IS4228 - Lecture 5 - Fall 2021

IS4228: Information Technology and Financial Services
IS4228
Information technology
and financial services
Lecture 5
8 Sept, 2021
1
Overview
• Capital Markets and the Pricing of Risk
• Basics of Portfolio
2
Discounted cash flow analysis
• Determine the asset’s expected cash flow
• Choose discount rate that reflects asset’s risk

• Risk-free interest rate
• Risk premium
• Equity cost of capital
• …
• Calculate present value
3
Value of $100 invested in 1925 in different assets
4
Value of $100 invested for different horizons
5
Risk and return -- St. Petersburg paradox

A casino offers a game of chance for a single player in which a
fair coin is tossed at each stage. The initial stake begins at 2
dollars and is doubled every time heads appears. The first
time tails appears, the game ends and the player wins
whatever is in the pot. Thus the player wins 2 dollars if tails
appears on the first toss, 4 dollars if heads appears on the first
toss and tails on the second, 8 dollars if heads appears on the
first two tosses and tails on the third, and so on.
Mathematically, the player wins 𝟐𝒌 dollars where 𝒌 is a
positive integer equal to the number of tosses.
• How much are you willing to pay to play this game?

6
Risk and return
• Assumption: Investors are risk-averse

• They do not like risk and must be compensated for taking
it.
• The investors demand a risk premium to bear risk.
• How much investors demand (in terms of a higher expected

return) to bear a given level of risk?
7
Common Measures of Risk and Return
• Different securities have different initial prices, pay

different cash flows, and sell for different future amounts.
• To make them comparable, the returns are measured by
the percentage increase in the value of an investment per
dollar initially invested in the security.
• When an investment is risky, there are different returns it
may earn.
• Each possible return has some likelihood of occurring.
• All this information is summarized with a probability
distribution, which assigns a probability, 𝒑𝑹, that each
possible return, 𝑅, will occur.
8
Example: probability distribution
BFI stock currently trades for $100 per share. You believe
that in one year there is a 25% chance the share price will be
$140, a 50% chance it will be $110, and a 25% chance it will
be $80. BFI pays no dividends, so these payoffs correspond to
returns of 40%, 10%, and -20%, respectively.
9

• Expected (Mean) Return
• Expected Return = 𝐸 𝑅 = σ𝑅 𝑝𝑅 × 𝑅
• 𝐸[𝑅𝐵𝐹𝐼 ] = 25%(−0.20) + 50%(0.10) +
25%(0.40) = 10%
• Variance: the expected squared deviation from the mean
• 𝑉𝑎𝑟(𝑅) = 𝐸[ 𝑅 − 𝐸 𝑅 2 ] = σ𝑅 𝑝𝑅 × 𝑅 − 𝐸 𝑅 2
• 𝑉𝑎𝑟 𝑅𝐵𝐹𝐼 = 25% × −0.20 − 0.10 2 + 50% ∗
0.10 − 0.10 2 + 25% × 0.40 − 0.10 2 = 0.045
• Standard deviation: the square root of the variance
• 𝑆𝐷 𝑅 = 𝑉𝑎𝑟(𝑅)
• 𝑆𝐷 𝑅𝐵𝐹𝐼 = 0.045 = 21.2%
10
Example: Common Measures of Risk and Return
11

• The standard deviation of a return is referred to as its
volatility.
• The standard deviation is more commonly used compared
to the variance.
• It is in the same units as the returns themselves.
• Variance and standard deviation do not differentiate
upside and downside risk.
• Semivariance (variance of the losses only)
• Expected tail loss (the expected loss in the worst x% of
outcomes)
• Often produce the same ranking, but are more
complicated to apply
12
Historical Returns of Stocks and Bonds
• In most situations, we do not know the explicit probability

distribution of a security.
• Extrapolate with historical data.

