Capital Markets and The Pricing of Risk: Chapter 10 (Part 2)

Chapter 10 (Part 2)
Capital Markets and

the Pricing of Risk
Stock Valuation Techniques:

The Final Word
No single technique provides a final answer regarding a
stocks true value. All approaches require assumptions or
forecasts that are too uncertain to provide a definitive
assessment of the firms value.
Most real-world practitioners use a combination of these
approaches and gain confidence if the results are consistent
across a variety of methods.
10-2
Beta:
A measure of market risk
A measure of:
How an individual shares
returns vary with market
returns
The sensitivity of an
individual shares returns to
changes in the market
For the market: Beta = 1

A firm with Beta =1 has average
market risk. It has the same
volatility as the market
A firm with Beta ___ 1 is more
volatile than the market
A firm with Beta ___1 is less
volatile than the market
10-3
Beta:
A measure of market risk
Beta-the slope of the characteristic line a measure of firms
mkt risk, even after a portfolio has been diversified;
It is this risk and only risk that matters for any investors
who have diversified;
Defensive stock: beta ___ 1, on avg less risky than the
market;
Offensive stock: beta ____ 1, on avg more risky than the
market.
10-4
Calculating beta (Beta shows the avg movement of of XYZ price in

response to mkt index)
Company XYZ return (%)
Market
index
return
(%)
Characteristic line
Beta = slope of
characteristic
line
10-5
Calculating Beta
j = jm x j/m ,
j = beta of security j;
jm = correlation coefficient between returns on security j and
the mkt;
j = std dev of returns on securities j;
m = std dev of returns on mkt return.
10-6
Required rate of return
Required
rate of
return
Risk-free
rate of
return
Market risk
premium
Risk
premium
Firm-specific
+
risk premium
10-7
Required rate of return
Risk-free
rate of
return
Risk
premium
d
ire
qu ld
re ou et
s sh ark
or n
st tur a m
ve e n um
in of r tai emi
An te on pr
ra ly c isk
on r
Required
rate of
return
Market risk
premium
Firm-specific
+
risk premium
10-8
Graphing this relationship
SML
Required
rate of
return
Market
return
11%
Risk-free
rate of
return
4%
Known as the
CAPM
Beta
10-9
The CAPM Model

SML: Security market line
The SML is a relationship between the _________ rate
of return and Beta - the measure of market risk
CAPM: Capital Asset Pricing Model
The return on the KLCI (Kuala Lumpur Composite
Index) on the Bursa Malaysia is a good approximation
for the ______ return
Treasury securities (or FD) are as close to riskless as
possible. i.e. Beta = 0
10-10
The CAPM equation
R j = R f + j ( R m R f )
where
Rj
Rf
j
Rm
= the required return on security j

= the risk-free rate of interest
= the beta of security j
= the return on the market index
10-11
Example
Suppose the Treasury bond rate is 4%, the average
return on the All Ords Index is 11%, and XYZ has a
beta of 1.2. According to the CAPM, what should be
the required rate of return on XYZ shares?
Rj = Rf + j ( Rm Rf )
Here:
Rf = 4%
Rm
= 11%
j = 1.2
Rj = 4 + 1.2 x ( 11 4 )
= 12.4%
According to the CAPM,
XYZ shares should be
______ to give a 12.4%
return
10-12
CAPM theory
Theoretically,
every security
should lie ___
the SML
Required
rate of
return
SML
11%
If a security is on the
SML, then investors
are being fully
compensated for ____
4%
0
Beta
10-13
CAPM theory
If a security is
above the
SML, it is
____priced
Required
rate of
return
SML
11%
If a security is
below the SML,
it is ____priced
4%
0
Beta
10-14
Criticisms of the CAPM

Technical issues
Return on the market
Is this observable?
Use of proxy data
Risk free rate of return

Beta
s a nd
ain a l
m sed oo
Re u t t
y
l
an
de r t
wi po
im
Best proxy?
Theoretical issue
Is it realistic to think that
the risk of an asset can be
accurately reflected by
only the one variable of
market sensitivity?
Measurement issues
Changes over time
10-15
Expected Return
Expected (Mean) Return
Calculated as a weighted average of the possible returns, where
the weights correspond to the probabilities.
Expected Return E R
PR R
E RBFI 25%( 0.20) 50%(0.10) 25%(0.40) 10%
10-16
Variance and Standard Deviation

