Professor Chinco

FIN3000
Principles of Finance
Chapter 12
Final exam

Departmental final exam: May 22nd, 10:30am-12:30pm.

Combination of multiple choice questions and calculated

numerical questions.

Given on BlackBoard.

Graded automatically. No partial credits allowed.

Today is last
class session
Big picture
Money has time value, and we need appropriate discount
rate to calculate value at different points of time

E[Payout at time t]
Present value at time 0 = ———————————————————
(1+r)t

Discount rate, r, is higher when either

a) Time-value of money is higher, or
b) Expected future payout is riskier
Big picture, ctd.
How is the discount rate r determined?

Start with prevailing risk-free rate, rf, and then add

an asset-specific risk premium:

r = rf + risk premium

The rf is compensation for the time-cost of money.

The risk premium is compensation for the riskiness of

the future payout.
Big picture, ctd.
How is the discount rate r determined?

Start with prevailing risk-free rate, rf, and then add

an asset-specific risk premium:

r = rf + risk premium

The rf is compensation for the time-cost of money.

The risk premium is compensation for the riskiness of

the future payout.
Big picture, ctd.
How is the discount rate r determined?

Start with prevailing risk-free rate, rf, and then add

an asset-specific risk premium:

r = rf + risk premium

The rf is compensation for the time-cost of money.

The risk premium is compensation for the riskiness of

the future payout.
Big picture, ctd.
How is the discount rate r determined?

Start with prevailing risk-free rate, rf, and then add

an asset-specific risk premium:

r = rf + risk premium

The rf is compensation for the time-cost of money.

The risk premium is compensation for the riskiness of

the future payout.
Big picture, ctd.
Ok. So… how is the risk premium determined?

There are two kinds of risks:

Idiosyncratic/asset-specific/diversifiable
Systematic/market-wide/non-diversifiable

The idiosyncratic risk can be diversified away.

The risk premium should only be determined by amount

of systematic risk in an asset’s future payouts. This
leads us to the Capital Asset-Pricing Model (CAPM).
Big picture, ctd.
Ok. So… how is the risk premium determined?

There are two kinds of risks:

Idiosyncratic/asset-specific/diversifiable
Systematic/market-wide/non-diversifiable

The idiosyncratic risk can be diversified away.

The risk premium should only be determined by amount

of systematic risk in an asset’s future payouts. This
leads us to the Capital Asset-Pricing Model (CAPM).
Big picture, ctd.
Ok. So… how is the risk premium determined?

There are two kinds of risks:

Idiosyncratic/asset-specific/diversifiable
Systematic/market-wide/non-diversifiable

The idiosyncratic risk can be diversified away.

The risk premium should only be determined by amount

of systematic risk in an asset’s future payouts. This
leads us to the Capital Asset-Pricing Model (CAPM).
Big picture, ctd.
Ok. So… how is the risk premium determined?

There are two kinds of risks:

Idiosyncratic/asset-specific/diversifiable
Systematic/market-wide/non-diversifiable

The idiosyncratic risk can be diversified away.

The risk premium should only be determined by amount

of systematic risk in an asset’s future payouts. This
leads us to the Capital Asset-Pricing Model (CAPM).
Today’s topics

What is market ß?

How to measure it

Connecting ß to r

Capital asset-pricing model (CAPM)

What is market
ß?
Market portfolio

If the entire stock market goes up or down, then all

stocks will be affected. Hence, this is systematic
risk. Not easy to diversify away.

Think about the market portfolio as a broad value-

weighted market index, such as the S&P 500.
Market ß “beta”
Return fluctuation in market portfolio represents a non-
diversifiable risk.

We can measure individual stock’s exposure to this risk by

assessing its co-movement with the market portfolio.

Does this stock tend to have high returns when the market
also does well? If so, then it will have a high market beta.

If the stock tends to do well during market crashes, then it

will have a negative market beta. i.e., it will provide
insurance against this kind of bad future state of the world.

The market beta of the market portfolio is 1.

Market ß “beta”
Return fluctuation in market portfolio represents a non-
diversifiable risk.

We can measure individual stock’s exposure to this risk by

assessing its co-movement with the market portfolio.

Does this stock tend to have high returns when the market
also does well? If so, then it will have a high market ß.

If the stock tends to do well during market crashes, then it

will have a negative market beta. i.e., it will provide
insurance against this kind of bad future state of the world.

The market beta of the market portfolio is 1.

Market ß “beta”
Return fluctuation in market portfolio represents a non-
diversifiable risk.

We can measure individual stock’s exposure to this risk by

assessing its co-movement with the market portfolio.

Does this stock tend to have high returns when the market
also does well? If so, then it will have a high market ß.

If the stock tends to do well during market crashes, then it

will have a negative market ß. i.e., it will provide
insurance against this kind of bad future state of the world.

The market beta of the market portfolio is 1.

Market ß “beta”
Return fluctuation in market portfolio represents a non-
diversifiable risk.

We can measure individual stock’s exposure to this risk by

assessing its co-movement with the market portfolio.

Does this stock tend to have high returns when the market
also does well? If so, then it will have a high market ß.

If the stock tends to do well during market crashes, then it

will have a negative market ß. i.e., it will provide
insurance against this kind of bad future state of the world.

The market ß of the market portfolio is 1.

An example

Suppose we look back at the trading history of Turbot-

charged Seafoods and pick out 6 months when the return
on the markets portfolio was plus or minus 1%:

Month Market Return % Turbot Return %

1 +1 +0.8
2 +1 +1.8
3 +1 −0.2
4 −1 −1.8
5 −1 +0.2
6 −1 −0.8
An example, ctd.
Each point shows Turbot’s
return as a function of
the market’s return.

The slope of the line is

Turbot’s market ß.

Turbot’s stock moves in

the same direction with
the market but not as far

Its market ß is >0 but

less than 1.
 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

 An example, ctd.
When the market’s return was +1%, Turbot’s
average return was +0.8%.

When the market’s return was -1%, Turbot’s

average return was -0.8%.

The slope of a line is its rise over run:

+0.8% - (-0.8%) = 1.6%

Rise Change in Turbot’s return
ß = —————— = —————————————————————————
Run Change in market’s return
+1.0% - (-1.0%) = 2.0%

= 1.6% / 2.0% = 0.8

How to measure
it
Estimating ß

ß captures the sensitivity of a stock’s return to the return

on the market portfolio.

ß can be estimated with past returns from the stock and the
market portfolio
Option 1: Ordinary Linear Regression
Option 2: SLOPE function from Excel

For this course, we need to understand how ß can be estimated,

but you are not required to estimate ßs by yourself.

ß for FedEx Corp: https://finance.yahoo.com/quote/FDX/

Estimating ß, ctd.
FedEx’s market ß
was 1.32 as of
May 10th 2022

Yahoo! is estim-
ating this value
using the past 5
years’ monthly
return data.
Estimating ß, ctd.
To calculate ß for a specific stock, we can follow the steps:

Download two data series:

a) Past returns of specific asset
b) Past returns of market index

Common to use 5 years of monthly data, which is t=1,2,…,60 months.

Regress asset’s return on the market’s excess return:

Asset’s return(t) = α + ß [Market’s return(t) - rf] + ε

Slope coefficient is the asset’s market ß.

 Ford’s ß
is 1.26
When the market’s return
increases by 1% in a given
month, Ford’s return is
typically 1.26% higher.
 PG&E’s ß
is 0.15
When the market’s return
increases by 1% in a given
month, PG&E’s return is
typically 0.15% higher.
Connecting ß to
r
Implication for r
Thus, we should expect Ford to have higher expected returns
than PG&E.

This is true even though both firms have similar return

volatilities. i.e., y-axis has same scale in both plots below.

Ford PG&E
ß ≠ return volatility
Ticker Company Beta Ticker Company Standard Deviation (%)
X U.S. Steel 3.01 X U.S. Steel 72.4
MRO Marathon Oil 2.39 MRO Marathon Oil 43.7
AMZN Amazon 1.47 NEM Newmont Mining 41.9
DIS Disney 1.39 AMZN Amazon 26.3
F Ford 1.26 BA Boeing 21.6
BA Boeing 1.24 INTC Intel 20.5
INTC Intel 1.07 CPB Campbell Soup 19.5
GE GE 1.06 PCG Pacific Gas & Electric 19.4
PFE Pfizer 1.02 GOOG Alphabet 19.3
IBM IBM 0.94 F Ford 18.7
GOOG Alphabet 0.91 GE GE 18.6
UNP Union Pacific 0.90 DIS Disney 18.2
UNP Union Pacific 18.1
XOM ExxonMobil 0.82
IBM IBM 17.4
SBUX Starbucks 0.75
WMT Walmart 16.4
KO Coca-Cola 0.70
SBUX Starbucks 15.8
MCD McDonald's 0.68
PFE Pfizer 15.2
CPB Campbell Soup 0.40
XOM ExxonMobil 13.9
WMT Walmart 0.37
MCD McDonald's 13.0
PCG Pacific Gas & Electric 0.15
KO Coca-Cola 12.5
NEM Newmont Mining 0.10
S&P500 9.4
Portfolio ß
We learnt portfolio’s standard deviation can be lower than
the average of individual stocks in the portfolio, due to
diversification.

Diversification reduces portfolio’s exposure to

idiosyncratic risks. But it can’t reduce exposure to
systematic risks.

The ß of a portfolio of stocks is the weighted average of

the ßs of each individual stock in the portfolio.
An example
With only two stocks, Ford and PG&E, we have:

Portfolio’s ß = (% invested in Ford) x Ford’s ß

+ (% invested in PG&E) x PG&E’s ß

If the portfolio has 50% of its money invested in Ford and

the remainder in PG&E, then we would have:

Portfolio’s ß = 50% x 1.26 + 50% x 0.15 = 0.705

An example
With only two stocks, Ford and PG&E, we have:

Portfolio’s ß = (% invested in Ford) x Ford’s ß

+ (% invested in PG&E) x PG&E’s ß

If the portfolio has 50% of its money invested in Ford and

the remainder in PG&E, then we would have:

Portfolio’s ß = 50% x 1.26 + 50% x 0.15 = 0.705

Class problem
If you owned all the S&P Composite Index stocks in the
same proportions as the index itself, then what would be
the ß of your portfolio?

