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Risk and Return in Practice: Problems and Questions 1. In December 1995, Boise Cascade's stock had a beta of 0.95.

The treasury bill rate at the time was 5.8%, and the treasury bond rate was 6.4%. The historical risk premium of the Standard&Poor index is 5.5%. The firm had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%. a. Estimate the expected return on the stock for a short term investor in the company. b. Estimate the expected return on the stock for a long term investor in the company. c. Estimate the cost of equity for the company. 2. Boise Cascade also had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%. The historical risk premium of the Standard&Poor index is 5.5%. a. Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the unlevered beta for the company. b. How much of the risk in the company can be attributed to business risk and how much to financial leverage risk? 3. Biogen Inc., as biotechnology firm, had a beta of 1.70 in 1995. It had no debt outstanding at the end of that year. a. Estimate the cost of equity for Biogen, if the treasury bond rate is 6.4% and the expected yield of S&P index is 12%. b. What effect will an increase in long term bond rates to 7.5% have on Biogen's cost of equity? c. How much of Biogen's risk can be attributed to business risk? 4. Genting Berhad is a Malaysian conglomerate, with holding in plantations and tourist resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and the long term government borrowing rate in Malaysia is 11.5%. The Malaysian Stock Market risk premium is expected to 7,5%. a. Estimate the expected return on the stock. b. If you were an international investor, what concerns, if any, would you have about using the beta estimated relative to the Malaysian Index? If you do, how would you modify the beta? 5. You have just done a regression of monthly stock returns of HeavyTech Inc., a manufacturer of heavy machinery, on monthly market returns over the last five years and come up with the following regression: RHeavyTech = 0.5% + 1.2 RM

The current T.Bill rate is 3% (It was 5% one year ago). The stock is currently selling for $50, down $4 over the last year, and has paid a dividend of $2 during the last year and expects to pay a dividend of $2.50 over the next year. The NYSE composite has gone down 8% over the last year, with a dividend yield of 3%. The risk premium of market is supposed to be 8,5%. a. What is the expected return on HeavyTech over the next year? b. What would you expect HeavyTech's price to be one year from today? c. What would you have expected HeavyTech's stock returns to be over the last year? d. What were the actual returns on HeavyTech over the last year? e. HeavyTech has $100 million in equity and $ 50 million in debt. It plans to issue $50 million in new equity and retire $50 million in debt. Estimate the new beta, if HeavyTech Inc. has a tax rate of 40%. 6. Safecorp, which owns and operates grocery stores across the United States, currently has $50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It is planning a leveraged buyout , where it will increase its debt/equity ratio of 8. If the tax rate is 40%, what will the beta of the equity in the firm be after the LBO? 7. Novell, which had a market value of equity of $2 billion and a beta of 1.50, announced that it was acquiring WordPerfect, which had a market value of equity of $ 1 billion, and a beta of 1.30. Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40%. a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was financed with equity. b. Assume that Novell had to borrow the $ 1 billion to acquire WordPerfect. Estimate the beta after the acquisition. 8. You are analyzing the beta for Hewlett Packard and have broken down the company into four broad business groups, with market values and betas for each group. Business Group Mainframes Personal Computers Software Printers Market Value of Equity $ 2.0 billion $ 2.0 billion $ 1.0 billion $ 3.0 billion Beta 1.10 1.50 2.00 1.00

a. Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the beta estimated by regressing past returns on HP stock against a market index. Why or Why not?

. Battle Mountain is a mining company. Given the volatility in commodity prices.30. a major cable TV operator. to be 1. Firm PharmaCorp SynerCorp BioMed Safemed % Change in Revenue 27% 25% 23% 21% % Change in Operating Income 25% 32% 36% 40% Beta 1. today how much would you expect to make as a return over the next year? [The six-month T. The service claims to use weekly returns on the stock over the prior five years and the NYSE composite as the market index to estimate betas. 10. The beta for the stock is estimated to be 0. Estimate the intercept (alpha) and slope (beta) of the regression.Bill rate is 6%] The market risk premium is supposed to be 8.5%. You have collected returns on AnaDone Corporation (AD Corp.00 1.60.). Which cost of equity would you use to value the printer division? c. Estimate the cost of equity for each division. If you bought stock in AD Corp.5% and the market risk premium is 5. a large diversified manufacturing firm. b.30 1. (HP had $ 1 billion in debt outstanding. estimate the cost of equity for Hewlett Packard. and the NYSE index for five years: Year 1981 1982 1983 1984 1985 AD Corp 10% 5% -5% 20% -5% NYSE 5% 15% 8% 12% -5% a.40 a. You replicate the regression using weekly returns over the same period and arrive at a beta estimate of 1.45. Calculate the degree of operating leverage for each of these firms. Assume that HP divests itself of the mainframe business and pays the cash out as a dividend. How would you reconcile the two estimates? 11.5%. A prominent beta estimation service reports the beta of Comcast Corporation. If the treasury bond rate is 7. Africa and Australia. The following table summarizes the percentage changes in operating income. Hewlett Packard’s effective tax rate is 36%) 9. silver and copper in mines in South America. Estimate the beta for HP after the divestiture. Use the operating leverage to explain why these firms have different betas. b.b.15 1. how would you explain the low beta? 12. percentage changes in revenue and betas for four pharmaceutical firms. which mines gold.