Variance - The expected squared deviation from the mean
2
Var (R ) E R E R
PR
E R
Standard Deviation- The square root of the variance
SD ( R )
Var ( R )
Both measures of the risk of a probability distribution

10-17
Variance and Standard Deviation (cont'd)

For BFI, the variance and standard deviation are:
Var RBFI 25% ( 0.20 0.10) 2 50% (0.10 0.10) 2
25% (0.40 0.10) 2 0.045
SD( R )
Var ( R )
0.045 21.2%
Volatility = Standard Distribution

The standard deviation is easier to interpret because it is in the same
units as the returns themselves.
10-18
Alternative Example 10.1

Problem
TXU stock is has the following probability distribution:
Probability
Return
.25
8%
.55
10%
.20
12%
What are its expected return and standard deviation?

10-19
Alternative Example 10.1 (contd) - Solution

Expected Return
E[R] = (.25)(.08) + (.55)(.10) + (.20)(.12)
E[R] = 0.020 + 0.055 + 0.024 = 0.099 = 9.9%
Standard Deviation
SD(R) = [(.25)(.08 .099)2 + (.55)(.10 .099)2 + (.20)(.12 .099)2]
= [0.00009025 + 0.00000055 + 0.0000882]
= 0.000179
= .01338 = 1.338%
10-20
10.3
Historical Returns of Stocks and Bonds
Computing Historical Returns

Realized Return
The return that actually occurs over a particular time period.
Rt 1
Divt 1 Pt 1
Pt
Ptt+1 1 Pt
Divt 1
Div
1
Pt
Pt
Dividend Yield Capital Gain Rate
10-21
10.3 Historical Returns of Stocks and Bonds (cont'd)

If you hold the stock beyond the date of the first dividend, then to
compute your return you must specify how you invest any
dividends you receive in the interim. Lets assume that all
dividends are immediately reinvested and used to purchase
additional shares of the same stock or security.
10-22
10.3 Historical Returns of Stocks and Bonds (cont'd)

If a stock pays dividends at the end of each quarter, with realized
returns RQ1, . . . ,RQ4 each quarter, then its annual realized return,
Rannual, is computed as:
1 Rannual (1 RQ1 )(1 RQ 2 )(1 RQ 3 )(1 RQ 4 )
10-23

Problem:
What were the realized annual returns for Ford stock in 1999 and
in 2008?
Date
Price ($) Dividend ($)
12/31/1998
58.69
1/31/1999
61.44
0.26
4/30/1999
63.94
7/31/1999
Return
Date
Price ($) Dividend ($)
Return
12/31/2007
6.73
5.13%
3/31/2008
5.72
-15.01%
0.26
4.49%
6/30/2008
4.81
-15.91%
48.5
0.26
-23.74%
9/30/2008
5.2
8.11%
10/31/1999
54.88
0.29
13.75%
12/21/2008
2.29
-55.96%
12/31/1999
53.31
-2.86%
10-24
Alternative Example 10.2 - Solution

Solution
We compute each periods return using Equation. For example, the
return from December 31, 1998 to January 31, 1999 is:
61.44 0.26
1 5.13%
58.69
We then determine annual returns:
R1999 (1.0513)(1.0449)(0.7626)(1.1375)(0.9714) 1 7.43%

R2008 (0.8499)(0.8409)(1.0811)(0.440) 1 66.0%
10-25

Solution
Note that, since Ford did not pay dividends during 2008, the return
can also be computed as:
2.29
1 66.0%
6.73
10-26
Average Annual Return (Portfolio)

1
R
T
R1
R2 L
RT
t 1
The average annual return for the S&P 500 from 1999-2008 is:
1
R
(0.210 0.091 0.119 0.221 0.287
10
0.109 0.109 0.158 0.055 0.37) 0.7%
10-27
Estimation Error: Using Past Returns to Predict the

