bill rate, with higher standard deviation of returns.

Measuring Risk

Example: Calculating variance and standard deviation. Suppose four equally-likely outcomes:

(1) (2) (3) Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 0 0 - 20 - 30 900 Variance = average of squared deviations from mean ( 0) = 1800/4 = 450 Standard deviation = square root of variance = 450 = 21.2%

Measuring Risk

Example: Calculating variance and standard deviation. Suppose four equally-likely outcomes:

Year Rate Of Return Deviation from Average Return Squared Deviaton

1992

1993 1994 1995 1996

+7.71

+9.87 +1.29 +37.71 +23.00

Measuring Risk

Example: Calculating variance and standard deviation. Suppose four equally-likely outcomes:

Scenarios Recession Normal growth Boom Auto Firms -8% 5% 18% Gold Firms 20% 3% -20%

Measuring Risk

The variance is the average of these squared deviation and therefore is a natural measure of dispersion. When we squared the deviations from the expected return we changed the units of measurement from percentages to percentage return. One last step is to get back to percentages by taking the square root of the variance. This is the standard deviation.

Diversification : strategy designed to reduce risk by spreading the portfolio across many investment. Portfolio diversification works because prices of different stocks do not move exactly together. Statistician makes the same point when they say that stock price changes are less than perfectly correlated. When does well, the others does badly.

Portfolio Diversification : is the investment in several different asset sectors. Diversification is not just holding a lot of assets.

For example if you own 50 internet stock you are not diversified. However if you own 50 stocks that span 20 different industries then you are diversified.

Unique Risk - Risk factors affecting only that firm and perhaps its immediate competitors. Also called diversifiable risk or specific risk or unsystematic. Market Risk - Economy-wide sources of risk that affect the overall stock market. Economy wide perils that threaten all businesses. Also called systematic risk. The diversification effect or the reduction in portfolio risk takes place with the addition of added securities until about 20 or 30 are included in the portfolio. Beyond that, the diversification effect of added securities is minimal.

While diversification eliminates the unique risk of individual securities, one cannot eliminate the market risk or systematic risk, the risks that affect the entire stock market.

For a diversified portfolio, only the market risk matters. When one discusses securities investment or investors, it is assumed that the security is held in a diversified portfolio and the relevant risk is market risk.

We have given you an intuitive idea of how diversification reduces risk, but to understand fully the effect of diversification, you need to know how the risk of a portfolio depends on the risk of the individual shares.

Suppose that 60% of your portfolio is invested in Campbell Soup and the remainder is invested in Boeing. You expect that over the coming year Campbell Soup will give a return of 3.1% and Boeing, 9.5%. The expected return on your portfolio is simply a weighted average of the expected returns on the individual stocks:

Expected portfolio return (.60 x .031) + (.40 x .095) = 5.7%

The exact procedure for calculating the risk of a two-stock portfolio is given in Figure 7.9 You need to fill in four boxes.

To complete the top left box, you weight the variance of the returns on stock 1 (21) by the square of the proportion invested in it (x21). Similarly, to complete the bottom right box, you weight the variance of the returns on stock 2 (22) by the square of the proportion invested in stock 2 (x22). The entries in these diagonal boxes depend on the variances of stocks 1 and 2; the entries in the other two boxes depend on their covariance. As you might guess, the covariance is a measure of the degree to which the two stocks covary. The covariance can be expressed as the product of the correlation coefficient 12 and the two standard deviations: Covariance between stocks 1 and 2 = 12 = 1212

x1x2 = proportions invested in stocks 1 and 2 12 = variance of stock returns 12 = covariance of returns (1212) 12 = correlation between returns on stocks 1 & 2

12 = 1 Campbell Boeing Campbell Soup x1212 = (.6)2 x (15.8)2 x1x21212 = .6 x.4x1x15.8 x 23.7 Boeing x1x21212 = .6 x.4x1x15.8 x 23.7

Portfolio variance = x1212 + x2222 + 2 (x1x21212) = [(.6)2 x (15.8)2] + [(.4)2 x (23.7)2] + 2 (.6 x.4x1x15.8 x 23.7) = 359.5 Standard deviation = 359.5 = 19% or 18.96

Or (.6 x 15.8) + (.4 x 23.7) = 19% - correct only if the prices of two stocks moved in perfect lock-step.

