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Corporate Finance
Session 6

Dilip Kumar 1

Concepts related to stocks

Primary Market: New securities
Secondary Market: Previously-issued securities
Common Stock: Ownership shares in publicly-held corporation
Book Value: Net worth of firm according to balance sheet
Dividend: Periodic cash distribution from firm to the shareholders
P/E Ratio: Price per share divided by earnings per share
Market Value Balance Sheet: Financial statement that uses
market value of assets and liabilities

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Returns
Dollar Return = Dividend + Change in Market Value
dollar return
%age return   dividend  change in market value
beginning market value beginning market value

 dividend yield  capital gains yield

, =

holding period return  (1  r1 )  (1  r2 )  (1  rn )  1

, = ln
Continuously compounded returns are additive, i.e., add the
intermediate periods returns to compute the whole period return.
Dilip Kumar 3

Measuring (Portfolio) Risk

Standard deviation is the square root of variance.
Variance is the average value of squared deviations from mean.
Variance can only be positive.

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Risk Premium
The Risk Premium is the additional return (over and above the
risk-free rate) resulting from bearing risk.
One of the most significant observations of stock market data is
this long-run excess of stock return over the risk-free return.
The average excess return from large company common stocks for the
period 1926 through 1999 was 8.4% = 12.2% – 3.8%
The average excess return from small company common stocks for the
period 1926 through 1999 was 13.2% = 16.9% – 3.8%
The average excess return from long-term corporate bonds for the period
1926 through 1999 was 2.4% = 6.2% – 3.8%

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Risk averse, risk seeking, risk neutral

Risk averse:
Investor prefers less risk to more risk.
Investors do not minimize risk, it’s a tradeoff, i.e., they play with risk to
earn more return. This means that the risk averse investors may have
risky assets in their portfolio.
Risk seeking:
Prefer more risk for the given expected return.
Risk neutral:
Do not care about risk, only look at expected returns while making
investments.

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Markowitz Portfolio Theory

Assumptions:
Investors maximize expected utility over a single period of investment
horizon.
Investors measure risk as variance (or standard deviation) of expected
returns.
Investors decision consider risk and return of the investment
opportunity.
Investors are risk averse.

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The Return and Risk for Portfolios

The rate of return on the portfolio is a weighted average of the
returns of the securities (assets) (constituents) in the portfolio:
rP  wB rB  wS rS
The expected rate of return on the portfolio is a weighted average
of the expected returns on the securities in the portfolio
E ( rP )  wB E ( rB )  wS E ( rS )

The variance of the rate of return on the two risky assets portfolio
is σP2  (wB σB )2  (wS σS )2  2(wB σB )(wS σS )ρBS
where BS is the correlation coefficient between the returns on the
securities in the portfolio.

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Things to consider under Markowitz Portfolio

Covariance

In Markowitz theory, correlation is a main driving force behind

portfolio management (i.e., behind diversification).

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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

Thus diversification can eliminate some, n

but not all of the risk of individual securities. (n  30)

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Two-Security Portfolios with Various Correlations

100% stock 1

return
 = -1.0

 = 1.0

 = 0.2
100% stock 2


Relationship depends on correlation coefficient
-1.0 <  < +1.0
If  = +1.0, no risk reduction is possible
If  = –1.0, complete risk reduction is possible
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Minimum variance portfolio and efficient frontier

Portfolio with the lowest standard deviation for given expected returns.
The portfolios that have greater expected return for a given level of risk
make up the efficient frontier.

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