RISK AND RATES OF RETURN 

Risk  
- Measure of the uncertainty surrounding the return that an investment will earn 
- The variability of returns associated with a given asset 
Return 
- Total gain or loss experienced on an investment 
Realized Return 
- Total gain or loss on an investment 
- Combined effect: Cash flow & Capital gain/loss  
- Can be expressed in amount or percentage 

 
Expected return 
- Weighted average of possible returns, where weights are determined by the probability 
that it occurs 

 
Average return 
a. Arithmetic average ​(r% on succeeding period) 
simple average or sum set of returns divide by their number 
b. Geometric or compound average return (​ r% over multiperiod horizon) 
rate of return earned on an investment that incorporates consideration for the 
effects of compound interest  

 
 
Nominal or quoted rate of return 
- Actual return before inflation 
Real rate of return 
- Nominal return adjusted to changes in prices due to inflation or other effects 
 
 

Ng, A.J.
Fisher effect model 
- Relationship between nominal rate, anticipated rate of inflation & real rate 

 
 
Risk Preferences 
  Preference  Risk Preference 

a. Risk averse  Increased return  Low Risk 

b. Risk Neutral  Higher return   Regardless 

c. Risk Seeking  Lower return  Higher risk 

 
Risk assessment 
- Variability of returns 
 
2 Approaches: 
1. Scenario analysis 
- Uses several possible alternative outcomes to obtain sense of variability of 
returns 
Range - measures asset’s risk 
(Return from optimistic MINUS Return from pessimistic) 
 
2. Probability distribution 
- Relates probabilities to associated outcomes 
Probability - chance that an outcome will occur 
 
Bar chart - simplest type of probabilistic distribution 
- Shows only a limited number of outcomes & assoc. probabilities 
 
Continuous probability distribution  
- Showing all possible outcomes & assoc. Probabilities 
 
Risk Measurement  
- Related to volatility of investment 
- Measured through variance or standard deviation 

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Measuring Risk 
- If probabilities are unknown, use historical data  

 
 
T-bills - stable but lower returns 
T-bonds- risk-free security, no risk of default on promised payment 
Stocks- riskiest  
 
Coefficient of Variation (CV)  
- Measure of relative dispersion that is useful in comparing risks of assets with differing 
expected returns 

 
 
Expected return for Portfolios 
Portfolio - combination of several individual investments 
Portfolio’s return = weighted average of expected rates of return of individual investments 
Portfolio weights (w) = amount invested in a security divided by Total portfolio investment 

 
 
Portfolio Risk and Diversification 
- Portfolio can be less risky than individual investments 
Diversification 
- Reduction in risk that comes about by combining 2 or more risky assets into a portfolio 
- The individual assets are LESS than PERFECTLY POSITIVELY correlated 
Correlation coefficient  
- Measure of degree to which 1 variation in 1 variable is related to the variation in another 
- Ranges -1 to +1 

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Portfolio Risk  
- Using SD of portfolio, not weighted ave of SDs 
- Difference is due to effects of diversification 

 
 
if correlation of coefficient (p) not given, use historical returns of portfolio 
- Using weighted average historical returns of the assets in the portfolio 

 
Total Risk = Diversifiable risk + Nondiversifiable risk 
 
Diversifiable risk (Unsystematic, unique, firm-specific, idiosynratic risk) 
- Portion of an asset’s risk that is attributable to firm-specific or random causes 
- Eliminated thru diversification 
Nondiversifiable risk (Systematic, market-wide risk) 
- Portion of asset’s risk attributable to market factors that affect all firms 
- Cannot be eliminated thru diversification 
 
Beta coefficient 
- Measures nondiversifiable risk 
- Measures extent to which a particular investment’s returns vary with returns in the 
market portfolio 
- Estimated as the slope of a straight line (Rise over Run) 
- Beta of overall market portfolio (1.00) 
- Beta of risk-free investment (0)  

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Portfolio Beta 
- Measures systematic risk of portfolio 
- Weighted average of betas of individual investments 

 
 
International Diversification 
- Inclusion of assets from countries w/bus. cycles not highly correlated with local’s  
- Reduces portfolio’s responsiveness to market movements 
- Over long period, tend to perform better than purely domestic portfolios 
- Earn higher returns 
- Currency risk & Political risk are unique  
 