• stable environment
• the distribution of future returns should mirror that of past
returns
13
Realized return
• The realized return is the return that actually occurs over a

particular time period.
𝑫𝒊𝒗𝒕+𝟏 +𝑷𝒕+𝟏
• 𝑹𝒕+𝟏 = −𝟏
𝑷𝒕
• Invest in a stock on date 𝑡 for price 𝑃𝑡 .
• The stock pays a dividend, 𝐷𝑖𝑣𝑡+1 , on date 𝑡 + 1
• The only dividend payment
• Sells the stock on date 𝑡 + 1 for price 𝑃𝑡+1
14
Realized Annual Return

• Dividends do not necessarily pay at the end of a year
• It can be in the middle of a year
• Multiple dividend payments can occur in a year
• Realized annual returns: the return in a year, assuming
that all dividends are reinvested immediately and are used
to purchase additional shares of the same stock
• 𝟏 + 𝑹𝒂𝒏𝒏𝒖𝒂𝒍 = 𝟏 + 𝑹𝟏 𝟏 + 𝑹𝟐 … (𝟏 + 𝑹𝒏 )
• 𝑅1 : the start of the year to the first dividend payment
• 𝑅2 : from the first dividend payment to the second one
• …
• 𝑅𝑛 : from the last dividend payment to the end of the year
15
Example: Realized annual return
16
Empirical distribution
• Over any particular period we observe only one draw from the
probability distribution of returns.
• Multiple draws by observing the realized return over multiple

periods.
• Empirical distribution: a histogram that summarizes the draws

from the probability distribution
• An approximation to the probability distribution
17
Empirical distributions of realized returns
18
Estimations
• The average annual return of an investment during some

historical period is the average of the realized returns for
each year.
ഥ = 𝟏 𝑹𝟏 + 𝑹𝟐 + ⋯ + 𝑹𝑻 = 𝟏 σ𝑻𝒕=𝟏 𝑹𝑻
• 𝑹
𝑻 𝑻
• Estimator of Variance
1
• 𝑉𝑎𝑟 𝑅 = σ𝑇𝑡=1(𝑅𝑡 ത
− 𝑅)
𝑇−1
• 𝑇 − 1 instead of 𝑇
• Estimator of standard deviation: the square root of the
variance estimator
19
Limitations of Expected Return Estimates
• Many individual stocks are very volatile
• Many have not been in existence for long
• The average return investors earned in the past is not a

reliable estimate of a security’s expected return
• Another approach: first estimate a security’s risk, and then

use the relationship between risk and return to estimate its
expected return.
20
The Historical Trade-Off Between Risk and Return
• The Returns of Large Portfolios
21
• The Returns of Individual Stocks
22
• Larger stocks have lower volatility overall.

• Even the largest stocks are typically more volatile than a
portfolio of large stocks, the S&P 500.
• There is no clear relationship between volatility and return.
• All stocks seem to have higher risk and lower returns than
we would have predicted from a simple extrapolation of
our data from large portfolios.
• Why wouldn’t investors demand a higher return from
stocks with a higher volatility?
23
An illustrative example
• Someone (A) tosses a fair coin toss and gives you $1 if it is

head and $0 if it is tail.
• How much you want to pay to A for this game given you
are risk averse?
• Another guy (B) stands besides A, and says that if A’s coin
toss shows tail, B will give you $1 and if A’s coin toss shows
head, B will give you $0.
• How much you want to pay to B?
• 𝑷 𝑨 +𝑷 𝑩 =𝟏
• 𝑷 𝑨 =𝑷 𝑩
• 𝑷 𝑨 = 𝑷 𝑩 = 𝟎. 𝟓
24
• Without B in the market, 𝑷 𝑨 < 𝟎. 𝟓

• With B in the market, 𝑷 𝑨 = 𝑷 𝑩 = 𝟎. 𝟓
• The existence of B changes the price of A
• With B in the market, a rational risk-averse investor will
not only buy A
• B will be bought at the same amount of A to hedge the risk
of A
• In an efficient portfolio, A and B will be bought 1:1
• The existence of B gives a possibility to hedge A’s risk.
25
Return
A, when B is not
in the market
Risk-free
asset
(portfolio
of A&B)
A, when B is
in the market
Volatility
26
• The Returns of Individual Stocks
27
Common Versus Independent Risk
• Consider two types of home insurance: theft insurance and

earthquake insurance.
• Assume that each year there is about a 1% chance that a
home will be robbed and a 1% chance that a home will be
damaged by an earthquake.
• An insurance company writes 100,000 policies of each type
for homeowners in San Francisco
• The risks of the individual policies are similar
• Are the risks of the portfolio of theft insurance policies and
earthquake insurance policies similar?
28
Common Versus Independent Risk
• Common risk: risks that are perfectly correlated

