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# Applied Corporate Finance Session 5:

## Risk, Returns and Financial Markets

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Learning Outcomes
Know how to calculate the return on an investment 2. Understand the historical returns on various types of investments 3. Understand the historical risks on various types of investments 4. Understand the implications of market efficiency 5. Know how to calculate expected returns 6. Understand the impact of diversification 7. Understand the systematic risk principle 8. Understand the security market line 9. Understand the risk-return trade-off 10. Be able to use the Capital Asset Pricing Model
1.
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1. Return on Investment

Total dollar return = income from investment + capital gain (loss) due to change in price Example:

You bought a bond for \$950 one year ago. You have received two coupons of \$30 each. You can sell the bond for \$975 today. What is your total dollar return?

## Income = 30 + 30 = 60 Capital gain = 975 950 = 25 Total dollar return = 60 + 25 = \$85

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Percentage Returns

It is generally more intuitive to think in terms of percentage, rather than dollar, returns Dividend yield = income / beginning price Capital gains yield = (ending price beginning price) / beginning price Total percentage return = dividend yield + capital gains yield

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## Example Calculating Returns

You bought a stock for \$35, and you received dividends of \$1.25. The stock is now selling for \$40.

## What is your dollar return?

Dollar return = 1.25 + (40 35) = \$6.25 Dividend yield = 1.25 / 35 = 3.57% Capital gains yield = (40 35) / 35 = 14.29% Total percentage return = 3.57 + 14.29 = 17.86%
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## Arithmetic Mean vs. Geometric Mean

An example:

Year 1 -- \$100 to \$50 R1= -50% Year 2 -- \$50 to \$100 R2 = 100% Whats your average return?

Arithmetic average = (-50+100)/2 = 25%!! From \$100 back to \$100 0% return Geometric mean

average return earned in an average period over multiple periods Geometric average average compound return per period over multiple periods The geometric average will be less than the arithmetic average unless all the returns are equal
Arithmetic
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## Arithmetic Mean vs. Geometric Mean (cont.)

Which is better?

The arithmetic average is overly optimistic for long horizons The geometric average is overly pessimistic for short horizons So, the answer depends on the planning period under consideration 15 20 years or less: use the arithmetic 20 40 years or so: split the difference between them 40 + years: use the geometric

Another example

Year 1 5% Year 2 -3% Year 3 12% Arithmetic average = (5 + (3) + 12)/3 = 4.67% Geometric average = [(1+.05)*(1-.03)*(1+.12)]1/3 1 = 0.0449 = 4.49%
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## The Importance of Financial Markets

Financial markets allow companies, governments and individuals to increase their utility

Savers have the ability to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing so Borrowers have better access to the capital that is available so that they can invest in productive assets

Financial markets also provide us with information about the returns that are required for various levels of risk

We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets

## Lessons from capital market history

There is a reward for bearing risk 2. The greater the potential reward, the greater the risk This is called the risk-return trade-off
1.
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## See Figures 12.5 to 12.7 for more detailed distributions of returns.

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Average Returns
Investment Large Stocks Small Stocks Long-term Corporate Bonds Long-term Government Bonds Average Return 12.3% 17.1% 6.2% 5.8%

Inflation
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3.8%
3.1%

## Table 12.3 Average Annual Returns and Risk Premiums

Risk premium = the extra return earned for taking on risk Treasury bills are considered to be risk-free The risk premium is the return over and above the risk-free rate Investment Large Stocks Small Stocks Long-term Corporate Bonds Long-term Government Bonds U.S. Treasury Bills Average Return 12.3% 17.1% 6.2% 5.8% 3.8%
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## Risk Premium 8.5% 13.3% 2.4% 2.0% 0.0%

Do you still remember the first lesson from stock market history? 1.There is a reward for bearing risk 10

Variability of returns

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## Review: Variance and Standard Deviation

Variance and standard deviation measure the volatility of asset returns The greater the volatility, the greater the uncertainty Historical variance, 2 = (R-)2 / (N-1) Standard deviation, = 2 See example in text and also in the next slide

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## Variance and Standard Deviation

Year Actual Return (R) Average Return () Deviation from the Mean d = (R-) Squared Deviation d2

0.15

0.105

0.045

0.002025

2
3 4 Totals

0.09
0.06 0.12 0.42

0.105
0.105 0.105

-0.015
-0.045 0.015 0.00

0.000225
0.002025 0.000225 0.0045

## Insert Figure 12.10 here

Second lesson: 2. The greater the potential reward, the greater the risk Risk-Return Tradeoff

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## Insert figure 12.11 here

Assumes normality but recent studies have shown that distributions have fat tails. Whats the implication? Extreme events are not that improbable!!! See Nassim Talebs Black Swan and Anti-Fragile
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Suppose you want to invest in a project with the same risk as a small-cap company, what should be the expected return?

