You are on page 1of 41

# Financial Management I

S S S Kumar
Indian Institute of Management Kozhikode
Calicut 673 570
A story of two stocks contd..

Financial Management I 2
A story of two stocks contd..

Financial Management I 3
Which one will you invest in???

A difficult one
Lets move on.

Financial Management I 4

Stock M Stock N

30% 26%

28% 13%

34% 48%

32% 11%

31% 57%

31% 31%

Financial Management I 5
Why risk and return are linked..

Investment A is the A
risk, is the
choice still
obvious?
B
B

B would die
out through
lack of takers!

Financial Management I 6
Stocks M and N contd

## The greater the risk, the higher the expected return

What is return?
What is the nature of the risk?
How is it measured?
How does it determine the return expected by shareholders
from their investment?

Financial Management I 7
Return

## A bond 1 month holding

period
Rs.952
1 month R

952 - 948
= .0168 = 1.68%
948

Financial Management I 8
annualized R:

## (1.0168)12 - 1 = .2213 = 22.13%

Financial Management I 9
example 2

## 100 shares ABC, 9 months

buy for Rs. 82, sell for Rs. 100
8 dividends
9 month R:

100 - 82 + 8
= .3171 =31.71%
82

Financial Management I 10
annualized R:

## (1.317)12/9 - 1 = .4437 = 44.37%

Financial Management I 11
Expected Return

## measuring likely future return

based on probability distribution
random variable

## E(R) = SUM(Ri x Prob(Ri))

Financial Management I 12
example 1

R Prob(R)
10% .2
5% .4
-5% .4

## E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%

Financial Management I 13
example 2

R Prob(R)
1% .3
2% .4
3% .3

## E(R) = (.3)1% + (.4)2% + (.3)(3%)

= 2%

Financial Management I 14
Risk

## measure likely fluctuation in return

how much will R vary from E(R)
how likely is actual R to vary from E(R)

Financial Management I 15
Measuring risk

Range
Variance
Standard deviation

Financial Management I 16
Measuring risk

Microsoft Office
Excel Worksheet

Financial Management I 17
Diversification

## A major implication is that the risk of a single stock can

be divided into two components
Unsystematic or diversifiable risk

## Cannot be eliminated through portfolio

diversification

Financial Management I 18
General expression for return

n
RP wi Ri
i 1

Financial Management I 19
General expression for risk

n n n
w i wi w j ij i j
2 2
i
2

i 1 j 1 i 1
i j

Financial Management I 20
Diversification and no. of stocks

Microsoft Office
Excel Worksheet

Financial Management I 21
Risk reduction through diversification

Financial Management I 22
Examples of Unsystematic risk

## 1. Company workers declare a strike

2. An accident occurs in the production facility
3. A formidable competitor enters the market
4. Loses a big contract
5. Makes a break-through in new
product/delivery/services
6. Key personnel leaves the organization
7. Customs duty increases/decreases

Financial Management I 23
Examples of Systematic risk

## 1. interest rate changes

2. Corporate taxes change
3. Government resorts to massive deficit financing
4. RBI changes to a restrictive credit policy
5. Full convertibility
6. Withdraws/imposes dividend tax
7. Increases/decreases capital gain taxes

Financial Management I 24
The Final Take Away

## Financial markets will not reward unsystematic risk

Because it can be eliminated through diversification at
practically no cost
Thus, the only risk that matters in determining the required
return on a financial asset is the assets systematic risk
In other words, the required rate of return on a financial
asset depends only on its systematic risk

Financial Management I 25
measuring relative risk

## if some risk is diversifiable,

then is not the best measure of risk
is an absolute measure of risk
need a metric that measures just the systematic
component

Financial Management I 26
Systematic Risk Measurement

## A firms systematic risk is usually measured relative

to the market portfolio
Portfolio that contains all the assets in the world
Systematic risk of a stock is estimated by
Measuring the sensitivity of its returns to changes in a broad
stock market index
Such as the S&P CNX 500 index
This sensitivity is called the stocks beta coefficient

Financial Management I 27
Beta,

## variation in asset/portfolio return relative to return of market

portfolio
mkt. portfolio = mkt. index
Nifty index or BSE 100 index

## % change in stock returns

% change in index returns

Financial Management I 28
interpreting

if
stock is risk free
if
stock return = market return
if
stock is riskier than market index
if
stock is less risky than market index

Financial Management I 29
Characteristic Line

Financial Management I 30
Using Regression

## Micros oft Office

Excel Works heet

Financial Management I 31
Betas of Nifty Stocks

Microsoft Office
Excel Worksheet

Financial Management I 32
PF of a Risk free asset and a risky asset A

## Micros oft Office

Excel Works heet

Financial Management I 33
PF of a Risk free asset and a risky asset A

Financial Management I 34
PF of a Risk free asset and a risky asset B

## Micros oft Office

Excel Works heet

Financial Management I 35
PF of a Risk free asset and a risky asset B

Financial Management I 36
Putting together

Financial Management I 37
Fundamental Relationship between risk and ret

Returns

E ( Ri ) R f

E(RC) i
E(RB)
E(RA)

A B C Beta

Financial Management I 38
E ( R ) R f [ E ( Rm ) R f ]

where
is the portfolio risk

## E( R m ) R f is the market risk premium

Financial Management I 39
implication

## expected return is a function of

Amount of systematic risk (Beta)
Reward for postponing consumption (risk free return)
Reward for bearing systematic risk (risk premium)

Financial Management I 40
CAPM tells us size of risk/return tradeoff
CAPM tells use the price of risk

Financial Management I 41