FM311 – Financial Management 1

Module 3. Risk, Return, and Cost of Capital

Lesson 1. Risk and Rates of Return

Time
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Lesson Objectives:

 Discuss investment risks and expected levels of return;

 Identify options of maximising resources on capital assets;
and
 Demonstrate the pricing models relative to capital assets
and investment decisions.

Introduction

Why do people with excess resources invest? The primary reason is the hope of
growing the assets further through expected returns. Is expected return absolutely
certain? The answer is “NO”. It depends on different risks associated with the
investment. You remember maybe what happened in the second half of 2018 until
first half of 2019 in many parts of Mindanao and eventually become a national issue;
the different investment scams affecting different walks of life from a typical
carpenter, labourer, housewife, to educated, and professionals. They were
succumbed to the chaos; putting their hard-earned money into the investment
schemes while defying the logical and realistic reasons. Why did that happen, that
millions of people fell victims?

They were driven by too much hope of getting much return of investment
that is too good to be true but blinded by what they saw the examples or good things
that already happened to few. They forgot the basic principle of investment and
finance. “There is no such thing as easy money, through legal means”.

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ACTIVITY

You check your personal financial transactions. Do you have investment account in
any form? List down your investment accounts? In case you have none at this point,
list down what you plan to invest and when do you plan do to it.

For your existing investment, indicate the net return it has accumulated to
date. What is the percentage of growth? For planned investment list, how much do
you think is your expected return? Why such estimate of return?

ANALYSIS

You have now the percentage of return of your investment. Evaluate it from the
things discussed in the introduction. Do your assessment. Write your answers in one
paragraph.

For planned investment list, do you think you can achieve those plans and
expected return? Specifically how?

ABSTRACTION

Investment
Investment refers to the current commitment of asset for a period of time with the
expectation of receiving returns to compensate the investor for:
(1) the time the funds are committed,
(2) the expected rate of inflation during the period, and
(3) the uncertainty of the future payments.

The process involves the postponement of consumption of the same asset in

exchange of the expected return. The “investor” can be an individual, legal entity, a
government, a pension fund, or other business organisations.

Determinants of Required Rate of Return:

 the time value of money during the period of investment;
 the expected rate of inflation during the period, and
 the risk involved.
Source: www. Pngall.com

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The summation of these three components is referred to as the required rate of

return. This is the minimum rate of return an investor is willing to accept from an
investment in exchange of that deferring of asset consumption.

The complexities of analysis and estimation of the required rate of return are
influenced by the market rates over time. This includes the following:

 A wide range of rates is available for alternative investments in any given

time;
 The rate of return on specific asset changes dramatically over time; and
 The difference among rates available on different assets changes over time.

Expected Returns and Risks

The Real-Risk-Free Rate - The basic interest rate assuming the absence of
inflation and uncertainty about the future of rates. This is the starting point of
establishing interest rate. After then, all the related risk premiums will be added to
come up with the final interest rate as the expected return for the investor at the
same time the rate of charges that the borrower/user of fund agrees to pay for
interest-bearing securities.

Whether the investment is placed in stocks, bonds, real estate, machine tools,
etc., if the expected rate of inflation increases, e.g., from 2 percent to 5 percent, the
investor’s required rate of return for his/her investments should increase by 3%.

In similar manner, if there is decline in the expected real growth of the

economy which will cause decline in real-risk-free rate, e.g., 1%, the required rate
of return on all investments should also decrease by 1%.

Source: www. Pinclipart.com

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Generally, investors require higher expected rate of return if they perceive

that there are uncertainties that will affect the expected rate of return. This increases
to the RFFR will make up then the risk premiums.

Major Sources of Uncertainty:

 Business risk
 Financial risk (leverage)
 Liquidity risk
 Exchange rate risk
 Country (political) risk

Source: www.cleanpng.com
Business Risk
This refers to the uncertainty of income flows attributed to the nature of a firm’s
business, its market position in the industry, and factors that may be inherent to the
business’ existence. If it is perceived to be less certain of good business operational
results, it will also less certain of the flow of income to investors. Thus, investors will
require risk premium to compensate the risk they (investors) absorbed.