Whats the return for small caps? 17.1% !! So your IRR must be at least 17%. If not better to invest in small-cap portfolio!

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## Stock prices are in equilibrium or are fairly priced

If this is true, then you should not be able to earn abnormal or excess returns
There are many investors out there doing research

## What Makes Markets Efficient?

As new information comes to market, this information is analyzed and trades are made based on this information Therefore, prices should reflect all available public information

If investors stop researching stocks, then the market will not be efficient
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## Insert figure 12.13 here

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Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns Market efficiency will not protect you from wrong choices if you do not diversify you still dont want to put all your eggs in one basket
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## Forms of Market Efficiency

Market efficiency is about whether information gets incorporated in the price. Eugene Fama suggests that information can be organized into 3 categories. Each category relates to a particular form of market efficiency.
Semistrong form

Strong form
All Information

Weak form
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## Strong Form Efficiency

Prices reflect all information, including public and private (insider information) If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

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## Semistrong Form Efficiency

Prices reflect all publicly available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns

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## Weak Form Efficiency

Prices reflect all past market information such as price and volume If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information Implies that technical analysis will not lead to abnormal returns Empirical evidence indicates that markets are generally weak form efficient
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4. Expected Returns

Expected returns are based on the probabilities of possible outcomes In this context, expected means average if the process is repeated many times The expected return does not even have to be a possible return

E ( R ) pi Ri

where

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i 1

## Example: Expected Returns

Suppose you have predicted the following returns for stocks C and T in three possible states of the economy. What are the expected returns?
State Boom Normal Recession Probability 0.3 0.5 ??? C 15 10 2 T 25 20 1

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## Variance and Standard Deviation

Variance and standard deviation measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations

pi ( Ri E ( R ))
2 i 1
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## Example: Variance and Std. Dev.

Consider the previous example. What are the variance and standard deviation for each stock?
Stock C 2 = 0.3(15-9.9)2 + 0.5(10-9.9)2 + 0.2(2-9.9)2 = 20.29 = 4.50%

Stock T

## 2 = 0.3(25-17.7)2 + 0.5(20-17.7)2 + 0.2(1-17.7)2 = 74.41 = 8.63%

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5. Portfolios

A portfolio is a collection of assets An assets risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

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## Example: Portfolio Weights

Suppose you have \$15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? DCLK: 2/15 = 0.133 \$2000 of DCLK KO: 3/15 = 0.2 \$3000 of KO INTC: 4/15 = 0.267 \$4000 of INTC \$6000 of KEI KEI: 6/15 = 0.4

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## Portfolio Expected Returns

The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio

E ( RP ) w j E ( R j )
j 1

You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

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## Example: Expected Portfolio Returns

Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio?

## E(RP) = 0.133(19.69) + 0.2(5.25) + 0.267(16.65) + 0.4(18.24) = 15.41%

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Portfolio Variance

Compute the portfolio return for each state: RP = w1R1 + w2R2 + + wmRm Compute the expected portfolio return using the same formula as for an individual asset Compute the portfolio variance and standard deviation using the same formulas as for an individual asset

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## Consider the following information

Invest 50% of your money in Asset A State Probability A B Boom 0.4 30% -5% Bust 0.6 -10% 25%

Portfolio
12.5% 7.5%

What are the expected return and standard deviation for each asset?

## A-(6% & 19.6%) B-(13% & 14.7%)

What are the expected return and standard deviation for the portfolio?