80. AD is planning to sell off one of its divisions. What proportion of this firm's risk is diversifiable? c. You also remember that AMR was not a very good investment during the period of the regression and that it did worse than expected (after adjusting for risk) by 0. What would be a good measure of the risk that you are taking on? How much of this risk would you be able to eliminate if you diversify? e.20 R squared = 5% There are 20 million shares outstanding. how would you evaluate AD's performance relative to the market? (The riskfree rate during the period was also 6% on an annual basis) d.5%? b. It plans to divest itself of one of the divisions for $ 20 million in cash and acquire another for $ 50 million (It will borrow $ 30 million to complete this acquisition). The division under consideration has assets which comprise half of the book value of AD Corporation.06% X-coefficient of the regression = 0. Looking back over the last five years. a. The firm has $ 20 million in debt outstanding. an oil and gas producing firm. and that your stock has a variance of 67%. and the division it is acquiring is in a business line where the average unlevered beta is 0. What would an investor in Mapco's stock require as a return. Assume now that Mapco has three divisions. You have just run a regression of monthly returns of American Airlines (AMR) against the S&P 500 over the last five years. (The firm has a tax rate of 36%) a. Intercept of the regression = 0. and 20% of the market value. if the T. You have misplaced some of the output and are trying to derive it from what you have. What is the beta of AMR? b. The market variance is 12%. You know the R squared of the regression is 0.20. Assume now that you are an undiversified investor and that you have all of your money invested in AD Corporation. The division it is divesting is in a business line where the average unlevered beta is 0. on the S&P 500 index and come up with the following output for the period 1991 to 1995. What will the beta of AD Corporation be after divesting this division? 13.36. What will the beta of Mapco be after this acquisition? 14.39 % a . and the current market price is $ 2. of equal size (in market value terms).Bond rate is 6% and the market risk premium is 5.46 Standard error of X-coefficient = 0. Its beta is twice the average beta for AD Corp (before divestment). You run a regression of monthly returns of Mapco Inc.c.

65 RMarket R2= 0. 1.4%. i. the average riskfree rate was 4.10% better than expected. An analyst has estimated. The firm has a debt/equity ratio of 3%. During this period. You have run a regression of monthly returns on Amgen. with the same risk level as the firm's existing business. a newspaper and magazine publisher. You have just run a regression of monthly returns on MAD Inc.5%. and the market risk premium is 8. Will the two firms have the same beta? If not. during the regression.month for the five years of the regression.28% + 1. . The current T. annually.5% and the current T.Bill rate is 5. Based upon the intercept. 0.05% + 1.20 The current one-year treasury bill rate is 4.25% better than expected on a monthly basis during the period of the regression.Bond rate is 6. you can conclude that the stock did A.. 1. against monthly returns on the S&P 500 index.5%. that the stock did 51. and arrived at the following result ñ RMAD = .20 RS&P The regression has an R-squared of 22%. D. What is the expected return on this stock over the next year? ii. to another firm which also has an R squared of 0. a large biotechnology firm.05% worse than expected on a monthly basis. during the period of the regression.0. The firm has 265 million shares outstanding.. The riskfree rate during the period of the regression was 6%. and come up with the following output ñ Rstock = 3.8% and the current thirty-year bond rate is 6.05% better than expected on a monthly basis during the period of the regression C. against returns on the S&P 500. 0. What was the intercept on the regression? c. why not? 15.48. You are comparing AMR Inc. Would your expected return estimate change if the purpose was to get a discount rate to analyze a thirty-year capital budgeting project? iii. Can you estimate the annualized riskfree rate that she used for her estimate? iv. It is planning to issue $2 billion in new debt and acquire a new business for that amount. Answer the following questions relating to the regression ñ a.25% worse than expected on a monthly basis during the period of the regression.84%. and faces a tax rate of 40%. B. selling for $ 30 per share. What will the beta be after the acquisition? 16. correctly.

70 1. a. The firm had a cash balance of $ 8 billion at the end of 1995. o It borrowed an additional $ 20 million. Firm Black & Decker Fedders Corp. the automotive manufacturer. None of the above. The publicly traded firms all have marginal tax rates of 40%. and faces a tax rate of 40%. The marginal tax rate was 36%. after these changes. for $ 20 million.20 1. 19. and bought back stock worth $ 40 million. which amounted to $10 billion in 1995.05 in 1995. MAD Inc. had $ 40 million in debt and $ 120 million in equity outstanding. o After the sale of the division and the share repurchase. Chrysler. Estimate the unlevered beta of the firm. .E.000 $ 200 $ 2250 $ 300 $ 4000 The private firm has a debt equity ratio of 25%. The marginal tax rate was 40%. 18. You now realize that MAD Inc went through a major restructuring at the end of last month (which was the last month of your regression).500 $5 $ 540 $8 $ 2900 MV of Equity $ 3.6. If the firm's tax rate is 40%. re-estimate the beta. 17. and made the following changes The firm sold off its magazine division. has a beta of 1. Estimate the beta for Chrysler after the special dividend. Estimate the unlevered beta for Time Warner. Estimate the effect of paying out a special dividend of $ 5 billion on this unlevered beta. c. It had $ 13 billion in debt outstanding in that year. You are trying to estimate the beta of a private firm that manufactures home appliances. and 355 million shares trading at $ 50 per share. Time Warner Inc. Maytag Corp.. which had an unlevered beta of 0. Part of the reason for the high beta is the debt left over from the leveraged buyout of Time by Warner in 1989. (1 point) b. National Presto Whirlpool Beta 1. had a beta of 1. b. Estimate the effect of reducing the debt ratio by 10% each year for the next two years on the beta of the stock. as well.40 1. You have managed to obtain betas for publicly traded firms that also manufacture home appliances.61.50 Debt $ 2. the entertainment conglomerate. a. b.20 0. The market value of equity at Time Warner in 1995 was also $ 10 billion.