Future
We can use a securitys historical average return to estimate
its actual expected return. However, the average return is
just an estimate of the expected return.
10-28
Estimation Error: Using Past Returns to Predict the

Future (cont'd)
Standard Error of the Estimate of the Expected Return
SD(Average of Independent, Identical Risks)
SD(Individual Risk)
Number of Observations
95% Confidence Interval
Historical Average Return (2 Standard Error)
10-29
Taking a Global Perspective

Investing today is more sophisticated and more international.
Investors now search for good companies, regardless of
their location.
Investment in foreign securities can be very rewarding but
also potentially very risky.
10-30
Diversification in Stock Portfolios

Firm-Specific Versus Systematic Risk
Firm Specific News
Good or bad news about an individual company
Market-Wide News
News that affects all stocks, such as news about
the economy
10-31
Impact of the Market

______ risk is the single most important risk affecting the
price movement of ordinary shares.
Particularly true for a diversified portfolio
of ordinary shares.
Accounts for 90% of the variability in a diversified portfolios return.
Investors buying foreign shares face market risk of the

economies in which the companies operate.
10-32
Portfolio Risk and Diversification
p %
35
20
Portfolio risk
Market Risk
0
10 20 30 40 ......
100+
Number of securities in portfolio
10-33
Required Rate of Return

___________ expected rate of return needed to induce
investment.
Given risk, a security must offer some minimum expected
return to persuade/compensate an investor purchase it.
RRR = RF + Risk premium.
Investors expect the risk free rate as well as a risk premium
to compensate for the additional risk assumed. Eg.
10-34
Components of the Required Rate of Return

RF = Real rate of return + Inflation premium
Real rate of return is the basic exchange rate in the economy.
Nominal risk free rate must contain a premium for expected
inflation.
The risk premium:

Reflects all _________ in the asset.
10-35
Understanding the Required Rate of Return

Different financial assets have different required rates of
return.
Different securities within a particular asset class will
have different required rates of return.
The level of required rate of return changes over time
(e.g. with changes in inflationary expectations or changes
in risk premiums).
10-36
The Risk-Return Trade-off
10-37

Firm-Specific Risk
Independent Risks
Due to firm-specific news
Also known as:
Firm-Specific Risk
Idiosyncratic Risk
Unique Risk
Unsystematic Risk
_____________Risk
Systematic Risk
Common Risks
Due to market-wide news
Also known as:
Systematic Risk
________________ Risk
Market Risk
In a portfolio, ______ firm specific risk can be diversified.

10-38

Consider two types of firms:
Type S firms are affected only by systematic risk.
There is a 50% chance the economy will be strong
and type S stocks will earn a return of 40%; There is
a 50% change the economy will be weak and their
return will be 20%. Because all these firms face the
same systematic risk, holding a large portfolio of type
S firms will not diversify the risk.
10-39
Diversification in Stock Portfolios (cont'd)

Type I firms are affected only by firm-specific risks.
Their returns are equally likely to be 35% or 25%,
based on factors specific to each firms local market.
Because these risks are firm specific, if we hold a
portfolio of the stocks of many type I firms, the risk is
diversified.
10-40
10.6 Diversification in Stock Portfolios (cont'd)

Actual firms are affected by both market-wide risks and firmspecific risks. When firms carry both types of risk, only the
unsystematic risk will be diversified when many firms stocks are
combined into a portfolio. The volatility will therefore decline until
only the systematic risk remains.
10-41
Figure 10.4 The Empirical Distribution of Annual

Returns for U.S. Large Stocks (S&P 500), Small Stocks, Corporate Bonds,
and Treasury Bills, 19262008
10-42
Figure 10.6 Historical Volatility and Return for 500 Individual

Stocks, by Size, Updated Quarterly, 19262005
10-43
Textbook Example 10.6
10-44
Type S Firm :
Expected return =
SYSTEMATIC RISK ONLY