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## 6. Expected vs. Unexpected Returns

Realized returns are generally not equal to expected returns There is the expected component and the unexpected component

At any point in time, the unexpected return can be either positive or negative Over time, the average of the unexpected component is zero

Announcements and news contain both an expected component and a surprise component

It is the surprise component that affects a stocks price and therefore its return This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated
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Efficient Markets

Efficient markets are a result of investors trading on the unexpected portion of announcements The easier it is to trade on surprises, the more efficient markets should be Efficient markets involve random price changes because we cannot predict surprises
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## 7. Systematic & Unsystematic Risk

Systematic risk

Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc.
Risk factors that affect a limited number of assets Also known as unique risk and asset-specific risk Includes such things as labor strikes, part shortages, etc.
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Unsystematic risk

Returns

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## Portfolio diversification is the investment in several different asset classes or sectors

Diversification is not just holding a lot of assets For example, if you own 50 Internet stocks, you are not diversified However, if you own 50 stocks that span 20 different industries, then you are diversified

Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns

This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another

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## Diversification and Portfolio Risk (cont)

M. Statman selected at random stocks from the NYSE to include in a portfolio. Starting with one stock he kept on adding more stocks to a portfolio and calculated the resulting risk of the portfolio. As more stocks were added, the portfolio risk declined . However, most of the benefits from diversification were obtained with 10 stocks. With 30 stocks, there was little remaining benefit from diversification.
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## Figure 13.1: Portfolio Diversification

Unsystematic risk is essentially eliminated by diversification

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## 9. Systematic Risk and Beta

There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that assets systematic risk since unsystematic risk can be diversified away How do we measure systematic risk?
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## We use the beta coefficient

A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

## What does beta tell us?

E.g. If the markets returns increases by 10%, the stocks return will increase by more than 10% However, if the markets return decreases by 10%, the stocks return will decrease by more than 10%
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## Consider the following information:

Standard Deviation
Security C Security K 20% 30%

Beta
1.25 0.95

Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?

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## Consider the previous example with the following four securities

Security DCLK KO INTC KEI Weight 0.133 0.2 0.267 0.4 Beta 2.685 0.195 2.161 2.434

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## 10. Security Market Line and Capital Asset Pricing Model

Remember that the risk premium = expected return risk-free rate The higher the beta, the greater the risk premium should be Can we define the relationship between the risk premium and beta so that we can estimate the expected return?

YES!

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Market Equilibrium

In equilibrium, all assets and portfolios must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market

E ( RA ) R f

E ( RM R f )

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30%

Expected Return

## 25% 20% 15% 10% 5% 0% 0

E(RA)

Rf

A
0.5 1 1.5 Beta
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Reward-to-Risk Ratio

The reward-to-risk ratio is the slope of the line illustrated in the previous example

Slope = (E(RA) Rf) / (A 0) Reward-to-risk ratio for previous example = (20 8) / (1.6 0) = 7.5

What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?

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## Security Market Line

The security market line (SML) is the representation of market equilibrium The slope of the SML is the reward-to-risk ratio: (E(RM) Rf) / M But since the beta for the market is ALWAYS equal to one, the slope can be rewritten Slope = E(RM) Rf = market risk premium

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## The Capital Asset Pricing Model (CAPM)

The capital asset pricing model defines the relationship between risk and return E(RA) = Rf + A(E(RM) Rf) If we know an assets systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets
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## Factors Affecting Expected Return

Pure time value of money: measured by the risk-free rate Reward for bearing systematic risk: measured by the market risk premium Amount of systematic risk: measured by beta

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Example - CAPM

Consider the betas for each of the assets given earlier. If the risk-free rate is 4.15% and the market risk premium is 8.5%, what is the expected return for each?
Beta Expected Return

Security
DCLK KO
INTC KEI

2.685 0.195
2.161 2.434

## 4.15 + 2.685(8.5) = 26.97% 4.15 + 0.195(8.5) = 5.81%

4.15 + 2.161(8.5) = 22.52% 4.15 + 2.434(8.5) = 24.84%

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Ethics Issues

Program trading is defined as automated trading generated by computer algorithms designed to react rapidly to changes in market prices. Is it ethical for investment banking houses to operate such systems when they may generate trade activity ahead of their brokerage customers, to which they owe a fiduciary duty? Suppose that you are an employee of a printing firm that was hired to proofread proxies that contained unannounced tender offers (and unnamed targets). Should you trade on this information, and would it be considered illegal?
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