Lecture 3

Valuing Risky Assets II

 Objectives
• Learn how to estimates beta from scenarios
• Discuss the Certainty Equivalent Method
• Learn how to estimate certainty equivalents
from prices in financial markets
The Certainty Equivalent (CE) Method
• Estimation of betas from scenarios.
• When to use the certainty equivalent method?
– Using risk-adjusted discount rate method is unintuitive or
technically impossible:
• PV has a different sign than expected cash flow, or PV is zero.
– Using risk-adjusted discount rate method is practically very
difficult:
• Comparison firms are not available.
• Estimating return-betas is not possible.
– Certainty equivalent method can be especially helpful in
two cases:
• When choosing among mutually exclusive projects.
• When forward prices are available.
The Certainty Equivalent (CE) Method
• Example: How is it possible that the sign of expected cash flow
differs from the sign of its present value?
– Consider the following project (assume CAPM holds and, for simplicity,
that the risk-free rate is zero):

Market Incremental
Outcome Prob. Return CF
Boom 0.5 12% 5,000
Recession 0.5 -2% -5,000

• Project has a zero expected cash flow but its present value is clearly
negative. Why?
• Project cannot be evaluated using the risk adjusted discount rate
method. Why?
 How does the CE Method work?
• Discount the certainty equivalent cash flows at
the risk-free rate.
• What are the certainty equivalent cash flows?
• Future certain cash flows that would make the
market indifferent between such cash flows or
taking the risky cash flows associated with the
project.
• That is, the CE method makes the adjustment for
risk in the numerator. By contrast, the risk-
adjusted discount rate method makes the
adjustment for risk in the denominator.
 Implementation of CE Method
• Compute the CE cash flow:
~ ~
CE (C )  E (C )  b(rM  rf )
~
cov(C , ~rM )
where b 
M 2

• Discount the CE cash flow at the risk-free rate:

~
E (C )  b(rM  rf )
PV 
1  rf
How does b compare to β?
b: cash-flow beta β: return beta
(a.k.a. dollar beta)

b measures the β measures the

covariance of cash covariance of returns
flows with returns with returns

b can be directly β cannot be directly

computed after computed from
forming scenarios scenarios

b: tracking portfolio’s β: tracking portfolio’s

dollar investment in percentage
the market portfolio investment in the
market portfolio
 How does b compare to β?
• If β’s are computable:
– For CAPM: b = βPV
– For APT, for each beta: bi = βi PV

• When applicable, both the CE method and the

risk-adjusted discount rate method must give
exactly the same answer.
 How does b compare to β?
• Proof: ~
E (C )
– We know that: PV 
1  rf   ( RM  rf )

~
– This implies that: PV (1  rf )  PV ( )( RM  rf )  E (C )

– Since b = β PV, then we have that

~
PV (1  rf )  b( RM  rf )  E (C )
Or
~
E (C )  b( RM  rf )
PV 
1  rf
 Example
• A firm has to decide whether to build 10 apartments for a
total cost of $20 million. One year after making the initial
investment, the project is done and the market value of the
apartments depends on the state of the economy. Evaluate
the project using the CE method. Assume CAPM holds and
that the risk-free rate is 6%.
Value of
Market Apartments
Outcome Probability Return (in millions)

Recovery 1/2 30% $35

Recession 7/16 -5% $18
Depression 1/16 -20% $10
 A quick statistics reminder
n
Mean : E ( x)     pi xi
i 1

n
Variance : Var ( x)  E ( x   ) 2   pi ( xi   ) 2
i 1

n
Covariance : Cov( x, y )   pi ( xi   x )( yi   y )
i 1
 Example
Value of
Market Apartments
Outcome Probability Return (in millions)

Recovery 1/2 30% $35

Recession 7/16 -5% $18
Depression 1/16 -20% $10

1.) E (~
rm )  1 (0.30)  7 (0.05)  1 (0.20)  0.11563
2 16 16

2.)Var (~rm )  1 (0.30  05.11563) 2  7 (0.05  0.11563) 2  1 (0.20  .1163) 2

2 16 16
 0.017  0.012  0.00623
 0.03523
~
3.) E (V )  1 (35)  7 (18)  1 (10)  2
2 16 16
 Example
~
4.)Cov(V , ~
rm )  1 (0.30  05.11563)(35  26) 
2
7 (0.05  0.11563)(18  26) 
16
1 (0.20  .11563)(10  26)
16

 0.82967  0.57971  0.31563

 1.725
5.) Use CE Method:
1.725
26 - (0.11563  0.06)
0.03523 23.276
PV  
1  0.06 1.06
 21.96

NPV  21.96  20  1.96  Accept theProject

Computing Certainty Equivalents from
Prices in Financial Markets
• The forward price of, e.g., a commodity, represents the
certainty equivalent price rather than its expected
price.
• A forward contract obligates you to buy or sell a
specific commodity at a specific price on a specific
delivery date.
• If you buy (long) such a forward contract, you must buy
the commodity at the stated time and price. If you sell
(short) the contract, you must sell the commodity at
the stated time and price.
• If forward prices are available and are related to future
cash flows, we should use the CE method for valuation.
Example: Valuation of a Copper Mine
• A mine will produce 25,000 pounds of copper one year
from now and 50,000 pounds of copper two years from
now.
– Assume that:
• Extraction costs are $0.10 per pound.
• Forward prices of copper are F1=0.65 $/pound and F2=0.60
$/pound.
• Risk free rates are 5% for one year bonds and 6% for two year
bonds.
– Questions:
• Describe the certainty equivalent cash flows.
• Find the tracking portfolio that perfectly tracks the cash flows of
the mine.
• Value the mine.
Example: Valuation of a Copper Mine
• What are the Certainty Equivalent Cash Flows?
~
CE (C1 )  F1Q1  K1  25,000 * 0.65  25,000 * 0.10
 $13,750

~
CE (C2 )  F2Q2  K 2  50,000 * 0.60  50,000 * 0.10
 $25,000
Example: Valuation of a Copper Mine
T=0 T=1 T=2

Mine Value PV  ? 25( P1  0.10) 50( P2  0.10)

Forward Contract
to buy 25K lbs of 0 25( P1  0.65) 0
copper at beg. of Yr 1
Forward Contract
to buy 50K lbs of
0 0 50( P2  0.60)
copper at beg. of Yr 2
Buy risk - free bonds
13,750
paying 25(0.65 - 0.10) 25(0.65  0.10) 0
beg. of yr1 1.05
Buy risk - free bonds
paying 50(0.60 - 0.10)
25,000 0 50(0.60  0.10)
beg. of yr 2 (1.05) 2
Replicated Cash
PV  $35,345 25( P1  0.10) 50( P2  0.10)
Flows
 Remarks:
• In the previous example, the portfolio perfectly tracks
the mine cash flows.
• Assumption: Copper production takes place on the
dates forward contracts matures.
• Availability of forward prices strongly suggests the CE
method.
• Why do we analyze a mine? (in general “commodity
based” projects)
• Unambiguous connection to underlying asset.
• Forward contract on a metal.
• Cash flows largely determined by the price of copper.