The average beta of comparable publicly traded firms is 0. The beta for the company at the end of 1995 was 0. You have been asked to estimate the beta for the division.50. Why would the beta decline over time? c. What concerns. an upscale retailer. a. How would you reconcile the two estimates? Which one would you use in your analysis? . b. You are analyzing Tiffany's. and find that the regression estimate of the firm's beta is 0. b. RJR Nabisco is considering spinning off its food division. and the debt/equity ratio was 1. if any. The chief financial officer of Adobe Systems.15. You also note that the average unlevered beta of comparable specialty retailing firms is 1. assuming that it decides to finance its media operations with a debt/equity ratio of 50%. would you have about using betas of comparable firms? 20. He subscribes to a service which estimates Adobe System's beta each year. The marginal corporate tax rate is 36%. The media business is expected to be 30% of the overall firm value in 1999. Southwestern Bell. What is the beta for the division? b. Is this decline in beta unusual for a growing firm? b. has approached you for some advice regarding the beta of his company. Estimate the beta for Southwestern Bell in 1999. estimate the beta for the company based upon comparable firms. He would like the answers to the following questions ñ a. assuming that it maintains its current debt/equity ratio. (The tax rate is 40%) b.a. 22. a. Would it make any difference if you knew that RJR Nabisco had a much higher fixed cost structure than the comparable firms used here? 21. a. Is the beta likely to keep decreasing over time? 23.95. the standard error for the beta estimate is in 1995.35 in 1991 to 1. a growing software manufacturing firm. the average debt/equity ratio for these firms is 50%. and the average beta of comparable firms is 1. The marginal corporate tax rate is 36%. and decide to do so by obtaining the beta of comparable publicly traded firms. and the average debt/equity ratio of these firms is 35%. and he has noticed that the beta estimates have gone down every year since 1991 . As the result of stockholder pressure.20. If Tiffany's has a debt/equity ratio of 20%.2. is considering expanding its operations into the media business. Estimate the beta for Southwestern Bell in 1999. a phone company. The division is expected to have a debt ratio of 25%. c. Estimate a range for the beta from the regression. Estimate the beta for the private firm.

5%) = 13. I would use the expected return of 11.15 (7. Problem 4 a.51% . New Debt/Equity Ratio = 1/2 = 0.00 (3/8) = 1.4) (0.5%) = 15.50 (2/(2+1)) + 1. This beta measures risk relative to a Malaysian index.50 (2/8) + 2.923 (1 + (1-0. Beta for Hewlett Packard = 1.10 (2/8) + 1.082) = 54.20 (-5% .Solutions Problem 1 a.63% c.5%) = 11.63% as the cost of equity Problem 2 a.50%) = 20. Unlevered Beta = 1.1%.95 (8. c.5% + 1.13% {I am using a premium of 7. b.5% + 1. The beta of 0.43 (1 + (1-.923076923 New Beta = 0.5)) = 1.88% (I am using the historical premium of 8.86 Problem 8 a.4) (8)) = 5.4) (50/100)) = 0. Actual Returns over last year = (50-54+2)/54 = -3.30 (1/(2+1)) = 1.20 / (1+ (1-.5% to estimate expected returns) b. Expected Return = 3% + 1.50 ! Firm has no debt Unlevered Beta for WordPerfect = 1. Expected Price Appreciation = 13.923 Problem 6 Unlevered Beta = 1.30 ! Firm has no debt Unlevered Beta for Combined Firm = 1.5%) = 13.4% + 0.40).70 (5.275 (5.40% + 1.50% for Malaysian stocks to reflect its higher risk. Cost of Equity = 6.4) (50/100)) = 0.70% e.55 b.00 (1/8) + 1. the cost of equity will rise by 1. Cost of Equity = 7. Expected Return = 11. its beta will drop to 0.20% Expected Price one year from today = $ 50 (1. because both of these are estimated with error b.5 New Beta = 1. Unlevered Beta for Novell = 1. Expected Return to Long-term Investor = 6.2 (8.95 / (1 + (1. all of the risk can be attributed to business risk.275 This beta may not be equal to the regression estimate of beta.00% Returns on Market = -8% + 3% = -5% d.95 can be broken down into business risk (0.95 (5. If the long term bond rate rises to 7.43 This would be the beta of the combined firm if the deal is all-equity.923 If the firm issues $ 50 million in equity and retires debt.35 Problem 7 a.8% + 0.20% .5%) = 14.5%. For an international investor an more appropriate beta may be the one estimated relative to a global index. Problem 3 a.10 $ c. If the deal is financed with debt.} b. Problem 5 a.5%) = -7.75% b. Expected Returns over last year = 5% + 1.20% b.($ 2.36) (1700/1500)) = 0.20 / (1 + (1-0.55) and financial risk (0. Expected Return to Short-term Investor = 5.50 / $ 50) = 8. Unlevered Beta = 0.0. Since the firm had no debt.

