Chapter 2

Rene M. Stulz, Thomson South-Western

 How do investors evaluate the risk
management policies of firm in which they
invest?

 Ignoring derivatives for time being, investors

have two powerful risk management tools:
◦ Asset allocation
◦ Diversification
 Perfect Financial Market
 Imperfect Financial Market
 Risk: the chance of suffering a financial loss.
 Return: the total gain or loss on
an investment.

Pt  Pt 1  Ct
Kt 
Pt 1
Kt = tingkat pengembalian yang diharapkan selama periode t
Pt = harga (nilai) asset pada tahun ke t
pt-1 = harga (nilai) asset pada tahun ke t-1
Ct = cash yang di terima dari investasi asset pada peiode t-
1sampai periode t
Suppose an investor named John Smith has wealth of $100,000
that he wants to invest in equities for one year. His broker
recommends two companies, IBM and XYZ. He decides that first he
wants to understand what his wealth would amount to after putting
all his wealth in IBM shares for one year.

If the stock price is $100 at the beginning of the year, the

dividends payments are $5, and the stock price appreciates by $20
during the year, what is the return per dollar invested?

Since he puts all his wealth in IBM, his wealth at the end of
the year is (Initial wealth)(1 + Return IBM)
 Stock returns are uncertain.
 The return of IBM is a random variable.
 The statistical tool used to measure the
likelihood of various returns for a stock is
called the stock’s return probability.
 Probability is a chance of occurring.
 The most common probability distribution
is the normal distribution.
 Expected value of return: average return
(probability-weighted average of all the possible
distinct outcomes of that variable).

If the probability distribution of a IBM’s stock specifies that it

can have only one of two returns, 0.1 with probability 0.4
and 0.15 with probability 0.6, what is the expected return?
(0.4x0.1)+(0.6x0.15)=0.13=13%
 If y is a random variable, E(y) is expected value, and p is
probability.
 Variance: quantitative measure of how the realizations of
the random variable are distributed around their
expected value, its provides a measure of risk.
VAR = ∑P [y – E(y)]2
 The square root of the variance: standard deviation
Standard deviation = n
   1
P (
i 1
y  E ( y ) 2

 Standard deviation of return is generally called the

volatility of returns.
If the return of 0.10 with probability 0.4 and return of 0.15
with probability 0.6, the variance of the return is 0.4(0.10-
0.13)2+0.6(0.15-0.13)2= 0.0006. The standard deviation is
0.0245 = 2.45%

If the probability distribution of a IBM’s stock specifies that it

can have only one of two returns, 0.025 with probability 0.4
and 0.20 with probability 0.6, its expected return is
unaffected but the volatility becomes 8.57% instead of 2.45%
 John wants to consider XYZ. He first wants to know
if he would be better off investing $100,000 in XYZ
rather than in IBM.
 He finds out that the expected return of XYZ is 26%
and the return volatility is 60%. So that XYZ has
twice the expected return and twice the volatility of
IBM.
 Using the volatility as a summary risk measure, XYZ
is riskier than IBM.
 Since XYZ has a high expected return compared to
IBM, John wants to consider investing something in
XYZ, forming a portfolio of the two stocks.
 The return of a portfolio is the weighted average of
the return of the securities in the portfolio, where
the weight for a security is the fraction of the
portfolio invested in that security.
 The fraction of portfolio: portfolio weight/ portfolio
share.

Suppose John puts $75,000 in IBM and $25,000 in XYZ. The

portfolio share of IBM is $75,000/$100,000 = 0.75
 n

w
i 1
i  Ri  E ( Rp )

If the expected return on IBM is 13% and the expected return

on XYZ is 26%, the expected decimal return of the portfolio
with a portfolio share of 0.75 in IBM and 0.25 in XYZ is: (0.75
x 0.13)+(0.25 x 0.26) = 0.1625 = 16.25%

John expects his wealth to be 100,000 x

(1+0.1625)=$116,250 at the end of the year
 Covariance: the expected value of the product of
the deviations of two random variables from their
mean: P[a-E(a)] [b-E(b)].
 The covariance is closely related to the correlation
coefficient.
 The correlation coefficient takes values between -
1, 0, and +1.
 Cov(a,b) = Corr(a,b) x Vol(a) x Vol(b)
 If the correlation coefficient between the portfolio
returns of IBM and XYZ is 0.5, volatility IBM is 0.3,
volatility XYZ is 0.6. The covariance portfolio is
0.5(0.3)(0.6) = 0.09.
 Variance of portfolio is:
w12Var(R1)+w22Var(R2)+2w1w2Cov(R1,R2)
 0.752(0.3)2+0.252(0.6)2+2(0.75)(0.25)(0.5)(0.3)(0.6)
= 0.11
 The volatility (standard deviation) is square root of
0.11= 0.3317=33.17%
 The impact on the volatility of the
investor’s portfolio return of investing in
XYZ depends on the correlation
coefficient between XYZ and IBM.
 Efficient frontier: upward-sloping part of
the curve graphing for each expected
return the lowest volatility portfolio that
produces that expected return.

Expected Return Volatility

IBM 13% 30%
XYZ 26% 60%
Portfolio 16.25% 33.17%
  Zero-coupon bonds (T-Bill): bonds in which the
interest payment comes in the form of capital
appreciation of the bond, so that no coupon is
paid.
T-bills are securities issued by the US government that mature in
one year or less. They pay no coupon, so that the investor’s dollar
return is the difference between the price paid on sale or at
maturity and the price paid on purchase. Suppose that T-bills
maturing in one year sell for $95 per $100 of face value. This
means that the holding period return computed annually is
(100 x 5/95)= 5.26%.
 The extra expected return of security
(portfolio) over the risk-free rate is called
risk-premium.
 The risk-premium: the reward the investor
expects to receive for bearing the risk
associated with that security (portfolio).
 If Rm is the return portfolio m, Rf is the
risk-free rate, E(Rm) – Rf is the risk
premium.
 Systematic risk
◦ CAPM : Rf + [ß x (Rm – Rf)]
◦ Security market line (SML)

 Unsystematic risk

Suppose that the risk-free rate is 5%, the market risk

premium is 6%, and the beta of IBM is 1.33.
The expected return of IBM = 5%+1.33(6%)=13%
 Firm value:
 Diversifiable risk
◦ Diversifiable risk does not affect the share price, and
investors don’t care about it because it gets diversified
within their own portfolio.
 Systematic risk
◦ Shareholder require the same risk premium for systematic
risks as all investors.

Hedging a risk does not increase firm value

Question:

Solution:
Solution:
Solution: