Introduction

 Expectation Level.
Financial Statements.
Time value of Money.
Bond valuation

Intrinsic Value

Maximize the value of the

Firm.
Teaching
Theory

Practice

Excel

Assignments
Course Deliverables
 This course builds the foundation for the electives in
Finance.(Finance Students)

 Portfoliomanagement.
 Security Analysis.
 Corporate Finance and Others.

 Even if students who do not want to specialize in

Finance, it is an important course to learn about firm
valuation process.
Chapter 6

Risk and Returns.

Learning Objectives
 The link between the firm’s risk and the rate of
return expected by the shareholders with the
weighted average cost of capital WACC.
 Why is it vital to understand the risk.
 What is the risk and how it is related with the
investment.
 Relationship between the risk and the required rate
of return.
 How risk and return interact to determine the
security prices.
Intrinsic value, Risk, and Return
Risk and Return
 There are 3 stock exchange in the US market
and the one is Nasdaq. (2014-2015)
Ova Science
384%

Bio Life
-81%
 Other than smaller firms,
Southwest Airline
125%

Avon Product Big Stock

-45%
What Happened in Pakistan
 Roughly more than 300 public limited firms are
traded in the year 2019. Who is the best performer.

Bawany Air Product

501.20%

Dewan Mushtaq Textile

-80.29%

Akzo Nobel
81.37%

-55.70%
Lesson
 Importance for Managers: may apply these
concepts as they plan the actions that shape the
future of the firms.
 Importance for the Investors: to understand the
risk to make appropriate investment decisions.
Investment Returns and Risks.
 Businesses and individuals invest today to earn more
tomorrow. How much they have earned is gauged in
returns.

 But, the initial size of investment matters so, as the

investment horizon therefore, dollar returns are not
enough.
Self-Test
Stand-Alone Risk Versus Portfolio Risk.
 Risk in finance can be defined as the lower than
expected return.
 Risk is studied at two levels-one is stand-alone
risk of a firm-second is the portfolio risk.
 First we measure the risk in discrete terms when
scenario analysis can be constructed.
 Lets take the example of 2013, when the market
fell sharply when the chairman of federal reverse
announced that stimulus policies may halt soon.
Probability Distribution for the discrete Outcomes.
Expected Rate of Return.
 The expected rate of return can be expressed as

 Such that,
Measuring the Stand-alone Risk:
 The expected rate of return is needed.
 Then deviations are to be taken such as,

 These deviations are squared to get the variance,

 Finally square root of the variance is the Standard

deviation
Self-Test.
Limitation of Discrete Distribution.
Risk in a Continuous Distribution.
 When the number of scenarios are increasing and
probable outcome become infinite, then the risk is
gauged using the normal distribution.
Explanation
 Now let us take the simple example that the average
annual rate of return is 10% and the standard deviation
is 35%.
 What is the probability that returns will within the limits of
-25% to 45% ?
 What are the chances that annual returns are even more
lower than -25%, that is, one SD lower than average
annual returns??
 What matters more 45% or -25% ???
 Now, if you have invested for 10 years, chance is 10%
that you will lose money, with 20 years of investment,
chance is 4%. Lesson ????
Using Historical Data to Estimate Risk.
 The average returns and the risk is estimated as
following using the historical data.
Two Firms: Averages and Standard Deviation.
 The graph of monthly returns for the last 4 years are shown
for the two firms, along with annualized return and SD.
Lessons from Last Graph
Risk and Returns for the Stocks
Historical Trade-Off b/w Risk and Return
 The historical tradeoff between risk and returns for the
different classes of investments in the US market.
In Pakistan Size and Value Premium.
 In case of Pakistan as well the smaller stocks are more
volatile than bigger stocks. Similarly, value stocks are
more volatile than growth stocks.
Risk in a portfolio Context:-
 All financial institutions have statutory required to hold
diversified portfolio to reduce the investment related
risks.
 First we start with the portfolio return in any period,
which is a simple weighted average of the actual returns
of the stocks in the portfolio.

 The average portfolio return over the number of periods,

Example
 Take the following example of Microdrive and Snail
Drive.