12 = .18 Campbell Boeing Campbell Soup x1212 = (.6)2 x (15.8)2 x1x21212 = .6 x.4x.18x15.8 x 23.7 Boeing x1x21212 = .6 x.4x.18x15.8 x 23.7

Portfolio variance = x1212 + x2222 + 2 (x1x21212) = [(.6)2 x (15.8)2] + [(.4)2 x (23.7)2] + 2 (.6 x.4x.18x15.8 x 23.7) = 212.10 Standard deviation = 212.10 = 14.6%

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Wise investors dont put all their eggs into just one basket: they reduce their risk by diversification. They are interested in the effect that each stock will have on the risk of their portfolio. Principal theme of this chapter. The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio.

1142

If you want to know the contribution of an individual security to the risk of a well- diversified portfolio, it is no good thinking about how risky that security is if held in isolationyou need to measure its market risk, and that boils down to measuring how sensitive it is to market movements. This sensitivity is called beta ().

Stocks with betas greater than 1.0 tend to amplify the overall movements of the market.

Stocks with betas between 0 and 1.0 tend to move in the same direction as the market, but not as far. Of course, the market is the portfolio of all stocks, so the average stock has a beta of 1.0.

1143

The market risk of a stock is measured by it beta coefficient which is an index of the stocks relative volatility Some benchmark of betas are as follows: 0.50 = stock is only half as volatile or risky as an average stock 1.00 = stock is of average risk 2.00 = stock is twice as risky as an average stock.

2 crucial points about security risk and portfolio risk: Market risk accounts for most of the risk of a well diversified portfolio. The beta of an individual security measures its sensitivity to market movements. In a portfolio context, a security s risk is measured by beta. General point: the risk of a well-diversified portfolio is proportional to the portfolio beta, which equals the average beta of the securities included in the portfolio.

Calculating the variance of the market returns and the covariance between the return on the market and those Anchovy Queen

1 2 Market Return Month 3 Anchovy Q Return 4 Deviation from average market return 5 Deviation from average Anchovy Q Return 6 Squared deviations from average market return 7 Product of deviations from average returns (col 4 x 5)

1

2 3 4 5 6

-8%

-11%

-10

-13

100

130

4

12 -6 2 8 2

8

19 -13 3 6 2

2

10 -8 0 6

6

17 -15 1 4 Total

4

100 64 0 36 304

12

170 120 0 24 456

Average

Covariance = jm = 456/6 = 76

Beta () = jm/m2 = 76/50.67 = 1.5

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Measuring Beta

The beta of a portfolio is just an average of the betas of the securities in the portfolio, weighted by the investment in each security. Beta of a portfolio = (fraction of portfolio in 1st stock x beta of 1st stock) + ( fraction of portfolio in 2nd stock x beta of 2nd stock) In the previous chapter we looked at past returns on selected investments. We found out the least risky investment was Treasury Bills. Since the return on treasury bills are fixed it is unaffected by what happens in the market. The beta of treasury bills is zero.

1148

Measuring Beta

Return to stock j vs return to market

Calculating Beta

1.5 Stock Return (%) 1

0.5

0.5 1 1.5

-1.5

-1

-0.5

-0.5 -1

Measuring Beta

1149

Measuring Beta

Suppose we had the following investment :

What is the expected return? What is the beta of this portfolio?

Security

Stock A Stock B Stock C Stock D

1150

Amount invested

$1,000 $2,000 $3,000 $4,000

Expected Return

8% 12% 15% 18%

Beta

.80 .95 1.10 1.40

1151

We have seen that diversification reduces risk and, therefore, makes sense for investors. But does it also make sense for the firm? Is a diversified firm more attractive to investors than an undiversified one? If it is, we have an extremely disturbing result. If diversification is an appropriate corporate objective, each project has to be analyzed as a potential addition to the firms portfolio of assets. The value of the diversified package would be greater than the sum of the parts. So present values would no longer add. Diversification is undoubtedly a good thing, but that does not mean that firms should practice it. If investors were not able to hold a large number of securities, then they might want firms to diversify for them. But investors can diversify. In many ways they can do so more easily than firms. Individuals can invest in the steel industry this week and pull out next week. A firm cannot do that. To be sure, the individual would have to pay brokerage fees on the purchase and sale of steel company shares, but think of the time and expense for a firm to acquire a steel company or to start up a new steel-making operation.