5% + 1 (5.125/6.852 (1. Intercept = 4.00 1.90 1.75 New Levered Beta = 1.235 New Debt/Equity Ratio = 1/5. Problem 10 Beta estimation services adjust betas towards one.5(5. It is possible that this adjustment is the reason for the difference between the regression beta (1.93 1.235 (1 + (1-.00 0. To the extent that commodity prices and stock prices are not highly positively correlated the low betas reflect the low market risk inherent in these stocks.36) (1/5.4% = 2.75) + 1.60 ( NYSE) The intercept is 4.30% On an annual basis. Expected Return over next year = 6% + 0.60) = 2.25 2.2.00 0.7%.10% c.5%) = 13. Division Beta Unlevered Beta Value of Equity Debt Firm Value Mainframes 1.00% cost of equity.5% + 1.25 Sofware 2.3% better than expected.5% + 2 (5. the beta is 0. I would use a 13.852 1.5%) = 11.389 (2.57 1.13 Printers 1.25/6.Mainframes Cost of Equity = 7.926 3.5%) = 13.30 Safemed 21% 40% 1.00 SynerCorp 25% 32% 1.60) and the reported beta of 1.15 BioMed 23% 36% 1.25 PCs 1.60.55% Personal Computers Cost of Equity = 7.125 1.00% To value the printer division.60 (8.Riskfree Rate (1-Beta) = 4.375/6.75) = 1.926 (3.10 (5.75) + 0.70% Riskfree Rate (1-Beta) = 6% (1-0.5%) = 15. Regression Results Returns on AD = 0. Assuming that the leverage is equally distributed across the divisions.38 Unlevered Beta = 1.40 b. c.50 1.5%) = 18.00 0.00 0. b. Problem 11 The beta reflects market risk and is estimated relative to a stock index. Problem 12 Year AD 1981 10% 1982 5% 1983 -5% 1984 20% 1985 5% NYSE 5% 15% -8% 12% -5% a.375 3.75)) = 1. Firms with high operating leverage also have high betas.50% Printer Division's Cost of Equity = 7.10 1.047 + 0.7% .45.75% Software Cost of Equity = 7.5% + 1.40% Intercept . .37 Problem 9 Firm %Revenue %OI Operating leverage Beta PharmaCorp 27% 25% 0.00 0. the stock did 2.25 2.389 2.019 2.28 1. I would expect these firms to have substantial firm-specific risk.

65) = 0.8) = 0. assuming that the cash is paid out and that the leverage is unaffected.65) Solving for the riskless rate.63 (1 + (1-.0032)12 .45 This is the beta after the divestiture.35 Solving for X.4% + 1.46/(1+(1-.36/.Riskfree Rate (1-1.60) = 1.21%/(0. Existing Debt/Equity Ratio = 20/(20*2) = 50. Problem 13 a.25)) = 1. i would use the long term bond rate as my riskless rate.5%) = 15.46 (5.42) Monthly Riskfree Rate = (1.0. Monthly Jensen's Alpha = (1.62 Market Value of Equity = 265 * $ 30 = 7. Expected Return on the Stock = 6. Monthly Riskless Rate = 0.20 1.39% = Intercept .65 (8.03)) = 1.1 = 0.950.83% b.0667)/(40/60) = 0.39% + 4.50 $ New Levered Beta = 1. X = 0. this suggests that 55% is diversifiable risk.20 (. Expected Return = 6% + 0.80 (50/90) = 0.2) + X (0.1 = 3.20 (20/60) + X (40/60) = 0. Unlevered Beta = 1.32% Annualized Riskless Rate = (1.48% c.42 b.8 = 0. Jensen's alpha = Intercept .65 / (1 + (1-.49% 3.01 Beta = 1.03 (7950) = 238. The R-squared of this regression is 45%.5)) = 0. 0.42) = -2. R squared = β 2 * σ m / σ i2 Beta2 = (0.89 .62 (1 + (1-.49% = 3.50 $ New Debt = $ 238.4) (2238.5%) = 8.39% (1-1.53% b.36) (1.0484)1/12 .28% .00% Unlevered Beta for the firm = 0.41% c.51)1/12 .4)(. because they might have different total variances.R squared = 95% c.d.84% (1-1.13 Problem 14 2 a. The two firms might not have the same beta.6 Solve for X.1 = 3.5/7950) = 1.42 New Unlevered Beta with new division. Intercept = -0.67)/0.65 (5.39% Solving for the intercept.35 .50 + $ 2000 = 2.36*0.08%). you would be exposed to all risk in AD.8% + 1. Problem 15 a. Yes.5%) = 18. this can be measured in terms of the standard deviation in AD returns (9.91% d.63 New Debt/Equity Ratio = (20 + 30)/40 = 1.0. If you were an undiversified investor. Beta for divested division = 2 (0. Expected Return on the Stock over next year = 4.Riskfree Rate (1-Beta) -0.25 New Levered Beta = 0. Proportion of the firm's risk that is diversifiable = 1 .42 (40/90) + 0.00 $ Existing Debt = 0. X = (0. e.12 = 2.35 Unlevered Beta of Firm without divested division 0.36) (.238.