Modern Portfolio Theory (MPT) 
- Investment theory by Harry Markowitz 
- Suggests it is possible to construct an efficient frontier of optimal portfolios 
- Not enough to look at the expected risk & return of 1 particular stock  
- Quantifies benefits of diversification, (not putting all your eggs in 1 basket) 
 
Efficient Portfolio 
- Maximizes return for a given level of risk 
 
Capital Asset Pricing Model (CAPM) 
- Links risk & return for all assets 
- Using beta coefficient to measure nondiversifiable risk 
- Assumes investors choose to hold optimally diversified portfolio that includes ALL risk 
investments (Market Portfolio) 
- Per CAPM, relevant risk of an investment relates to how the investment contributes to 
the risk of this market portfolio 
 
2 Parts: Risk-free rate of return & risk premium  
Risk premium = return of riskier - less risky investment 
Market Risk Premium:  

  
CAPM Equation: 

 
 
 
 

Ng, A.J.
CAPM: Stock Over/undervaluation 

 
 
Key Insights on CAPM: 
- Investments with same beta have the same E(r) 
- Investors will require a higher rate of return on investments with higher Betas 
- CAPM graph ~ Security market line (SML) 
- Graph that reflects required return in the market place for each level of 
nondiversifiable risk (beta) 
- Relies on historical data, may or may not reflect future variability of returns 
- Rough approximations 
- Assumes markets are efficient  
- Although unrealistic, studies have provided support for existence described by CAPM, 
with stock exchange 
 
Efficient Market Hypothesis (EMH)  
- States securities prices accurately reflect FUTURE CF & based on all info avail. To 
investors 
Efficient market 
- All avail. Information is fully incorporated to prices of securities  
- Returns the investors earn CANNOT be predicted 
- Degree of market efficiency 
- Weak - past market info 
- Semi strong - public info 
- Strong - all info, including private info 
- Markets are expected to be at least weak & semi strong 
 
Key Points: 
● Return on investment can be expressed either in amount or percentage  
● Riskier investments have higher expected return (not necessarily realized return)  
● Risk measured by volatility of investment through variance or standard deviation  
● Two types of average rate of return: arithmetic or geometric/ compound 
● Individual stocks have higher volatility compared with portfolios  
● A well-diversified portfolio eliminates unsystematic risk without decreasing returns  
● Diversifiable risk offers no incremental reward  
● Investments with higher Nondiversifiable risk pay higher returns on average  
● Expected return and nondiversifiable risk of a portfolio equals the weighted average of 
expected returns and beta of the assets in the portfolio  

Ng, A.J.
 ● CAPM offers a risk-based approach in calculating expected return of an investment  
● Efficient market hypothesis (EMH) states that securities prices accurately reflect future 
expected cash flows and are based on all information available to investors 
 
BOND VALUATION 
Bond 
- A long-term (10 year or more) debt instrument indicating that the issuer has borrowed 
certain amount of money and promises to repay in the future under clearly defined terms  
 
Basic Features of a Bond 
● Bond indenture- legal document specifying rights of the bondholders and the duties of 
the issuing corporation 
● Par value or face value or principal- stated amount that the firm is to repay upon the 
maturity date  
● Coupon interest rate- percentage of a bond’s par value that will be paid annually 
(typically in two equal semiannual payments), as interest 
● Maturity date- date on which the bond issuer must repay the principal or par value to the 
bondholder  
● Bond rating- credit rating given to a bond, creditworthiness of the bond 
● Restrictive or protective covenants- provisions in bond indenture that place operating 
and financial ​constraints on the borrower  
○ positive covenants- requirements that borrower must do/ meet as long as bonds 
remain outstanding  
○ Negative covenants- requirements that borrower must not do  
● Sinking fund provision- restrictive covenant that requires the​ systematic retirement ​of 
bonds prior to their maturity 
● Conversion feature- allows bondholders to change each bond i​ nto a stated number of 
shares​ of common stock ​(bond to shares) 
● Call provision- gives the issuer the opportunity to ​repurchase bonds at a stated call price 
prior to maturity (​ repurchase bonds) 
○ Call premium- amount by which bond’s c ​ all price exceeds its par value  
● Stock purchase warrants- instrument the give their holders the r​ ight to purchase a 
certain number of shares o ​ f issuer’s common stock at a specified price over a certain 
period of time ​(purchase shares) 
 
