Finance for Entrepreneurs

FE - #10617
Joaquim Pina
DCSA
FCT-NOVA

Fall 2022 FE #10617 -- Joaquim Pina 1

Investments -- Risk, Return and Hedging
• Raising funds
• Fit between sources of financing and their maturity with the needs/assets/projects
and minimize the cost of capital
• Sources include:
• Loans; Bonds; Shares; profits/retained earnings
• Manage (interest) risks (swaps, forward rate agreements, caps, floors, collars)

• Apllication of funds
• Choose a porfolio of financial, and eventually, real, assets to maximize return
availabe funds while managing risk
• Assets include:
• Shares (look at, e.g., EPS=NI/Shares and Price-Book=Quote/Book value); Bonds (e.g., subject
to risk of haircuts); Futures; Options; Commodities

Fall 2022 FE #10617 -- Joaquim Pina 2

Investments – Credit Risk I
• Credit risk - sources
• Product life-cycle
• Business/market risk
• Management/Human Resources
• Cost structure - Fixed costs weight
• Debt-to-Equity (and maturity; cost)
• Interest rate and Exchange rate behavior
• Macroeconomic environment; including economic policy stance
• …among other sources, some specific to the business/firm/sector/country/world

Note: Soares, J. O., Catalão-Lopes, M., Ribeiro, M and Pina, J. P., 2011, “Quantitative versus qualitative criteria for
credit risk assessment”, Frontiers in Finance and Economics, 8 (1), pp. 69-87

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Investments – Credit Risk II
• Default risk and scoring – index Altman Z
• Few indicators based on financial statements, particularly the Balance sheet
and Income Statement
Altman, E., 1968, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”, Journal of
Finance, 23(4), pp. 589-609

Z = 1.2*(WorkingCapital/Assets)+ 0.4*(RetainedEarnings/Assets)+3.3*(EBIT/Assets)+1*(Sales/Assets)
+0.6*(MarketValue/Debt)
Scoring: A for Z>2.99; B for 1.81>Z>2.99; C for Z<1.81

• Other measures include, e.g., VaR - Value at Risk

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Investments – Portfolio of assets
• CAPM – Captial Asset Pricing Model
• Taking R,F-risk free intetrest, R,P-return on portfolio, R,i-return on security i,
R,M-Market return, E(.) means Expected, Sigma,M and Sigma,P measure
dispersion of market returns and portfolio returns, respectively

• CML – Capital Market Line, E(R,P) = R,F + [(E(R,M) - R,F)/Sigma,M]*Sigma,P

• SML – Security Market Line, E(R,i) = R,F + Beta,i*(E(R,M) - R,F), where Beta,i
measures how returns of security i co-move with market returns;
notice that returns above the Risk free rate are risk rewards; namely, expected
return on security i, E(R,i), exceeds risk free rate, R,F, by its sensitivity, Beta,i , to
market risk, E(R,M) - R,F

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Investments – Performance of portfolio
• Performance of a financial portfolio – reward to risk
(E(R,P)-R,F) = Alpha,P + Beta,P* (E(R,M) - R,F)

• Sharpe Ratio – (R,P -R,F)/Sigma,P, risk-adjusted return, looking at total risk

• Treynor Ratio – (R,P -R,F)/ Beta,P, risk-adjusted return, looking at systematic risk

• Jensen Alpha – , Alpha,P, excess return (if >0, beats market; otherwise, below SML);
i.e., Alpha,P = E(R,P) – [R,F) + Beta,P* (E(R,M) - R,F)], Alpha equals actual return,
E(R,P), less the CAPM risk-adjusted expected return

• …among other measures

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Investments – topics I
• Uncovered Interest Parity
• R,home = R,foreign + expected change in Exchange rate
Notes: Covered parity; Risk premium
* Another parity related with Goods&Services transactions,
Purchasing Power Partity -- P,home=P,foreign*E --, where E is the Exchange rate of
home per foreign currency

• Options are derivative financial assets

• For securities we find, European and American options, which differ in that the latter
can be traded before the term;
* Option is not an agreement for selling or buying, is only the option of doing that (ie.,
exercise it); an option to sell is named PUT and na option to buy is named CALL

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Investments – topics II
HEDGING:
• Swaps – exchanging interest rate payments
• Caps – use options to set a maximum interest rate for borrowers
• Floors – use options to set a minimum interest rate for investors
• Forward Rate Agreement – set interest rate for a future period

Further issues, see, e.g.,

Bodie, Z., Kane, A. and Marcus, A., 2013, Investments, McGraw-Hill
Hull, J., 2014, Options, Futures, and Other Derivatives, Pearson

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Investments – topics II
ONLY sample illustration
ONLY for illustration of concepts and strategies

• Managing Interest Rate Risk,

https://www.investopedia.com/articles/optioninvestor/08/manage-interest-
rate-risk.asp

• Hedging strategies,
https://www.investopedia.com/articles/optioninvestor/08/manage-interest-
rate-risk.asp

• Sample on Options and Strategies,

https://www.investopedia.com/trading/options-strategies/

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