0.5 (40%) + 0.5(- 20%) = 10%
Standard Deviation/Volatility :
NOT DIVERSIFIABLE
10-45
Type I Firm :
FIRM SPECIFIC RISK ONLY
Expected return =
0.5 (35%) + 0.5(- 25%) = 5%
Standard Deviation/Volatility :
DIVERSIFIABLE
10-46
Volatility of Portfolios of Type S and I Stocks

Systematic risk
only
Systematic
+
Firm Specific Risk
Firm specific risk

only
10-47
No Arbitrage and the Risk Premium

Arbitrage opportunity: Any situation in which it is possible to
make a profit ________ taking any risk or making any
investment. Eg. Borrow @ Rf to invest.
Arbitrage exists as a result of market inefficiencies; it
provides a mechanism to ensure prices do not deviate
substantially from fair value for long periods of time.
10-48
No Arbitrage and the Risk Premium

The risk premium for diversifiable risk is _______, so
investors are not compensated for holding firm-specific risk
(unsystematic risk/unique risk).
If the diversifiable risk of stocks were compensated with an
additional risk premium, then investors could buy the stocks, earn
the additional premium, and simultaneously diversify and eliminate
the risk.
10-49
No Arbitrage and the Risk Premium (cont'd)

By doing so, investors could earn an additional premium without
taking on additional risk. This opportunity to earn something for
nothing would quickly be exploited and eliminated. Because
investors can eliminate firm-specific risk for free by diversifying
their portfolios, they will not require or earn a reward or risk
premium for holding it.
10-50

The risk premium of a security is determined by its
systematic risk and does not depend on its diversifiable risk.
This implies that a stocks volatility, which is a measure of total risk
(that is, systematic risk plus diversifiable risk), is not especially
useful in determining the risk premium that investors will earn.
10-51

Standard deviation is not an appropriate measure of risk for
an individual security.
There should be no clear relationship between volatility and
average returns for individual securities. Consequently, to
estimate a securitys expected return, we need to find a
measure of a securitys systematic risk.
10-52
10-53
Textbook Example 10.7 (cont'd)
10-54
Measuring Systematic Risk

Efficient Portfolio
A portfolio that contains only _________ risk.
There is no way to reduce the volatility of the
portfolio without lowering its expected return.
Market Portfolio
An efficient portfolio that contains all shares and
securities in the market
The S&P 500 is often used as a proxy for the market portfolio.
10-55
10.7 Measuring Systematic Risk (cont'd)

Sensitivity to Systematic Risk: Beta ()
The expected percent change in the excess return of a
security for a 1% change in the excess return of the
market portfolio.
Beta _______ from volatility. Volatility measures total
risk (systematic plus unsystematic risk), while beta is
a measure of only _________ risk.
10-56
10-57
Change of return in the market portfolio

= 47% - (-25%) = 72%
Changes in return in Type S firm = 40% - (-20%) = 60%
S = Return of Firm S
= 60%/72% = 0.833%
Market Return
Firm I has only firm specific risk No systematic risk
I = 0
10-58
10.7 Measuring Systematic Risk (cont'd)

Interpreting Beta ()
A securitys beta is related to how sensitive its underlying
revenues and cash flows are to general economic conditions.
Stocks in cyclical industries are likely to be more sensitive to
systematic risk and have higher betas than stocks in less sensitive
industries.
Cyclical industry: an industry that is sensitive to the
business cycle, such that revenues are generally
higher in periods of economic prosperity and
expansion, and lower in periods of economic downturn
and contraction. Eg: Airline industry.
10-59
Beta and the Cost of Capital

Estimating the Risk Premium
Market risk premium
The market risk premium is the reward investors expect to earn for holding
a portfolio with a beta of 1.
Market Risk Premium E RMkt rf
Capital Asset Pricing Model :

E R Risk-Free Interest Rate Risk Premium
rf (E RMkt rf )
10-60

Problem
Assume the economy has a 60% chance of the market return will
15% next year and a 40% chance the market return will be 5%
next year.
Assume the risk-free rate is 6%.
If Microsofts beta is 1.18, what is its expected return next
year?
10-61

Solution
E[RMkt] = (60% 15%) + (40% 5%) = 11%
E[R] = rf + (E[RMkt] rf )
E[R] = 6% + 1.18 (11% 6%)
E[R] = 6% + 5.9% = 11.9%
10-62
10-63
Recap: Some important terminologies

