Universidad Carlos III de Madrid 9/2/2010

Topic 4: RISK AND RETURN – Outline

Topic 4 - Characteristics of 1. VALUING STOCKS

Individual Assets and The Gordon growth model or discounted cash flows

Portfolios: Risk and Return 2. RISK AND RETURN

• Risk and return of a financial asset
Copyright of Spanish version from David Moreno
Translation into English by Francisco Romero
• Risk and return of a portfolio
Universidad Carlos III
Financial Economics 3. DIVERSIFICATION
Teacher: Beatriz Mariano
The correlation coefficient
Specific and systematic risks

Topic 4: RISK AND RETURN - Objectives 1- VALUING STOCKS

The VALUE of shares/stocks can be estimated using
To value equities by discounting cash flows different methods. Some of these methods are not of interest
for the shareholder.
To understand the concept of portfolio of assets
ACCOUNTING VALUE: VALUE based on the balance sheet [Equity = Assets –
Liabilities] .
To calculate the risk and return of a portfolio  i.e. shareholders capital + retained profits

To analyze the effect of diversification LIQUIDATION VALUE: VALUE: cash leftover after selling the company’s
assets and paying off its debts.
 €/share resulting from closing the company and liquidating its assets

MARKET VALUE:VALUE share price in the seconday market. It is the value

investors attach to the firm. Examples:
 Capacity to generate profits;
 Valuable intangible assets (R&D);
 Profitble growth opportunities.

3 4

(c) David Moreno y María Gutiérrez 1

Universidad Carlos III de Madrid 9/2/2010

1- VALUING STOCKS 1- VALUING STOCKS

Shares are valued as any other asset: DISCOUNTED CASH FLOWS METHOD
 Calculating the PRESENT VALUE of the future cash
flows (GORDON GROWTH MODEL)
Shareholders expect to receive two types of cash flows:  A share´s PV is given by:
 Dividends
 Capital gains D1 D2 D +P t=N
D + PN
P0 = + + ... + N NN =  t
Therefore, the return per share of firm i obtained between 1 + r (1 + r ) 2
(1 + r ) t =1 (1 + r )
t

period 1 and 0 (one period) is:

 Where Dj is the expected dividend for period j, PN is the expected
DIV1 + P1 − P0 share price in period N.
Ri = Dividends can be computed  r is the expected return offered by shares in an equivalent risk class
P0 as follows: (return offered by alternative investment opportunity with same
DPA=BPA*Pay Out Ratio level of risk)

1- VALUING STOCKS 1- VALUING STOCKS

The general formula to value stocks is: Example Calculate the price of one share of
Example:
SOGECABLE considering that expected dividends per
t =∞ share for the coming two years are 2€ and 3€ respectively
Dt
P0 =  and the estimated selling price in two years is €11.5. The
t =1 (1 + r ) t expected return offered by shares with a similar level of risk
is 8.8%.
 This makes sense as shares do not have a “maturity date” (as
opposed to bonds) unless the firm goes bankrupt or is
acquired by another firm and ceases to exist.
 This is consistent with the previous formula taking into
account that PN is the sum of the discounted dividends from
N+1 onwards.

7 8

(c) David Moreno y María Gutiérrez 2

Universidad Carlos III de Madrid 9/2/2010

1- VALUING STOCKS 1- VALUING STOCKS

Solution Valuing stocks becomes simpler when making some assumptions

related to the flow of future dividends.

VALUING STOCKS WHEN FUTURE DIVIDENDS

ARE CONSTANT
 We use the formula for the PV of a perpetuity.

D
P0 =
r
 If dividends grow at a constant rate “g”

D1
P0 =
r−g

9 10

2- RISK AND RETURN 2- RISK AND RETURN

At present investors have access to a great variety of assets Assets can be combined in many different ways originating many
(real and financial). different portolios.
 Bonds, shares, investment funds, etc.  Derivatives, active management, emerging markets etc.