12 Unlevered Beta after the divisional sale.19 (1 + (1-.36)(13000/(355*50)) = 0. Beta for private firm = 0.25)) = 1. this beta might not adequately reflect its risk.333333333 New Beta = 1. Unlevered Beta = 1.61 / (1+(1-.13 b.20 5 200 2.05% better than expected during the period of the regression.05% Monthly Riskfree Rate = 1.59 Problem 19 Company Beta Debt Equity D/E Black&Decker 1.06(1/12) .00 $ Equity before restructuring = $ 120 + $ 40= 160.Problem 16 a. Debt/Equity Ratio = 13000/(355*50-5000) = 1.27 Problem 18 a.49% (1-1.20 / (1+(1-.37)) = 0. c.4) (.05 / (1 + (1-.71 Solving for X.67 1.67% Whirlpool 1.00% National Presto 0. the risk of a firm may be affected by its size.4) (0.36)(1.4) (10/10)) = 1.750.50% Average 1.02) = 1.20 540 2250 24.20 / (1+(1-. the private firm may care about firm-specific risk as well.00 $ Debt/Equity Ratio before restructuring = 20/160 = 12.96 The unlevered beta after the special dividend will be 0.125)) = 1.00% Unlevered beta = 1. New Beta after the special dividend = 0.Riskfree Rate (1-Beta) = -0. 0.33% Fedders 1.20 37.96 (1+(1-.05% .50% Maytag 1. The firms might not be directly comparable in terms of business mix.42871 1. if the private firm is much smaller.0. With special dividend.20) = 0.6(20/180) + X (160/180) = 1. Unlevered Beta after divisional sale = 1.98 a. this beta reflects only market risk. X = 0.19 New Debt/Equity Ratio after restructuring = 40/120 = 0. Problem 20 . Finally.01 b.4)(.50 2900 4000 72.33)) = 1.50% Unlevered Beta before restructuring = 1.96.49% The stock did 0.71 b. Value of Firm before dividend = 13000 + 355*50 = 30. Debt before restructuring = $ 40 million .41 2 30% 0.4)(.12 Solving for X.98 (1+ (1-.00 $ 0 (8000/30750) + X (22750/30750) = 0.1 = 0.70 8 300 2. Intercept .40 2500 3000 83. Estimated Debt Ratios Year Debt Ratio D/E Beta 1 40% 0.$ 20 million = 20.02 Assuming that the beta of cash is 0.43 Problem 17 a. Unlevered Beta = 1. Furthermore. b.

66 (1 + 0.7) + .36) (. Problem 23 a.15 (1+0. Discussion Issues and Derivations 1.55) + 0. Overall Debt Ratio = 1 (. it is not unusual.90 b. Underlying assumptions: The mean-variance assumption can hold only if (a) all investors have quadratic utility function or (b) returns are normally distributed.78 (1 + (1-.29 b. Implication: Portfolio A with higher expected return and the same variance as portfolio B will be preferred to B II.85 Beta with this debt ratio = 0. c.85)) = 1.02 Problem 22 a. If it finances its media operations with a 50% D/E ratio.2) = 1. Benefits of Diversification For any desired level of risk (s) there exists a portfolio of several assets which yields a higher expected return than any individual security E(Rp) = Σ wi E(Ri) σ2p = Σ Σ wi wj Covij Efficient portfolios: maximize returns for any level of risk.6*.35)) = 0.3 (0. Unlevered Beta for Food Business = 0.7 (0. The Single Index Model: The Logical Limit of Diversification Assumptions: (a) Riskfree lending and borrowing (b) Markets which are frictionless there are no transactions costs (c)Homogeneous expectations Implications: (1) The risky portfolio than when combined with the riskless asset .25 c.91) = 0. I would expect it to stop as the beta approaches one.08 b.25 .90 / (1+0. They measure reward using expected return and risk using variance.00)) = 1. Implications: (a) Everybody should diversify (b) Investors should try to identify and hold efficient portfolios (c) This method has very heavy computational requirements.20 / (1 + 0.36) (1.64*. It is entirely possible that both of these estimates are from the same distribution.91 Unlevered Beta in 1999 = 0. The higher fixed cost structure would lead me to use a higher unlevered beta for Nabisco. I would expect it to continue since Adobe still has a beta well above one.95/ (1 + (1-.5) = 0.25)) = 0.36) (. Establish the Objects of Choice: Mean versus Variance Theme: Investors are risk averse.64 (0.66 Beta in 1999 = 0. Unlevered Beta of phone business = 0. As firms grow and become larger. they generally become more diversified and less risky. I would trust the "comparable firm" estimate more. Unlevered Beta of comparable firms = 1.78 Beta for Food Division = 0.1. Yes. b.3) = 0. Problem 21 a.66 (1 + (1-. Range for beta from regression With one standard error : 0. No. The regression estimate is very noisy.64*1) = 0. A Derivation of the Capital Asset Pricing Model I.55 Unlevered Beta of media business = 1.15 Beta for Tiffany's based on comparable firms = 1. III.a.5 (.

How much of each is held will be a function of the investor's risk aversion. IV. Existence of Non-Marketable Assets (such as Human Capital) The separation principle still holds but. E(Ri) = E(Rz) + β (E(Rm) . Step 6: This measure can be standardized by dividing by the market variance. This portfolio is called the zero-beta portfolio. all investors hold combinations of the two.Rf) where di = Dividend yield on asset i Rf = After-tax riskfree rate V. No Riskless Asset Basis: If no riskless asset exists investors can use a portfolio of risky assets which is uncorrelated with the market portfolio instead as the riskless asset.E(Rz)) where E(Rz) is the expected return on a zero beta portfolio II. Existence of Heterogeneous Expectations and Information Model: To get strong conclusions we have to assume that all investors have a certain class of utility functions (Constant Absolute risk aversion) and complete markets (At least as many independent securities as states). • Variants of the Capital Asset Pricing Model I. The final model for expected return has a dividend component E(Ri) = a + βi (E(Rm) . b = Covim/ σ2m. The Risk of an Individual Asset Step 1: Individuals diversify and hold portfolios Step 2: The risk of a security is the risk it adds to the portfolio Step 3: Everybody holds the market portfolio Step 4: The risk of a security is the risk that it adds to the market portfolio.(3) Since all investors hold the same market portfolio it must contain all assets in the economy in proportion to their value. (2) Everybody holds some combination of the market portfolio and the risky asset. (b) Efficient portfolios with the riskfree asset lie along the segment RfT and those containing only risky assets lies along the segment TMC. the market portfolio and the zero-beta portfolio. .Rf) + c (di . Properties of the Zero-beta portfolio (1) Of all the the zero-beta portfolios this has the minimum variance (2) The separation principle applies here with the two portfolios.e. (3) The expected return on any security can be expressed as a linear function of its beta. Existence of Taxes Model: The model considers differential taxes on dividends and capital gains in a one-period context where investors maximize their one-period returns. Step 5: The covariance between an asset "i" and the market portfolio (Covim) is a measure of this added risk. The higher the covariance the higher the risk. Riskless Lending but no Riskless Borrowing Basis: (a) There is a piecewise linear relationship between expected return and beta for efficient portfolios. (b) The market price of risk includes the variance of the market and the covariance between the market portfolio and the portfolio of non-marketable assets IV.maximizes returns is the market portfolio. i. (a) Investors hold different portfolios of risky assets depending upon the portfolios of nonmarketable assets that they possess. III.