• Earthquake
• Independent risk: risks that share no correlation
• Theft
• When risks are independent, the aggregation of them are
quite predictable.
• Law of Large Number
• The averaging out of independent risks in a large portfolio
is called diversification.
29
Firm-Specific Versus Systematic Risk
• Firm-specific news is good or bad news about the company

itself.
• A firm might announce that it has been successful in
gaining market share within its industry.
• Market-wide news is news about the economy as a whole

and therefore affects all stocks.
• The Federal Reserve might announce that it will lower
interest rates to boost the economy
30
Firm-Specific Versus Systematic Risk
• Fluctuations of a stock’s return that are due to firm-

specific news are independent risks.
• A.k.a., firm-specific, idiosyncratic, unique, or
diversifiable risk
• Fluctuations of a stock’s return that are due to market-

wide news represent common risk.
• A.k.a., systematic, undiversifiable, or market risk
31
No Arbitrage and the Risk Premium
• By having a large portfolio, the firm-specific risks are

cancelled out
• There is nearly no risk in holding the portfolio of a large
number of theft insurance policies
• The risk premium for diversifiable risk is zero, so investors
are not compensated for holding firm-specific risk.
• Risk-free interest rate is earned by the large portfolio, and
thus the individual securities.
• The risk premium of a security is determined by its
systematic risk and does not depend on its firm-specific
risk.
32
Diversification benefits
33
Efficient portfolio
• Efficient portfolio: a portfolio that contains only systematic

risk
• An efficient portfolio cannot be diversified further
• A natural candidate for an efficient portfolio is the market
portfolio, which is a portfolio of all stocks and securities
traded in the capital markets.
• Usually, the market portfolio is assumed to be efficient.
• Practically, the S&P 500 portfolio is often used as an
approximation for the market portfolio.
34
Sensitivity to Systematic Risk: Beta
• Changes in the value of the market portfolio represent

systematic shocks to the economy.
• The systematic risk of a security is calculated by the

sensitivity of the security’s return to the return of the
market portfolio, known as the beta (β) of the security.
• The beta of a security is the expected % change in its
return given a 1% change in the return of the market
portfolio.
35
Sensitivity to Systematic Risk: Beta
• E.g., Suppose the market portfolio is equally likely to

increase by 30% or decrease by 10%. A firm goes up on
average by 43% when the market goes up and goes down
by 17% when the market goes down.
43%−(−17%)
• 𝑏𝑒𝑡𝑎 = = 1.5
30%−(−10%)
• What’s left?
• 43 − 30% ∗ 1.5 = −2%
• −17 − −10% ∗ 1.5 = −2%
• Sometimes referred to as alpha
36
Interpreting Betas
• Beta measures the sensitivity of a security to market-wide

risk factors.
• How sensitive a company’s underlying revenues and cash
flows are to general economic conditions.
• Relatively low betas: PG&E (a utility company), Johnson
& Johnson (pharmaceuticals), General Mills and Hershey
(food processing), and Amgen (biotechnology).
• Relatively high betas: Oracle, Advanced Micro Devices’
(AMD), Coach and Tiffany & Co..
37
Beta and the Cost of Capital

• The market risk premium
• Investors’ appetite for market risk from the market portfolio
• 𝑀𝑎𝑟𝑘𝑒𝑟𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐸 𝑅𝑀𝑘𝑡 − 𝑟𝑓
• Adjusting for beta
• Consider an investment opportunity with a beta of 2.
• This investment carries twice as much systematic risk as an
investment in the market portfolio.
• For each dollar we invest in the opportunity, we could invest
twice that amount in the market portfolio and be exposed to
exactly the same amount of systematic risk.
• Investors will require twice the risk premium to invest in an
opportunity with a beta of 2.
38
Beta and the Cost of Capital
• Cost of capital 𝒓𝑰 for an investment with 𝜷𝑰 satisfy