Financial Risk
This risk is relative to the mode which the firm financed its business operations. If a
firm uses only equity to finance business operations, it will deal only business risk
due to absence of creditors. But if the firm borrows funds for business operations, it
has to pay first the interest charges to creditors before it can provide share of income
to stockholders. Thus, such uncertainty of expected returns to equity investors will
increase.

Liquidity Risk
This risk refers to the uncertainty introduced by the secondary market of financial
securities. When investors buy financial assets, he/she expects that the security will
mature (in the case of bonds) or it can readily be sold to other investors if the need
for cash arises. If the financial security cannot be sold immediately in the market at
the prevailing price, thus liquidity risk increases.

Exchange rate risk

This refers to the uncertainty on expected returns to investors who purchased
financial securities denominated by a currency other than that of the host country.
Foreign exchange rates fluctuates on a daily basis.

Source: www.fromthegenesis.com

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Country risk
Referred also as political risk; an uncertainty of expected returns caused by a
possibility of major changes or concerns in the political or economic environment
of a country.
.

Source: www.wallstreetmojo.com

Capital Asset Pricing Model (CAPM)

CAPM is a tool used in analyzing the possible expected returns risky assets or
portfolio. This is used in complicated analysis particularly in big portfolios.

Market Liquidity
Liquidity has big impact to market prices. The liquidity of an asset (portfolio)
depends on the ease and speed with which it can be sold at fair market value. Also
part of liquidity are the related costs of engaging in a transaction, particularly the
bid–ask spread. Another bigger factor is the price impact. For instance, the adverse
movement in market price when an investor will execute a very large volume. It can
result to abrupt rise or fall in prices.

Expected Return and Variance

Let us take for instance that you (as portfolio analyst) perceived that there are four
equally likely states of the economy: depression, recession, normal, and good state.
The expected returns on portfolio of Aggressive, Inc. would likely follow the
direction and condition of the economy. On the other hand, expected returns of
Carpe Diem, Inc. do not closely follow the condition of the economy. Expected
returns of the two companies are shown on the succeeding table.

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Based on the computed values above on the comparison between standard

deviations of the two companies, the SD of Aggressive Inc. is almost twice of Carpe
Diem’s. This means that the portfolio of Aggressive Inc. is more volatile.

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Covariance and Correlation

The statistical analysis of variance and standard deviation measure the variability of
individual stock in the portfolio. It is also used to measure the relationship between
the return on one stock and of another. Covariance and correlation can assist in
measuring whether two random variables are related or not; also in measuring how
they are related.

Covariance

Correlation

In order to calculate the correlation, just divide the covariance by the

standard deviations of the two portfolios.

In the above example, the portfolios of the two companies are negatively
correlated; though it is not a perfect negative correlation as the correlation value is
less than “-1.0”.

Capital Asset Pricing Model Formula:

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Portfolio Beta
Consider the example on the table below for the return in the market and return of
Brezdhen Company.

Based on the given possibilities of returns, the market return could either be
20% or -10%; while Brezdhen has four possibilities of returns. It would be helpful in
the analysis to take the expected return on a security for a given return on the
market. In this example, we will assume that the four states of economy are equally
likely of happening.

Brezdhen’s stock responds to the movements in the market as indicated by

its own return which is higher in bull market than in bear market. Now, we measure
how responsive the security is to movements in the market. In the bull economy,
the market return is 30%, i.e., (20% - (-10%); obviously higher than in bear economy.
Then, Brezdhen’s expected return in bull economy is 40%, i.e., 25%- (-15). Therefore,
Brezdhen’s stock has a responsiveness coefficient (beta) of 1.33, i.e., (40%/30%).