and risk premiums can be estimated also from the historical data. based upon betas. and try to explain these differences using differences on measurable financial characteristics of the firms issuing these assets. The more difficult question is deciding which financial variables to use in explaining returns. again using the same data (c) the "risk premiums" associated with each factor These factor betas and factor premiums are then used. and then compare these betas to expected returns in the next time period. in conjunction with a riskfree rate to get an expected return for an asset. While all of this occurs behind the screen of the factor analysis. • More on Factor Analysis and the Arbitrage Pricing Model Central to applying the arbitrage pricing model is the use of a factor analysis. • Building a Regression Model Generally. To prevent factors from being double counted. in their much quoted study. the betas of each asset are re-estimated against the identified macro economic factors. In the factor analysis. This evidence suggests that . The coefficients on these regressions yield the betas. To test the CAPM therefore one has to observe and be able to measure this efficient market portfolio. The search then begins for macro economic factors that exhibit the same time series behavior. we ensure that the factors that emerge are independent of each other. Issue 2: The CAPM is difficult to test on individual assets The noisiness in beta estimates and the fact that the CAPM yields expected returns for individual assets over the long term makes it difficult to test the CAPM by trying to relate expected returns on individual assets (such as stocks) to their betas. If one cannot do so one cannot test the CAPM. What most tests of the CAPM do instead is to look at portfolios of stocks. inflation rates and GNP growth) over time. the time series behavior of each factor can be derived from the factor analysis. Fama and French. In a typical factor analysis. what emerges as output from the analysis includes: (a) the number of common factors that appeared to affect asset prices over the period for which the data is available (b) the betas of each asset relative to each factor. Once macro economic factors have been matched up with the unnamed factors in the factor analysis. we begin with pricing data on a large number of assets over very long time periods. The best place to start is to look at the empirical evidence that has been accumulated over time on market efficiency and the CAPM. regression models begin with the cross sectional differences in returns across stocks at any point in time. The beta estimation may be done by running a multiple regression of stock returns (for each stock) against changes in macro economic variables (such as interest rates. • Estimating the Macro Economic Factors in a Multi-Factor Model Once the number of factors have been identified in an arbitrage pricing model.• Testing the CAPM: Issues and Discussion Issue 1: The CAPM can never be tested because the market portfolio can never be observed Central to the CAPM is the concept of a market portfolio which includes every asset in the economy. we look for factors that seem to move prices on large numbers of assets in unison. used differences in market capitalization and price to book ratios to explain differences in returns across stocks. One cannot use of an inefficient portfolio like the S&P 500 or the NYSE 2000 or even every stock in the economy to estimate betas and test for linearity (like all the studies have done) because (a) The betas measured against an inefficient portfolio are meaningless measures and cannot be used to accept or reject the CAPM which is really a theory about betas measured against the efficient market portfolio (b) For every inefficient portfolio there exists a set of betas which will satisfy the linearity condition. As an example.

anything about the business that makes its earnings less certain or more unstable qualifies as operating risk. In the interests of efficiency (and to prevent problems in the regression from independent variables being correlated with each other). many of these variables tend to be correlated with each other. the lower the rating of a bond. Clearly. For a junk bond. low PE stocks tend to also be low PBV ratio stocks which pay high dividends. on average. it makes sense to use the measure that is most highly correlated with returns and drop the others. they tend to fit in much more cleanly into the mean-variance framework than do bonds. That includes anything that might adversely affect the company's market or its profitability (such as volatile raw-materials costs or rising labor costs).High dividend yield stocks seem to earn higher returns. the question may arise as to why we do not use bond betas to get expected returns for bonds. The reason lies in the absence or presence of symmetry in returns for each of these asset classes. and thus.Low market capitalization stocks seem to earn higher returns. risk comes in many guises. . • Why not use bond betas to arrive at the cost of debt? Given that we use stock betas to arrive at expected returns for stocks. PBV and PS ratio stocks seem to earn higher returns. • Credit Scores as Alternatives to Bond Ratings Bond ratings are a tool that we use to measure default risk and arrive at a cost of debt. which is what default risk and ratings measure. for instance. Consequently. which looked at some commonalties among great managers. Thus. A journal entry I wrote in December. than low dividend yield stocks While the initial regression may include all of these variables. the greater the upside potential. Lenders (such as banks) have historically used credit scores as a measure of default risk. so this journal entry takes a closer look at the concept. Thus. on average. Thus. the risk measure that we have to use has to be a downside risk measure. A high debt load compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. touched briefly on the idea of separating a company's operating risk from its stock's price risk. it may be possible to estimate a beta like a stock beta and get an expected return from it. the upside potential for a AA rated bond is fairly limited. than high market capitalization stocks . which over time have been correlated with default risk. but it is limited by the fact that bonds can at best become default-free. Morningstar Operating Risk In investing. So what are operating risk and price risk? Operating risk is the risk to the company as a business. have much more symmetric returns than bonds. than high PE. Basically.. A credit score is derived by measuring how a borrower scores on a variety of measures. as in life. Corporate bonds have some upside potential. the greater the likelihood that we can estimate bond betas and expected returns on them. Thus. on average.Low PE. Stocks. PBV and PS ratio stocks . I find that breaking down risk along those lines is a particularly helpful way of looking at stocks. the use of price to book value ratios by Fama and French. especially when lending to individuals and private businessess. which have potentially unlimited upside potential as well as significant downside potential.