• 𝑟𝐼 − 𝑟𝑓 = 𝛽𝐼 × 𝐸 𝑅𝑀𝑘𝑡 − 𝑟𝑓
• 𝑟𝐼 = 𝑟𝑓 + 𝛽𝐼 × 𝐸 𝑅𝑀𝑘𝑡 − 𝑟𝑓
• Negative beta
• negative risk premium
• do well when times are bad
• insurance against the systematic risk
• Gold
39
Overview
• Capital Markets and the Pricing of Risk
• Basics of Portfolio
40
Portfolio weights
• Portfolio weights: the fraction of the total investment in the

portfolio held in each individual investment in the
portfolio.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
• 𝑥𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
• E.g., a portfolio with 200 shares of Dolby Laboratories
worth $30 per share and 100 shares of Coca-Cola worth
$40 per share.
• The total value of the portfolio is 200 × $30 + 100 ×
$40 = $10000
200×$30 100×$40
• 𝑥𝐷 = = 60%, 𝑥𝐶 = = 40%
$10000 $10000
41
Portfolio return
• 𝒙𝟏 , … , 𝒙𝒏 are the portfolio weights of the 𝑛 investments in a

portfolio
• These investments have returns 𝑹𝟏 , … , 𝑹𝒏
• The return of the portfolio is
• 𝑅𝑝 = 𝑥1 𝑅1 + 𝑥2 𝑅2 + ⋯ 𝑥𝑛 𝑅𝑛
• The expected return of this portfolio is
• 𝐸 𝑅𝑝 = 𝐸 𝑥1 𝑅1 + 𝑥2 𝑅2 + ⋯ + 𝑥𝑛 𝑅𝑛 = 𝑥1 𝐸 𝑅1 +
𝑥2 𝐸 𝑅2 + ⋯ + 𝑥𝑛 𝐸[𝑅𝑛 ]
42
Covariance of two stocks
• Covariance is the expected product of the deviations of two

returns from their means.
• If two stocks move together, their returns will tend to be
above or below average at the same time, and the
covariance will be positive, vice versa.
• The covariance between returns 𝑹𝒊 and 𝑹𝒋 is:
• 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = 𝐸[(𝑅𝑖 − 𝐸[𝑅𝑖 ])(𝑅𝑗 − 𝐸[𝑅𝑗 ])]
• Estimate of the Covariance from Historical Data
1
• 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = σ𝑡(𝑅𝑖,𝑡 − 𝑅ഥ𝑖 )(𝑅𝑗,𝑡 − 𝑅ഥ𝑗 )
𝑇−1
• T-1 instead of T again!
43
Correlation of two stocks
• The sign of the covariance is easy to interpret, its

magnitude is not.
• It will be larger when the stocks move together but also
when each of the two stocks are more volatile.
• To control for the volatility of each stock, correlation is
introduced.
𝐶𝑜𝑣(𝑅𝑖 ,𝑅𝑗 )
• 𝐶𝑜𝑟𝑟 𝑅𝑖 , 𝑅𝑗 =
𝑆𝐷 𝑅𝑖 𝑆𝐷(𝑅𝑗 )
• Correlation is always between -1 and 1.
44
Computing a Portfolio’s Variance and Volatility