Risk: The potential variability in future cash flows. Can be
measured by the Standard deviation of the expected return.
Risk premium: The additional return expected for assuming
risk.
Yield to maturity: The rate of return the investor will earn if a
bond is held to maturity.
Historical return: The return earned on a past investment.
Expected rate of return: The arithmetic mean or average of all
possible outcomes where those outcomes are weighted by the
probability that each will occur.
10-64
Terminologies (Continued)
Beta: The relationship between an investments returns and
the market returns. This is a relative measure of the
investments non-diversifiable risk.
Covariance: The statistical measure of the degree of comovement between two asset returns. It essentially
measures the tendency of the two stocks to co-vary. A
positive covariance between two stock returns suggested
that as one return goes up the other tends to go up as well,
and vice versa.
10-65
Terminologies (Continued)
Correlation coefficient: A standardised measure of
covariance. While covariance can theoretically take on any
value, the correlation coefficient takes on values between -1
and 1.
Required rate of return: The minimum rate of return
necessary to attract an investor to purchase or hold a
security. It is also the discount rate that equates the present
value of the cash flows with the value of the security.
Efficient portfolios: Portfolios with a higher level of return for
the same level of risk, or a lower level of risk for the same
level of return.
10-66

Capital Markets and The Pricing of Risk: Chapter 10 (Part 2)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Markets and The Pricing of Risk: Chapter 10 (Part 2)

Uploaded by

Copyright:

Available Formats

Chapter 10 (Part 2)

Capital Markets and

Stock Valuation Techniques:

For the market: Beta = 1

Calculating beta (Beta shows the avg movement of of XYZ price in

Required rate of return

Required rate of return

Graphing this relationship

The CAPM Model

The CAPM equation

= the required return on security j

Criticisms of the CAPM

Risk free rate of return

E RBFI 25%( 0.20) 50%(0.10) 25%(0.40) 10%

Variance and Standard Deviation

Standard Deviation- The square root of the variance

Both measures of the risk of a probability distribution

Variance and Standard Deviation (cont'd)

Volatility = Standard Distribution

Alternative Example 10.1

What are its expected return and standard deviation?

Alternative Example 10.1 (contd) - Solution

Historical Returns of Stocks and Bonds

Computing Historical Returns

Dividend Yield Capital Gain Rate

10.3 Historical Returns of Stocks and Bonds (cont'd)

10.3 Historical Returns of Stocks and Bonds (cont'd)

1 Rannual (1 RQ1 )(1 RQ 2 )(1 RQ 3 )(1 RQ 4 )

Alternative Example 10.2

Price ($) Dividend ($)

Price ($) Dividend ($)

Alternative Example 10.2 - Solution

R1999 (1.0513)(1.0449)(0.7626)(1.1375)(0.9714) 1 7.43%

Alternative Example 10.2 - Solution

Average Annual Return (Portfolio)

Estimation Error: Using Past Returns to Predict the

Estimation Error: Using Past Returns to Predict the

95% Confidence Interval

Historical Average Return (2 Standard Error)

Taking a Global Perspective

Diversification in Stock Portfolios

Impact of the Market

Investors buying foreign shares face market risk of the

Portfolio Risk and Diversification

Number of securities in portfolio

Required Rate of Return

Components of the Required Rate of Return

The risk premium:

Understanding the Required Rate of Return

The Risk-Return Trade-off

Diversification in Stock Portfolios

In a portfolio, ______ firm specific risk can be diversified.

Diversification in Stock Portfolios

Diversification in Stock Portfolios (cont'd)

10.6 Diversification in Stock Portfolios (cont'd)

Figure 10.4 The Empirical Distribution of Annual

Figure 10.6 Historical Volatility and Return for 500 Individual

Textbook Example 10.6

SYSTEMATIC RISK ONLY

FIRM SPECIFIC RISK ONLY

0.5 (35%) + 0.5(- 25%) = 5%

Volatility of Portfolios of Type S and I Stocks

Firm specific risk