Clorox. now commands 31 times its trailing earnings. year in and year out. fit as well. I might be inclined to take a chance on those theoretical. before they moved into the low operating risk. imagine a company in a turnaround situation--that is. If these companies don't meet or exceed those high expectations. In large part. quarter after quarter. the Microsofts--companies that have advantages such as leading market position. I usually visualize the balance between operating and price risk as a four-box matrix. To think why that might be important. These companies--though they occasionally post lower-thanexpected growth or weak earnings--have delivered over the long haul. the market has raised the premium on its future earnings. though other companies. and superior profitability that enable them to post reliable earnings and growth. Low operating risk and high price risk The leading stocks in today's market mostly fit into this box. . and I try and fit stocks into one of the four categories: low operating risk and high price risk. in large part because the company has been so reliable in the past. most stocks tend to congregate in the two boxes above. Since the market is more or less efficient. has more to do with the stock than the business. If the stock is expensive. High operating risk and low price risk Cyclicals--with their reliably unreliable earnings-tend to crowd into this corner. but the most common is probably looking at a stock's price multiples. I try and figure out how its operating risk balances its price risk. a P/E that's 50% higher than its average P/E over the past five years. and high operating risk and high price risk.Price risk. and downside risk--or the price risk--is comparatively limited. There are different ways to look for price risk. As you've probably realized by now. these stocks could be in for a long period of sub-par returns until earnings catch up with the prices. And if those earnings don't materialize. These are the Coca-Colas. Warren Buffett's stocks fit into this category when he bought them. the chances are good that the stock will tank. And any glitch in earnings--and every company has glitches. But if the stock is cheap. on the other hand. the Gillettes. against that of the industry. the market. one that carries a fair amount of operating risk. low operating risk and low price risk. brand-name franchises. with less-than-ideal markets or mediocre managements. high operating risk and low price risk. such as P/E or price/book. The potential upside is great if the company comes through. or any other index that will yield a meaningful comparison. A stock whose multiples are comparatively high carries more price risk than one whose multiples are lower. high price risk box. these stocks can make up for their lack of earnings stability--a la the turnaround example above--or their choppy growth. it tends to exact a higher price for higher quality and a lower price for lower quality. no matter how steady it is over all--could send these stocks into a tailspin. with their low price risk. Low operating risk and low price risk These stocks are the Holy Grail of value investors. I probably wouldn't be interested because much of the potential improvement in earnings is already figured into the price. The big problem with this box is finding stocks that fit into it. In other words. for example. risky future earnings. When I look at a stock. And the market has noticed. Smaller or less well-known companies with good managements or strong market niches can also end up here.

The article then goes on to categorize firms based upon operating risk and price risk. For example. is this a useful categorization? If not. A stock that's risky because its operations are unstable is a different kind of investment than one that's risky because it's expensive. An investor who might consider one might not consider the other. In order for their high-priced stocks to do well. how would you modify it? Morningstar Market Risk & Time While the stock and bond markets can be risky in the short run. which of the four groups would you invest in? Why or why not? 4.3%.9% to -43. Questions: 1. you can compare the stock to your investment style and decide if it fits. Two categories include firms with high (low) operating risk and low (high) price risk.1% per year for the best ten years. These are companies whose businesses are new.9 % .1 % . But they are also usually in popular or glamorous industries. It's a case of investor know thyself and thy stock. If you are an investor who is diversified. returns have varied from -0. and the greater the odds of earning a return close to the long-term average. Given the distinction in chapter 3 between diversifiable and non-diversfiable risk. Most often. hot start-ups and small tech plays end up here. or are so small that they carry a lot of operating risk. How would you explain the mismatch? Why might a firm with high (low) operating risk have low (high) price risk? 3. what does operating risk measure? What does price risk measure? 2. the lower your chances of losing money. time has a moderating effect on market risk. This article draws a distinction between operating risk and price risk. The longer you hold a stock or bond investment.5 % +20. these companies need turn in some convincing evidence that they could be the next Microsoft. however. Because once you have a handle on that. a one-year investment in stocks has historically produced returns ranging from +53.9% per year for the worst ten years to +20. What's important is really the exercise of considering which of the above categories is more appropriate to the stock and why. which means that the market has put a high price tag on those uncertain earnings.High operating risk and high price risk This playground is pretty much off limits to all but die-hard growth investors.3 % +23.0.9 % -43. If you were an investor who is not diversified.9 % -12. Holding Period 1 Year 5 Years 10 Years Range Of Returns on Stocks: 1926 to 1997 Best Return Worst Return +53. Over ten-year periods.