Portfolio ß = 1.0
Class problem
If you owned all the S&P Composite Index stocks in the
same proportions as the index itself, then what would be
the ß of your portfolio?

Portfolio ß = 1.0
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
 Class problem Ticker Company Beta
X U.S. Steel 3.01
MRO Marathon Oil 2.39
AMZN Amazon 1.47
What is the ß of a 3-stock portfolio with 25% of DIS Disney 1.39
its money in Union Pacific, 40% of its money in F Ford 1.26
GE, and the remaining 35% of its money in Marathon BA Boeing 1.24
Oil? INTC Intel 1.07
GE GE 1.06
PFE Pfizer 1.02
Union Pacific’s ß = 0.90
IBM IBM 0.94
GE’s ß = 1.06 GOOG Alphabet 0.91
Marathon Oil’s ß = 2.39 UNP Union Pacific 0.90
XOM ExxonMobil 0.82
SBUX Starbucks 0.75
Portfolio ß = (% invested in UNP) x UNP’s ß KO Coca-Cola 0.70
MCD McDonald's 0.68
+ (% invested in GE) x GE’s ß
CPB Campbell Soup 0.40
+ (% invested in MRO) x MRO’s ß WMT Walmart 0.37
= 25% x 0.90 + 40% x 1.06 + 35% x 2.39 PCG Pacific Gas & Electric 0.15
NEM Newmont Mining 0.10
= 1.49
Capital Asset-
Pricing Model
(CAPM)
Three ways to diversify
Stock investors can eliminate specific risks by holding a
diversified portfolio of many stocks

Three ways to diversify:

a) Construct your own portfolio of 20 or more stock
b) Buy shares of a mutual fund and have the fund manager
construct the portfolio
c) Buy shares of an exchange-traded fund (ETF), which
acts like fund but trades like stocks

Mutual funds and ETFs provide investors with diversific-

ation and professional management at low cost
High E[Return] ≠ good investment
The S&P 500’s had an average excess return of 9.2% over the past 10 years.

Suppose mutual-fund manager with ß = 1.5 had average excess return of 12%
per year over this same time period.

Does the fund manager have superior skill?

No.

Given his market ß = 1.5, we would have expected his average returns to be:

9.2% x Fund manager’s ß = 13.8%

High E[Return] ≠ good investment
The S&P 500’s had an average excess return of 9.2% over the past 10 years.

Suppose mutual-fund manager with ß = 1.5 had average excess return of 12%
per year over this same time period.

Does the fund manager have superior skill?

No.

Given his ß = 1.5, we would have expected his average returns to be:

9.2% x Fund manager’s ß = 13.8%

Capital Asset-Pricing Model
(CAPM)
An asset’s risk premium is given by its market ß times the
average excess return on the market:

Risk premium = (Asset’s ß) x (E[Market return] - rf)

Hence, we can compute the asset’s expected return as

follows:

r = rf + Risk premium
= rf + (Asset’s ß) x (E[Market return] - rf)
Capital Asset-Pricing Model
(CAPM)
An asset’s risk premium is given by its market ß times the
average excess return on the market:

Risk premium = (Asset’s ß) x (E[Market return] - rf)

Hence, we can compute the asset’s expected return as

follows:

r = rf + Risk premium
= rf + (Asset’s ß) x (E[Market return] - rf)
An example

Marathon Oil’s ß = 2.39.

E[MRO’s return] - rf = 9.2%
The average excess return on the market is 9.2%.

According to the CAPM, Marathon Oil’s risk premium is

MRO’s risk premium = 2.39 x 9.2% = 22.0%

When holding Marathon Oil stock, you should expect to

earn the risk-free rate plus 22.0% per year.
Security Market Line (SML)

We can plot the CAPM equation on a graph, with ß on the

x-axis and E[Return] on the y-axis.
Resulting line is called the Security Market Line (SML):
r = rf + ß x (E[mkt return] - rf)
3% 10% 3%
Assume a Treasury bill rate of 3%
and a market return of 10%.

The market risk premium is 10 –

3 = 7%.

X: a stock with a beta of .5

Y: a stock with a beta of .2

ß
Big picture
Money has time value, and we need appropriate discount
rate to calculate value at different points of time

E[Payout at time t]
Present value at time 0 = ———————————————————
(1+r)t

Discount rate, r, is higher when either

a) Time-value of money is higher, or
b) Expected future payout is riskier
Final exam
Final exam

Departmental final exam: May 22nd, 10:30am-12:30pm.

Combination of multiple choice questions and calculated

numerical questions.

Given on BlackBoard.

Graded automatically. No partial credits allowed.

The end