 In general they hold more than one of these assets, i.e. they How do investors pick their favorite
hold a PORTFOLIO. portfolio?
 Assuming that investors are risk averse
The objective is
 Given two assets with the same
to: MAXIMIZE
What is a Portfolio? return, the one with lowest risk is
RETURN AND
preferred.
A collection of assets (shares, bonds, derivatives, real estate, MINIMIZE RISK
etc) held by an institution or individual.  They prefer a certain cash-flow to
a risky cash-flow with the same
 Each asset represents a % of the total portfolio value. The
expected value.
weight of each asset is represented by W i , with N
Wi = 1  A+ B 1 1
i =1 U  > 2 U ( A) + 2 U ( B )
 2 
11 12

(c) David Moreno y María Gutiérrez 3

Universidad Carlos III de Madrid 9/2/2010

2- RISK AND RETURN 2- RISK AND RETURN

Risk averse investors demand an extra premium for holding risky How to calculate the expected return of an asset:
assets, known as risk premium
premium..  The formula below applies to the period [0,1]:
 This is related to the variability or risk of the asset’s returns.
E[CFi ,1 ] + E[ P1 ] − P0
What happened historically? E[R i ] =
where:
E [CF] is the expected cash flow
P0
Historical data for the US (1926-
1926-2001
2001)) Bodie, Kane and
(dividends, interests etc.)
 E[P1] is the expected price
Marcus (2004), “Investments”, McGrawHill.
Small caps Blue Chips Long Term Medium Treasury  For an asset whose payments/outcomes are uncertain the expected
Bonds Term Bonds Bills return is defined as:
Avg. annual
18.29% 12.49% 5.53% 5.30% 3.85
Return
Annualized K
standard
deviation
39.28% 20.3% 8.18% 6.33% 2.25%
E[R i ] =  p i * E[ Ri ] Where pi is the probability
to obtain this outcome
k =1

13 14

2- RISK AND RETURN 2- RISK AND RETURN

Example: a financial analyst wants to calculate the expected

Example:
return of investing in shares whose return is 1.5% with a 15% It is often the case that investors do not know the
probability, 5% with a 25% probability and 4% otherwise. probability distribution of the expected returns of a specific
asset; however, they have access to information about
historical returns.
Solution::
Solution

The historical average return is often used as a good measure of the

expected return of an asset. It is calculated as follows:
1 T
E[ Ri ] = μi =  Rt
T t =1
Where T is the number of
historical data used. Rt is the
return of this asset in period
t.

15 16

(c) David Moreno y María Gutiérrez 4

Universidad Carlos III de Madrid 9/2/2010

2- RISK AND RETURN 2- RISK AND RETURN

How to calculate the portfolio return: How to measure the risk of an asset:
 For a portfolio with “N” assets, the portfolio expected return is the Variance (ex-ante):
weighted average of the expected return of the individual assets. Risk is related to the dispersion
of returns relative to its K
Var ( Ri ) ≡ σ i2 =  ps [Rs − E ( R )]
2
expected return. s =1
N
E ( R p ) = w1 E ( R1 ) + w2 E ( R2 ) + ... + wN E ( RN ) =  wi E ( Ri ) “p” stands for
“portfolio”
σ i = σ i2
i =1

 When using the assets’ historical returns, the portfolio historical Historical Variance (ex-post):
return is:
1 T
σ2 =  ( Rt − μ )2
T − 1 t =1
N
R p = w1 R1 + w2 R2 + ... + wN RN =  wi Ri Variance or
μ is the average return
i =1 Standard Deviation

17 18

Year End of year Return

price (€)
2- RISK AND RETURN 1995 12.5
1996 13.2 0.056
1997 14.6 0.106
Example: Determine the
Example: Year End of year 1. Rt calculation
1998 14.2 -0.027
historical average return price (€) We use returns not prices.
1999 13.9 -0.021

and the historical risk of 1995 12.5

2000 14.5 0.043
2001 14.9 0.028
investing in shares of 1996 13.2 2002 15.8 0.060
URARSA using the 2003 15.6 -0.013
1997 14.6
following data: 2. Historical avg. Return calculation:
1998 14.2
1 2003
1999 13.9
μURARSA =  Rt = 2.90%
8 t =1996
2000 14.5
2001 14.9 3. Historical standard deviation of returns of URARSA shares:
2002 15.8
2003 15.6 1 8
σ=  ( Rt − 0.0290) 2 = 0.047 ≈ 4.7%
8 − 1 t =1
19 20

(c) David Moreno y María Gutiérrez 5

Universidad Carlos III de Madrid 9/2/2010

2- RISK AND RETURN 2- RISK AND RETURN

How to measure portfolio risk: With N assets:

The portfolio return is the weighted average of the returns of the individual
assets. N N N
σ p2 =  wi2σ i2 +  wi w j Cov( Ri , R j )
Do we follow the same process to measure risk? i =1 i =1 j =1
 No. j ≠i
 There is a diversification effect from including assets in a portfolio.
or
Portfolio Variance (with 2 assets only): N N
σ p2 =  w j wiσ i , j
σ 2 ( R p ) = w12σ 12 + w22σ 22 + 2 w1 w2 Cov( R1 , R2 ) i =1 j =1