Types of Bond  
A. By Issuer 
a. Corporate bonds- issued by a corporation.  
b. Municipal bonds- issued by local government and municipalities to help finance 
public projects (schools, highways, bridges, prisons, etc.)  
c. Treasury bonds- issued through Bureau of Treasury department as direct 
obligation of the Republic of the Philippines 

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 d. Agency bonds- issued by specific government agencies to be used for certain 
projects  
e. Eurobonds- bond issued by an ​international ​borrower and sold to investors in 
countries with currencies ​other ​than the currency in which the bonds is 
denominated  
f. Foreign bond- issued by foreign corporation or government and is denominated 
in investor’s home currency  
B. By Features 
a. Fixed-rate bonds- coupon payments are fixed in amount over the bond’s life  
b. Floating-rate or variable rate bonds- interest rates that adjust up or down 
depending on movements of an agreed upon benchmark, such as LIBOR  
i. London Interbank Offered Rate (LIBOR)- daily rate based on the interest 
rates at which banks offer to lend in the London wholesale or interbank 
market (market where banks loan each other money)  
c. Debentures- Unsecured bonds  
d. Subordinate Debenture (Unsecured bonds) – Claims are not satisfied until those 
of the creditors holding certain (senior) debts have been fully satisfied  
e. Income bonds- payment of interest is required ​only when earnings are available  
f. Zero or low-coupon or pure discount bonds- issued with no or very low coupon 
payments and sold at large discount from par  
g. Junk (high-yield) bonds- high-risk debt that has a ​below ​investment-grade bond 
rating (rated Ba/BB or lower)   
h. Mortgage bonds- bond secured by​ real estate or buildings  
i. Collateral Trust bonds –​secured by stock and/or bonds​ that are owned by issuer. 
Collateral is usually 25% to 35% greater than bond value  
j. Equipment Trust Certificates- used to f​ inance new equipment​ or “rolling stock”.  
i. type of leasing where trustee buys the asset with funds raised through 
sale of trust certificates and then lease it to the firm. Title for the 
equipment is held in trust for the holders until the debt is paid off (final 
lease payment is made).  
k. Amortizing bond- bonds that are paid off in ​equal periodic payments​ with those 
payments including part of the principal (par value) along with the interest 
payments  
l. Non-amortizing bonds- bonds that are paid-off with p ​ eriodic interest payments 
first​ and the p
​ rincipal to be paid on maturity date  
m. Convertible bonds- debt securities that can be converted into a issuer’s stock at a 
pre-specified price (bond to stock) 
n. (Mandatory) Exchangeable bonds- investors have ​option o ​ r are required to 
convert into CS​ of another company other than issuer Callable bonds 
i. issuer has right to repurchase in the future at a predetermined price  
o. Putable bonds- investors can ​sell bonds back to issuer a ​ t a predetermined price  
p. Premium bond- bond that is selling above its par value  
q. Discount bond- bonds that sell at a discount below par value  

Ng, A.J.
 r. Extendible notes- ​short maturities​, typically 1-5 years, that can be renewed for a 
similar period at the option of the holders  
Bond Markets 
● Corporate Bonds are traded in public financial markets  
● Firm enlist the help of investment banker when raising funds in the public financial 
market  
 
3 Basic Functions of Investment Bank: 
1. Underwriting- investment banker assumes the risk of selling a security at a satisfactory 
price  
2. Distributing- selling to public through security dealers  
3. Advising- analyze capital structure against prevailing market conditions, and make 
recommendation about what general source of capital should be issued 
 
Credit or Yield spread 
- difference in YTM of a c ​ orporate bond and treasury bond​ with almost the same maturity 
- Yield spread increases as maturity increases and bond ratings decline  
- Spread is expressed in basis points where 100 basis points equals 1 percent  
 
Basic Valuation Model 
Valuation 
- process that links risk and return to determine​ worth of asset  
- Value of any asset is the PV of all future cash flows it is expected to provide over the 
relevant time period  