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As a result of the analysis, Brezdhen’s expected return is positively related to

the market’s return. Portfolio beta measures how responsive is the security’s return
to the market’s movement. And, with Brezdhen’s beta value of 1.33, it means that
Brezdhen’s return is magnified 1.33 times over market return. If the market does
good, Brezdhen’s will do better. In contrast, if the market is down, Brezdhen’s stock
will incur even more losses.

Now, consider if an investor with portfolio’s return close to that of the market
will add Brezdhen’s stock into his/her portfolio. Since Brezdhen’s beta is 1.33, adding
Brezdhen’s stock to his/her portfolio will contribute much risk to his/her entire
portfolio.

This analysis may help in considering securities with negative betas. An

investor may perceive them as hedges or insurance policies where the securities with
negative beta are expected to do well if the market does poorly. In contrast, it will
do bad when the market is in good condition. Therefore, adding a negative-beta
security to a large and diversified portfolio will reduce the risk of the entire portfolio.
It will mitigate the overall effects of risks in the portfolio.

Further, if you weigh all securities by their market values, you will arrive at a
portfolio which is the same as the market. It is defined that the beta of the market
portfolio is “1.0”. Thus, for every 1% movement in the market, the market must also
move by 1%.

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Formula for Beta:

To sum up the analytical process, beta measures the responsiveness of a security to

movements in the market portfolio.

Relationship Between Risk and Expected Return (CAPM)

It is well-discussed that the expected return of a security should be positively related
to its risk. Remember the basic principle: “High Risk: High Return/High Losses; Low
Risk: Low Return/Low Losses.”

Therefore, what you should do to mitigate risk? First, you analyse the
expected return on the stock market as a whole. Then, you analyse the expected
returns on individual securities.

Expected Return on Market

Generally, investors want to be compensated with the risks they assumed.

That is why risk premium come into play to be positive. But exactly how positive is
it? It is argued that the best estimate could be done for future risk premium is to
consider the average historical risk premiums.

e.g.
Historical data indicated that the expected return on common stocks was 10.43%
over the period 1957 through 2013. The average risk-free rate on 91-day Treasury bills
over the same period was 5.97 percent. Therefore, the average difference between
the two is 4.46%, i.e., (10.43% - 5.97%). Analysts have perceived this to be useful in
estimating the difference to occur in the future.

Further, if the risk-free rate, generally estimated by the yield on a one-year

Treasury bill, is 5 percent, the expected return on the market is therefore 9.46%.

Take note, it would still be projection based on historical data. There is

nothing that could perfectly predict actual values for the future events. An investor

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should keep himself/herself informed of what is going on in the market; always

update with the relevant market data that could aid in the analysis then to make
decisions on his/her portfolio.

Equity Risk Premium Historical Data

Source: cdn.ymaws.com

APPLICATION

Case 1.

Investor C established a portfolio by investing 20% in Stock M, 35% in Stock P, and

45% in Stock Q. The expected returns on these stocks are 9.2%, 11.1%, and 13.8%,
respectively.
What is the portfolio’s expected return? Interpret your answer.

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Case 2.
If a given stock in the portfolio had established 1.23 beta; the related expected
return is at 11.7percent, and 3.5percent is the current earning of a risk-free asset;

a. Determine the expected return on a portfolio that is equally invested in

the two assets?
b. If a portfolio of the two assets has a beta of 0.7, what are the portfolio
weights?
c. If a portfolio of the two assets has an expected return of 9%, what is its
beta?
d. If a portfolio of the two assets has a beta of 2.46, what are the portfolio
weights? How do you interpret the weights for the two assets in this case? Discuss.

CLOSURE

It is advised that you do more readings and work on more examples from the
references provided for this course to reinforce your learning in this lesson. If you
think that there are items that cannot clear out yourself, do communicate with your
professor. Otherwise, if you believe you are ready to take on the next module, let us
proceed. Good Luck!

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