21 22

2- RISK AND RETURN 2- RISK AND RETURN

To calculate the Example:: Form an equally-

Example
1N  Asset Ri Variance Covariance
Covariance: Cov ( R A , RB ) =  ( RA − μ A )( RB − μ B )
T  t =1
weighted portfolio with shares
of ACCIONA and of BBVA.
ACCIONA 10% 0.0076 -0.0024
Compute the risk and return
of such portfolio. BBVA 8% 0.00708
Correlation coefficient Cov ( RA , RB )
between the returns of ρ A, B =
σ A *σ B
two assets:
Solution:
 Portfolio weights: W1=W2=0.5

 Portfolio return:
Portfolio Variance using the correlation coefficient:
R p = 0.5(0.10) + 0.5(0.08) = 0.09
σ 2 ( R p ) = w12σ 12 + w22σ 22 + 2w1 w2 ρ1, 2σ 1σ 2  Portfolio risk:
Var ( R p ) = 0.52 (0.0076) + 0.52 (0.00708) + 2(0.5)(0.5)(−0.0024) = 0.00247
σ p = σ p2 = 0.00247 = 0.0497
23 24

(c) David Moreno y María Gutiérrez 6

Universidad Carlos III de Madrid 9/2/2010

2- RISK AND RETURN 2- RISK AND RETURN

 The variance of a portfolio is lower than the variance of Knowing that risk and return are:
returns of the individual assets included in the portfolio. E ( R p ) = wA E ( RA ) + wB E ( RB )
σ 2p = wA2σ A2 + wB2σ B2 + 2wA wB Cov( RA , RB )
Portfolio with Risk Reduction Diversification effect
different assets Then, the portfolio variance is:
2 2 2
1 1 1 1 1
σ p2 =   σ 2 +   σ 2 + 2  σ 1, 2 = σ 2 + σ 1, 2
2 2 2 2 2
And the portfolio variance for an equally-weighted portfolio with “N”
Proof
Proof: assets is:
2 2 2 2 N
We can show mathematically how risk is reduced in a portfolio N
1 2 N N 1 1 2 1 N
σ p2 =    σ +    σ i , j = N   σ +    σ
when adding an asset: i =1 N i =1 j =1  N  N N i =1 j =1
i, j

j ≠i j ≠i
 Assume two assets (A and B), both with the same variance,
and invest 50% of your money in each asset. We have N(N-1) Covariances; i.e.
the cov of each asset with the other
25
assets 26

2- RISK AND RETURN 2- RISK AND RETURN

The average covariance can be seen as the average of the covariances: The risk of an individual asset is eliminated by
diversification (specific
specific risk, unique risk, non
non--
N N

 σ
i =1 j =1, j ≠i
i, j

σ i, j =
N ( N − 1) systematic risk or idiosyncratic risk).
risk

Substituting the average covariance in the previous formula:

The risk of a well diversified portfolio comes from its
1 2 1
σ 2p = 
2
1 2 1
σ +   N ( N − 1)σ i , j =  σ + σ i , j −  σ i , j
market risk or systematic risk.
risk.
N N N N
 This risk is measured by the beta (covered in topics 4-7)

 If we increase the number of assets (N→∞), the portfolio variance  Investors do not care about an asset’s unique risk as it can be
eliminated by diversification.
tends to the average covariance between the portfolio’s assets.

 Part of the risk is eliminated when increasing the number of assets.

27 28

(c) David Moreno y María Gutiérrez 7

Universidad Carlos III de Madrid 9/2/2010

2- RISK AND RETURN Readings

See below how specific risk disappears when adding assets to a Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate Finance. McGraw
portfolio. Hill
 Chapters 7 and 8
Portfolio
Riesgo de
la cartera p
Risk Suárez Suárez, Andrés S. (2005). Decisiones óptimas de inversión y financiación en
la empresa. Ediciones Piramide.
 Chapter 30.

Brigham E.F. and Daves, P. R. (2002). International Financial Mangement.

South-Western.
 Chapter 2.
Specific Risk
Riesgo específico

Grinblatt, M. and Titman, S. (2002). Financial Markets and Corporate Strategy.

McGraw Hill
Systematic
Riesgo sistemático
 Chapters 4 and 5.
Risk
Number
número
of assets
títulos 29 30

Interesting Websites

BANCO DE ESPAÑA:
 http://www.bde.es

DIRECCIÓN GENERAL DEL TESORO:

 http://www.tesoro.es

MERCADO AIAF:
 http://www.aiaf.es

BOLSA DE MADRID
 http://www.bolsamadrid.es

31

(c) David Moreno y María Gutiérrez 8