1152

This conclusion is important for corporate finance, because it justifies adding present values. The concept of value additivity is so important that we will give a formal definition of it. If the capital market establishes a value PV(A) for asset A and PV(B) for B, the market value of a firm that holds only these two assets is: PV(AB) = PV(A) + PV(B) A three-asset firm combining assets A, B, and C would be worth PV(ABC) PV(A) + PV(B) + PV(C), and so on for any number of assets. We have relied on intuitive arguments for value additivity. But the concept is a general one that can be proved formally by several different routes. The concept of value additivity seems to be widely accepted, for thousands of managers add thousands of present values daily, usually without thinking about it.

Summary

1. Investors care about the expected return and risk of their portfolio assets. The risk of the overall portfolio can be measured by the volatility of returns, that is the variance or standard deviation. 2. The standard deviation of the returns of an individual security measures how risky that security would be if held in isolation. But an investor who holds a portfolio of securities is interested only in how each security affects the risk of the entire portfolio. 3. The contribution of a security to the risk of portfolio depends on how securitys returns vary with the investors other holdings.

The risk that can be eliminated by diversification is called unique risk. Unique risk arises because many of the perils that surround an individual company are peculiar to that company and perhaps its direct competitors.

Again unique risk (unsystematic risk) are risk factors affecting an individual company and perhaps its direct competitors.

Market risk (systematic risk) risk that you cant avoid regardless of how much you diversify. Market risk stems from economy wide perils that threaten all business.

Market risk explains why stocks have a tendency to move together, so that even well diversified portfolios are exposed to market movements. For a reasonably well-diversified portfolio only market risk matter. Thinking about risk? How can we tell which risks are unique and diversifiable? Where do market risk come from?

There are 3 messages which you want to take from this chapter: 1. Some risks look big and dangerous but are really diversifiable.

If a risk is a unique risk, reflecting perils specific to a particular company, investors can avoid that risk by combining it in a diversified portfolio with many other assets or securities.

From an investor s perspective, unique risk need not be a concern.

2. Market risks are macro risks. Diversified portfolios are not exposed to the unique risks of individual holdings. However, they are exposed to uncertain events which affect the entire securities market or the entire economy. These macro factors include changes in interest rates, industrial production, inflation, exchange rates and energy cost. When these macro factors are favorable, investors do well and vice versa when they go the other way. 3. Risk can be measured. We can measure how risky a stock is by comparing its price fluctuations to those of the market as a whole.

Completion Qs!

Returns from stocks come from (dividends/interest) and ________________ gains or losses.

Ans...dividends, capital

Ans...Real

Ans...market

The Dow Jones Industrial Average includes (less/more) stocks than the Standard & Poors Composite Index.

Ans...less

Completion Qs!

Short-term Treasury Bills are (less/more) risky than long-term Treasury Bonds.

Ans...less

Ans...less

The extra average return from investing in long-term versus short-term Treasury securities is known as the _____premium.

Ans...maturity

On an historic basis, the higher the risk the (higher/lower) the return.

Ans...higher

Completion Qs!

The expected market return is equal to the interest rate on Treasury Bills plus the (normal/real) risk premium.

Ans...normal

The opportunity cost of capital for (safe/risky) projects is the rate of return offered by Treasury Bills.

Ans...safe

Ans...risk

A measure of volatility that is the average value of squared deviation from the mean is called ________.

Ans...variance

Completion Qs!

Another measure of risk is the square root of variance which is also called the ______ _________.

Ans...standard deviation

Ans...expected

Common stocks as a group have a (higher/lower) standard deviation campared to corporate bonds.

Ans...higher

Diversification (increases/reduces) variability because prices of different stocks (do/do not) move exactly together.

Ans...reduces

Completion Qs!

Counter cyclical stocks do well when others do (poorly/well).

Ans...poorly

_______ risk refers to risk factors affecting only a particular firm. It is also called (diversifiable/non-diversifiable) risk.

Ans...Unique; diversifiable

Ans...market

Ans...cannot

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

13-63

Diversifiable Risk

The risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unique or asset-specific risk If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away

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