 Now if 75% is invested in SnailDrive and 25% is invested

in the MicroDrive then the return on the portfolio is,

 Now with these weights the portfolio return is higher than

SnailDrive but what about the risk.
 The Standard Deviation of this portfolio is actually 21.8%
which is lesser than SD of SnailDrive which is 25.8%.
Why Portfolio Risk is Lower.
 Whenever, a portfolio is constructed, then the risk of
overall portfolio depends not only the Standard Deviation
of the stocks but also on their correlation structure.
 The correlation is the tendency of the two stocks to move
together. Lesser the correlation the higher is the benefits
of the diversification and thus lesser risk.
 Precisely, the portfolio SD is lesser than the weighted
average of the individual stocks’ SDs, if the correlation
between the stocks is lesser than 1.’
 The maximum benefit from diversification is then the
correlation between the stocks is -1. In fact with -1,
correlation, the portfolio risk can be 0 with positive
returns.
Diversification and Multi-Stock Portfolios.
 If one keeps on increasing the number of stocks in the
portfolio, even if this selection is random, the average
portfolio risk with the large number of stocks is always
less.
 There are more than 2000 common stocks are listed in
the NYSE.
 The average SD of the stock in recent years is 35%.
 The market SD is 20%.
 The average SD of the portfolio with more stocks is
always lesser than the SD of the portfolio with lesser
stock.
 In Pakistan for last 10 years, the average SD of the
single stock is 62.62% and for the market it is 21.95%
Diversification
The Limit of Diversification.
 The firm specific risks such as, lawsuits, strikes,
marketing programs success/failure etc. are diversifiable.
 Market risk that stems from inflation, recession, higher
interest rates that affect all firms cannot be diversified.
The Relevant Risk of a Stock: The Capital Asset
Pricing Model (CAPM)
 What is the risk in the context of the stock when all of the
stock specific risk can be diversified.
 The stock risk is its contribution to the well-diversified
portfolio risk, which is much smaller than the stock’s
stand-alone risk.
 This relevant measure of risk is the stock beta which can
be estimated as under,

 The stocks with the high σi with tend to have high beta,
further with the high correlation with the market will also
tend of have higher beta.
Continued…
 Now lets see that how the beta of the portfolio is
calculated.

 Now, suppose that investor owns a $100,000 and

invested $25,000 in each of four stocks; the stocks have
beta of 0.6, 1.2, 1.4 and 1.4. The weight of each stock in
the portfolio is 25%. The portfolio’s beta will be,
Continued….
 The variance and the standard deviation of the well
diversified portfolios is

 The contribution of each stock for the SD of portfolio is

computed as under,

 Using the above formula for the example for stocks we

can get the contribution of SDs of the stocks for the
portfolio.
Continued…
Estimating Beta
 Beta is estimated using the historical data and it is
assumed that it will remain stable in future to represent
the inherent risk of the firm.
 The historical data could be monthly returns over 10
years,5 years or 4 years.
 The Table given below gives the information about the
MicroDrive and SnailDrive for last 4 years.
Reproduce!!!!!
Continued….
 There are well known companies that provide the betas
related information for the firms.

 There are other ways to estimate betas as well,

Interpreting the Estimated Beta
 What does beta tell.
Reproduce!!!
Self-Test
The Relationship between Risk and Return in the
Capital Asset Pricing Model.

 If beta is an adequate measure of the risk of the stock

then the required rate of return associated with that stock
should be linked with its beta.
The Security Market Line (SML)
 The required rate of return is the risk free rate plus the
extra return that investor require to hold a risk stock.
 The SML formalizes this concept by showing that stocks
risk premium is the product of stock’s beta and the
market premium.
Risk-Free Rate and Market Risk Premium
 The yield on the long-term Treasury bonds is often used
to measure the risk free rate.
 This rate, any investor will earn without facing a default
risk, therefore the investor wants higher returns than risk
free rate, whenever risky investment is made.
 The market premium is the extra rate of return that
investors require to invest in the stock market rather than
investing in the Treasuries.
 Whereas, the required rate of return on the market is
sum of risk free rate and the risk premium on the market.
The Risk Premium for an Individual Stock.
 The CAPM shows that the risk premium for an individual
stock is equal to the product of the stock’s beta and
market premium.
Continued….
 Following figure shows the SML when risk free rate is
6% and market premium is 5%.
The impact on Required Returns due to change in
the Risk-Free Rate, Risk Aversion, and Beta
 The required return depends on the risk-free rate, the
market risk premium, and the stock’s beta.
 Change in risk-free rate increases the required return of
all the stocks, but do not change the slope of SML.
 On the other hand if market premium changes that it will
effect the risk aversion and the slope of the SML will be
become steeper.
 If the market premium rises then its effect on the riskier
stock. For instance, the required rate of return of the
stock with b=0.5 will only increase by 1.25% and stock
with b=1 finds its required rate of return to be increased
by 2.5%. Market premium changes from 5% to 7.5%.
Figure
Changes in a Stock’s Beta Coefficient.
 Given risk aversion and positively sloped SML the higher
the stock beta the higher the required rate of return.
 A firm can change its beta through chances in the
composition of its assets and through its use of debt.
 Change is capital structure and call for higher debt ratio
increases the beta.
 Company beta can also increase if the industry
competition increases.
Portfolio Returns and Portfolio Performance
Evaluation.
 The required rate of return on a portfolio is the weighted
average of the required returns on the individual assets
in the portfolio:

 For using the above equation one needs not to estimate

the beta of the portfolio, in fact portfolio beta is the
average of the individual betas of the portfolios.
 Further with the above equation one can also evaluate
the performance of the managers by comparing the
require rate of returns in liaison with betas.
Required Returns versus Expected Returns:
Market Equilibrium
 There is a difference between the market price and
intrinsic value of a stock.
Continued….
 Market mechanism is such that price of the securities,
either bond or stock, move towards their intrinsic value.
 Resultantly, in market equilibrium.
Continued…