 
Steps:  
1. Estimate amount and timing of cash flow  
2. Estimate appropriate discount rate on bond of similar (market’s required yield to 
maturity)  
3. Calculate price using present value 
 
● Value of corporate debt is equal to the PV of the contractually promised principal and 
interest payments (the cash flows) discounted back to the present using the market’s 
required YTM on similar risk  
● Price = PV of coupons + PV of principal  
● PV of mixed stream or combination of annuity and lump sum  
 

Ng, A.J.
Bond Pricing equation: 

 
 
Features: Bond Yields 
Current or coupon yield 
- measure of a bond’s cash return for the year  

 
Effective yield 
- annual rate of return assuming coupon payments were reinvested earning the coupon 
rate  

 
Yield to maturity (YTM) aka Bond equivalent yield (BEY) 
- compound annual rate of return earned on a debt security purchased on a given day and 
held to maturity  
Effective annual yield (EAY) or effective annual return (EAR) 
- annualized YTM taking compounding effect during the year [1 + (YTM/m)]m - 1  
Yield to call (YTC) 
- rate of return that investors earn if they buy a callable bond and hold it ​until it is called 
back  
Holding period yield 
- compound annual return earned by the investor over the holding period for the bond; 
same calculation of YTM except for period and ending value  
 
Calculating YTM 
- similar to solving rate of return on an investment with multiple future cash flows  
- simply the discount rate that makes present value of the bond’s promised interest and 
principal equal to the bond’s observed market price  
 
Interpolation 
- Is a method of determining the more exact rate between a range or interval of rates  
1. Find the difference in net present value (or PV factor) between the range  
2. Find the absolute difference (i.e., ignore a plus or minus sign) between the desired PV 
(calculated PV factor) and the present value (or PV factor) for the lower rate  
3. Divide the value from Step 2 by that found in Step 1 to get the percent total distance 
across the range attributable to the desired or calculated value.  
4. Multiply the percent found in Step 3 by the interval width over which interpolation is 
being performed.  

Ng, A.J.
 5. Add the value found in Step 4 to the interest rate associated with the lower end of the 
interval.  
 
4 Key Relationships 
1. The value of the bond is inversely related to changes in the market’s required yield to 
maturity  
2. The market value of a bond will be less than the par value if the market’s required yield 
to maturity is above the coupon interest rate and will be valued above par value if the 
market’s required yield to maturity is below the coupon interest rate  
a. Discount or premium – the amount by which a bond sells below or above its par 
value  
3. As the maturity date approaches, the market value of a bond approaches its par value  
4. Long-term bonds have greater interest-rate risk than short-term bond  
a. Interest-rate risk – variability in a bond’s value caused by changing interest rates 
b. Prices of longer-term bonds fluctuate more when interest rate change than do 
prices of shorter-term bonds  
 
Term Structure of interest rates 
- (positive) relationship between the maturity and interest rates (such as rate of return 
bonds with similar level of risk)  
Yield curve- graphical depiction of term structure of interest rates 
Inverted yield curve downward - sloping yield curve indicates that s ​ hort-term interest are 
generally higher​ than long-term interest  
Normal yield curve- u ​ pward ​sloping yield curve indicates that​ long-term interest rates are 
generally higher​ than short-term interest rates  
Flat yield curve- A yield curve that indicates that interest rates d​ o not vary much​ at different 
maturities  
 
Key Analysis 
● The greater the uncertainty about future benefits, the higher the discount rate to be 
applied in discounting  
● If coupon rate or yield is higher than YTM, bonds are traded at a premium  
● If coupon rate or yield is lower than YTM, bonds are traded at a discount  
● When required rate of return equals coupon rate, bonds trade at par  
● As required rate of return increases, bonds’ prices decreases, and vice versa  
● Prices of long-term bond are much more sensitive to changes in interest rates than 
short-term bond prices  
● Interest rate risk and default risk can change market’s required return which affects 
bond prices  
● Bonds with lower ratings must offer investors higher yields  
● The slope of the yield curve is highly correlated with future economic growth  
● Yield spread increases as maturity increases and bond ratings decline  
 

Ng, A.J.
STOCK VALUATION 
Equity Securities 
- An instrument that signifies an ownership position (called equity) in a corporation, and 
represents a claim on its proportional share in the corporation's assets and profits 
- Riskier than bonds but has higher return on average  
 