• For a two-stock portfolio with 𝑅𝑃 = 𝑥1 𝑅1 + 𝑥2 𝑅2 ,
• 𝑉𝑎𝑟 𝑅𝑝 = 𝑥12 𝑉𝑎𝑟 𝑅1 + 𝑥22 𝑉𝑎𝑟 𝑅2 +
2𝑥1 𝑥2 𝐶𝑜𝑣 𝑅1 , 𝑅2
• 𝑆𝐷 𝑅𝑝 = 𝑉𝑎𝑟(𝑅𝑝 )
• E.g., Consider the portfolio containing shares of West Air
and Tex Oil. The weight on the two stocks are 50% each.
The volatility of both stocks is 0.134, the covariance
between the stocks is -0.0128
• 𝑉𝑎𝑟 𝑅𝑝 = 50% 2 0.134 2 + 50% 2
0.134 2
+2×
50% × 50% × −0.0128 = 0.0026
• 𝑆𝐷 𝑅𝑝 = 0.0026 = 5.1%
45
The Volatility of a Large Portfolio
• Consider a portfolio of 𝒏 stocks with weights 𝒙𝟏 , 𝒙𝟐 , … , 𝒙𝒏

• 𝑹𝒑 = 𝒙𝟏 𝑹𝟏 + 𝒙𝟐 𝑹𝟐 + ⋯ + 𝒙𝒏 𝑹𝒏
• 𝑽𝒂𝒓 𝑹𝒑 = σ𝒊 σ𝒋 𝒙𝒊 𝒙𝒋 𝑪𝒐𝒗(𝑹𝒊 , 𝑹𝒋 )
• If the stocks are equally weighted

1
• 𝑉𝑎𝑟 𝑅𝑝 = Average Variance of the Individual Stocks +
𝑛
1
(1 − )(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑆𝑡𝑜𝑐𝑘𝑠)
𝑛
46
Volatility of an Equally Weighted Portfolio v.s. the

Number of Stocks
47
Thank you!
Reminder: the 4rd individual assignment is due before next

lecture. (6:30 PM, 15 Sept)
48

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IS4228: Information Technology and Financial Services

• Capital Markets and the Pricing of Risk

Discounted cash flow analysis

• Determine the asset’s expected cash flow

• Choose discount rate that reflects asset’s risk

• Calculate present value

Value of $100 invested in 1925 in different assets

Value of $100 invested for different horizons

Risk and return -- St. Petersburg paradox

• How much are you willing to pay to play this game?

Risk and return

• Assumption: Investors are risk-averse

• The investors demand a risk premium to bear risk.

• How much investors demand (in terms of a higher expected

Common Measures of Risk and Return

• Different securities have different initial prices, pay

Example: probability distribution

Common Measures of Risk and Return

Example: Common Measures of Risk and Return

Common Measures of Risk and Return

Historical Returns of Stocks and Bonds

• In most situations, we do not know the explicit probability

• Extrapolate with historical data.

• The realized return is the return that actually occurs over a

Realized Annual Return

Example: Realized annual return

• Multiple draws by observing the realized return over multiple

• Empirical distribution: a histogram that summarizes the draws

Empirical distributions of realized returns

• The average annual return of an investment during some

Limitations of Expected Return Estimates

• Many individual stocks are very volatile

• Many have not been in existence for long

• The average return investors earned in the past is not a

• Another approach: first estimate a security’s risk, and then

The Historical Trade-Off Between Risk and Return

• The Returns of Large Portfolios

The Historical Trade-Off Between Risk and Return

• The Returns of Individual Stocks

The Historical Trade-Off Between Risk and Return

• Larger stocks have lower volatility overall.

• Someone (A) tosses a fair coin toss and gives you $1 if it is

• Without B in the market, 𝑷 𝑨 < 𝟎. 𝟓

The Historical Trade-Off Between Risk and Return

• The Returns of Individual Stocks

Common Versus Independent Risk

• Consider two types of home insurance: theft insurance and

Common Versus Independent Risk

• Common risk: risks that are perfectly correlated

Firm-Specific Versus Systematic Risk

• Firm-specific news is good or bad news about the company

• Market-wide news is news about the economy as a whole

Firm-Specific Versus Systematic Risk

• Fluctuations of a stock’s return that are due to firm-

• Fluctuations of a stock’s return that are due to market-

No Arbitrage and the Risk Premium

• By having a large portfolio, the firm-specific risks are

• Efficient portfolio: a portfolio that contains only systematic

Sensitivity to Systematic Risk: Beta

• Changes in the value of the market portfolio represent

• The systematic risk of a security is calculated by the

Sensitivity to Systematic Risk: Beta