If your investments are targeted for your child's college tuition in three years.9 % As you can see. as your time horizon is lengthened? If so. 1998 Investors Must Recall Risk. your . But many financial advisers and other experts say that these days investors aren't taking the idea of risk as seriously as they should. for instance. What you can afford depends mainly on your time horizon -. Or. not those. why? If not. relative to bonds. it should be noted that past performance in the stock and bond markets does not necessarily predict future performance.1 % + 5.9 % +14. What are the implications of this article for the measures of risk and risk premiums used in the risk and return models developed in chapter 3? The Wall Street Journal Interactive Edition -. and they are overexposing themselves to stocks. R-I-S-K. be sure that you understand your tolerance for risk and that your portfolio is designed to match it. risk can be substantial over short periods. that belief is confirmed.15 Years 20 Years 25 Years +18. Of course. like sending your kids to the college of their choice or having the retirement lifestyle you crave. for shorter-maturity long before you will need the money. But over longer horizons. The same principle applies to bonds.2 % +16. the chance of losing money is substantially reduced. "And when the market drops hundreds of points and rebounds immediately. Do you think that stocks become less risky.7 % + 0. it takes ten years before returns are consistently positive. about three years.January 23. possibly preventing you from meeting important objectives. Questions: 1. why not? 2." says Gary Schatsky. a financial adviser in New York. So before the market goes down and stays down. For long-term bonds. [Media] Risk is the potential for realizing low returns or even losing money." The danger is that when the market declines and stays down for months -. can be tricky.6 % + 3. You must consider not only how much risk you can afford to take but also how much risk you can stand to take. which is the worst possible time. they will panic and sell their investments as their shares are declining in value. "The market has been so good for years that investors no longer believe there's risk in investing.investors won't be able to meet their short-term financial goals. though bonds are less risky than stocks. Assessing your risk tolerance. however. Investing's Four-Letter Word By KAREN HUBE Staff Reporter of THE WALL STREET JOURNAL What four letter word should pop into mind when the stock market takes a harrowing nose dive? some analysts predict it eventually will -.

and ask them 'So now what would you do?' " As it turns out. For some of the biggest risk-takers. Some of these risk tests. I may say high risk because I don't want to look wimpy.000 in the S? 500 in November 1972. ability to take on risk is low because you may not have time to recover if the value of your portfolio declines.000 loss. however. Money in the account can be used to speculate in the stock market. a unit of Apollo Group Inc.Y." says Richard Bernstein." he says." says Mr." says Mr. some people will gloss over the less impressive details of their investing histories. whose questionnaire is part of a broader investing-education program. Md. many experts agree. "It's impossible for someone to assess their risk tolerance alone. you can afford to take more risks because you would have plenty of time to ride out dips in the market. vice president of education programs for Scudder.your temperamental tolerance for risk -is more difficult.. But if you have 10 years before your child heads to portfolio is more abstract than a $30. Bernstein. a $150. the investment would have been worth $88. "A variety of behavioral factors come into play... a certified public accountant who teaches investing-related courses at the College for Financial Planning in Denver. "I may say I don't like risk. Roge. "I tell my clients to imagine they had put $100. Rather than using percentages. financial security and tendency to make risky or conservative choices. "We want to help them understand what risk means to them. a financial adviser in Bohemia. he says.000. N. "If my broker asks me if I want high-risk or low-risk securities. and Vanguard Group in Malvern. "When you convert percentages to figures. say Mr. Then I tell them that the next year. "I watch to see how they flinch. director of quantitative research at Merrill Lynch & Co. such as one created by Vanguard (www." says Richard" Similarly. Some firms that offer such quizzes include Merrill Lynch." Many experts warn." Typically. Pa. their investment would have been worth $67. The benefit of the questionnaires is that they are an objective resource people can use to get at least a rough idea of their risk tolerance. most people rank as middle-of-the-road risk-takers. "Only about 10% to 15% of my clients are aggressive. Zurich Group Inc. "They are not precise. particularly those who say they like to gamble. he says. Phoenix. Baltimore. brokerage firms and mutual-fund companies have created risk quizzes to help people determine whether they are conservative. Clemans and other advisers. risk questionnaires include seven to 10 questions about a person's investing experience. It isn't quantifiable. many financial advisers. He routinely asks to see copies of his clients' tax returns to get a reliable account of gains or losses. He then explains that after the first year. "They are good for leading discussions but not for coming up with a final risk score. Clemans. of New York. "Some investors just love the excitement of getting a stock pick from a brother-in- . say." says Ron Meier.'s Scudder Kemper Investments Inc. yet will take more risk than the average person. is to ask yourself some difficult questions. The idea of a 20% decline on. Rowe Price Associates Inc. To that end." says Mr." says Mr. T. that the questionnaires should be used simply as a first step to assessing risk tolerance. Mr. Roge recommends creating an "action account" that includes no more than 10% of their assets. Schatsky. think in dollar terms. says he cites the 1972-1974 bear market to help his clients realize how much they can lose." says Robert Benish. "The aim is always to find the fine line between greed and fear. They need to be prepared for that. can be found on-line. says Ronald Roge." The second step.000. "The typical investor may not have ever experienced a negative turn in the stock market. often you see very different psychological effects. moderate or aggressive investors. a financial adviser in Columbia. in New York. such as: How much you can stand to lose over the long term? "Most people can stand to lose a heck of a lot temporarily. Financial adviser Glen Clemans of Portland. The real acid test. Determining how much risk you can stand -. is how much of your portfolio's value you can stand to lose over months or years.

law." says Mr. Inc." Copyright ©1998 Dow Jones & Company. . "People who need that kind of action should have an outlet for it. Roge. even though they may lose money. All Rights Reserved.