 
 
Preferred Stock 
● gives its holders certain privileges that make them senior to common stockholders.  
● are promised a fixed periodic dividend, which is stated either as a percentage or as a 
peso amount.  
● often considered ​quasi-debt ​because, much like interest on debt, it specifies a fixed 
periodic payment (dividend). 
● Preferred stock is unlike debt in that it has no maturity date 
Par-value preferred stock  
- preferred stock with a stated face value that is used with the specified dividend 
percentage to determine the annual dollar dividend.  
No-par preferred stock  
- preferred stock with no stated face value but with a stated annual dollar dividend. 
 
Features of Preferred Stock 
● Restrictive covenants including provisions about passing dividends, the sale of senior 
securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of 
common stock.  
● Cumulative preferred stock 
○ preferred stock for which all passed (unpaid) dividends in arrears, along with the 
current dividend, must be paid before dividends can be paid to common 
stockholders. 
● Noncumulative preferred stock  
○ preferred stock for which passed (unpaid) dividends do not accumulate. 

Ng, A.J.
 ● A callable feature  
○ a feature of callable preferred stock that allows the issuer to ​retire​ the shares 
within a certain period time and at a specified price.  
● A conversion feature  
○ a feature of convertible preferred stock that allows holders to change each share 
into a stated number of shares of common stock. (preferred to common) 
 
Common Stock 
● Authorized shares  
○ the shares of common stock that a firmʼs corporate charter allows it to issue.  
● Outstanding shares  
○ issued shares of common stock held by investors, this includes private and 
public investors.  
● Treasury stock  
○ issued shares of common stock held by the firm; often these shares have been 
repurchased b ​ y the firm.  
● Issued shares  
○ shares of common stock that have been put into circulation  
● Issued shares = outstanding shares + treasury stock  
 
Voting Rights 
● Elect board of directors (BOD)  
● Approve any change in corporate charter (e.g. new stock issuance or merger)  
● Proxy 
○ voting in which a designated party is provided with temporary power of attorney 
to vote for the signee at the corporation’s annual meeting  
 
Two commonly used voting procedures:  
1. Majority voting- each share of stock allows the shareholder ​one v​ ote, and each position 
on the BOD is voted on s ​ eparately  
2. Cumulative voting-each share of stock allows the shareholder a ​ number of votes equal 
to the number of directors being elected​. Shareholder can cast his/her all votes for a 
single candidate or split them among the various candidates  
 
● A proxy battle is an attempt by a nonmanagement group t​ o gain control​ of the 
management of a firm by soliciting a sufficient number of proxy votes.  
● Supervoting shares is stock that carries with it ​multiple votes per share​ rather than the 
single vote per share typically given on regular shares of common stock.  
● Nonvoting common stock is common stock that carries ​no voting rights​; issued when 
the firm​ wishes to raise capital t​ hrough the sale of common stock but does ​not want to 
give up its voting control 
 
 

Ng, A.J.
Agency Costs 
● Agency Problem- managers may put their p ​ ersonal interests​ ahead of the firm’s owners 
if their incentives are not properly aligned with those of firm’s stockholders  
● Managers​ avoid unpleasant tasks​ such as taking on less profitable projects that they 
personally like, not reducing number of employees as needed, avoiding very risky 
projects that may jeopardize their jobs  
● Agency costs are difficult to quantify but can be seen in stock prices  
○ e.g. stock price increase for removal on ineffective management team  
 
Equity Issuance and trading  
● Investment banks assist firms in the process of issuing securities to investors whether 
○ Initial public offering (IPO)- first public sale  
○ Seasoned equity offering (SEO)- re-offering of previously issued stock  
● New securities trade in the primary market via Initial public offering (IPO) where it is first 
time a company issues stock to the public.  
● Currently outstanding securities are traded in secondary stock market  
○ Bid Price- highest price offered to purchase  
○ Ask Price- lowest price offered for sale  
● PSE is the only stock exchange in the Philippines 
● Unified trading floor in BGC  
● Main index for PSE is the PSEi, which measures the relative changes in the free 
float-adjusted market capitalization of the 30 largest and most active common stocks 
listed at the PSE  
 
Preferred Stock Valuation 
● Preferred Stock (PS)- f​ ixed c ​ ash flows without maturity, hence,  
○ PV of a level perpetuity​ will be used based on promised yield and promised cash 
flows  
● Market’s required yield on PS is the promised rate of return on PS  
● Preferred stock valuation equation:  

 
 
Common Stock Valuation  
● More complex than that of preferred stock since there is ​no fixed cash flow​ stream 
(variable and uncertain)  
 
Using Basic Valuation (Discounted Dividend) Model:  
1. Estimate amount and timing of cash flow  
2. Evaluate risk & determine investor’s required rate of return  
3. Calculate price using present value  
 

Ng, A.J.
 ● Value of a share of common stock is equal to the PV of all future cash flows (dividends)  
● Common stock (CS)- with no maturity  
● Dividend is based on 
○ 1) profitability of the firm and  
○ 2) management’s decision to pay dividends or retain earnings for growth  
● Price/ Value- PV of the entire dividend stream the stock will pay in the future 
 

 
 
3 Models to dividend valuation: 
1. Zero growth 
● assumes a constant, non-growing dividend stream (using PV of a level 
perpetuity) 
● *use expected dividend  

 
2. Constant Growth (Gordon Growth Model) 
○ dividend will grow at a constant rate, PV of a growing perpetuity  
○ *use expected dividend 

 
3. Variable Growth or 3-stage growth 
○ dividend initially have a rapid growth before a stable one 
○ Present value calculation is divided into two periods, the fast-growth period and 
the stable-growth period following it. 

 
 
 
 
 
 
 

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Interpretation: 
● Comparing the computed intrinsic value of a stock and its current stock price, we can 
assess whether a stock is overvalued or undervalued 

 
 
Growth Rate (Historical) 
● If historical data is provided, we can calculate historical annual growth rate using FV of a 
lump sum equation as follows:  

 
 
Estimating Growth Rate (using ROE and Retention ratio) 
● Growth rate depends on many factors such as new investments, return on equity (ROE), 
proportion of earnings reinvested known as retention ratio  
● Retention ratio (RR) + dividend payout ratio (DPR) = 1  
● Using financial statements, we can calculate growth rate as follows: 
 

 
 
Investor’s required rate of return (used in valuation) 
● Determined by two key factors  
○ Level of interest rates in the economy  
○ Risk of firm’s stock  
● Using CAPM model 

 
Other CS Valuation 
● If the firm doesn’t pay dividends or if it is difficult to estimate the dividend amount and 
when it will be paid, we can use different valuation approach such as:  

Ng, A.J.
 
Free Cash Flow model  
1. Discount free cash flow (FCF) to determine total enterprise value  

 
2. Deduct value of debt and preferred shares from the total value to obtain Value of common 
stock  

 
3. Divide value of common stock by number of shares outstanding to determine price per share  
 
Book value model  
● amount per share of common stock that would be received if all of the firm’s assets 
were s ​ old for their book value​ and proceeds remaining after paying all liabilities 
(including PS) were divided among common stockholders.  
 
Liquidation value model  
● amount per share of common stock that would be received if all of the firm’s assets 
were s ​ old for their current market value a
​ nd proceeds remaining after paying all 
liabilities (including PS) were divided among common stockholders 
 
P/E Ratio Valuation model (Relative Valuation Model) 
● Price/ earnings (P/E) ratio or earnings multiplier- price per share divided by company’s 
earnings per share.  
● Value of CS can be calculated by multiplying the firmʼs expected earnings per share 
(EPS) by the average price/earnings (P/E) ratio for the industry. 

 
 
Key Analysis: 
● Equity securities is riskier than debt securities, hence, has higher potential rewards  
● Preferred-stock is a quasi-debt security since it has both debt and equity features  
● Valuation of stocks applies our fundamental valuation model wherein the price today is 
simply the PV of all future cash flows  
● Preferred stock is valued using promised yields and promised cash flows 
● Due to higher uncertainty of cash flows from common stocks, we use different 
assumptions and estimates in our valuation  
● Common stock are valued using expected future dividends and expected rate of return  
● Value of common stock depends on investor’s expectations of dividend growth, 
otherwise, they can use or P/E multiples 

Ng, A.J.