FINC 6001 LECTURE 1

Risk Return and Magic

ADMIN
Graham Partington
Building H69 Room 413
Consulting time: Thursday 10.00 to 12.00
See me in person rather than using email
Textbook: Intermediate Corporate Finance
6001
Builds on FINC 5001
LEARNING OUTCOMES

1. Understand economic, financial, and behavioural issues in
corporate finance and be able to apply these ideas to decision
making in diverse and unpredictable environments.
2. Think critically about underlying theories, concepts,
assumptions and arguments in corporate finance.
3. Formulate and present persuasive arguments relevant to
problems in corporate finance.
Many students are weak in this area and it is a skill that is
critical to successful careers. So make sure you work on it.
4. Acquire and apply real data to problems in corporate
finance.

TEACHING & LEARNING
Classes & Assigned Questions
Learn by thinking and doing
Outline, Overheads , Solutions specimen test &
exam questions on Blackboard website
Quiz question solutions publishers web-site &
Blackboard (see Course Outline)

ADMIN CONTD
Assesment
1. Semester Test 1 (In Class) 25%
2. Semester Test 2 (In Class) 25%
3. Final Examination 50%
4. Practical Exercises Pass/Fail (2 out of four)
5. Academic Honesty Module


LECTURE 1: TOPICS COVERED
The Nature and Measurement of Returns
Many Decades of Capital Market History
Measuring Risk and Return
Portfolio Risk
Beta (market) and Unique Risk
Diversification
NATURE OF RETURNS
Time Preference + Risk Aversion



Required Return
= Price of Time + Price of Risk x Level of Risk



Given
by r
f

Impatience to consume
Alternative investments
The province of asset
pricing models
EQUILIBRIUM
Prices in Equilibrium:
Required Return = Expected Return
But Actual Return is not necessarily equal to
Expected Return
Hence RISK

MEASURING RETURNS
Returns are the growth in wealth in relative to
the wealth invested.
Often adjusted for the timing of the cash flows.
Eg. Allow for reinvestment of dividends
Usually expressed as a rate per period.
For shares usually defined as:
Capital Gain + Dividend Yield


1
+ A
t
t t
P
D P
A POTENTIAL MEASUREMENT
PROBLEM
Dimensional consistency
Price changes are in market values
Dividends are in face values
These values can differ
For example, if dividends and capital gains are taxed
differently
Often ignored or assumed away
Eg. standard CAPM either assumes no taxes, or that
dividends and capital gains are equally taxed.
A PROBLEM IN MEASURING AUSTRALIAN
EQUITY RETURNS
Following the introduction of dividend
imputation, shareholders get a tax credit
with their dividend
BUT not for all companies
Difficult to account for this invisible
component of returns
Report % of dividends franked, or
Compute dividend yield as:

1

Dividend Yield
Where = the market value of franking credits as a percentage of face value
= the face value of the franking credit
t
t
F D
P
F
v
v

+
=

Problem: How big is v?
ALTERNATIVE RETURNS
1
1
( )
EX
t t t
t
P P D
P

+
1
1
( )
CUM
t t
t
P P
P

1
1
( )
EX
t t t
t
P P qD
P

+
A. This standard definition of return
uses the ex-divided price at t
B. This alternative definition of return
uses the cum-dividend price at t. The
dividend does not appear as it is
capitalised in the cum dividend price
C. This return definition includes
dividends scaled by q (The ratio of market
value to face value) and gives the same
return as B (unlike A, unless q = 1)
q =??
The Value of an Investment of $1 in 1926
with Reinvestment: US Markets
Source: Ibbotson Associates
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
L
o
g

s
c
a
l
e

Year End
1
5520
1828

55.38
39.07
14.25
Nominal Dollars
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
The Value of an Investment of $1 in 1926
with Reinvestment: US Markets
Source: Ibbotson Associates
L
o
g

S
c
a
l
e

Year End
1
613
203

6.15
4.34
1.58
Real Dollars
EQUITY MARKET RISK (BY COUNTRY)
16.64
17.88
18.93
19.79
21.51 21.64
22.28 22.71 22.71
23.35 23.58 23.64 23.8
24.93
27.91
29.24
33.66
34.17
0
5
10
15
20
25
30
35
40
C
a
n
a
d
a
A
u
s
t
r
a
l
i
a
S
w
i
t
z
e
r
l
a
n
d
U
S
A
D
e
n
m
a
r
k
U
K
I
r
e
l
a
n
d
S
p
a
i
n
N
e
t
h
e
r
l
a
n
d
s
S

A
f
r
i
c
a
S
w
e
d
e
n
B
e
l
g
i
u
m
A
v
e
r
a
g
e
F
r
a
n
c
e
N
o
r
w
a
y
J
a
p
a
n
I
t
a
l
y
G
e
r
m
a
n
y

(
e
x

1
9
2
2
/
3
)
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

o
f

A
n
n
u
a
l

R
e
t
u
r
n
s
,

%

Average Risk (1900-2006)
AVERAGE MARKET RISK PREMIA (BY COUNTRY)
4.85
5.33 5.5
5.95 6.06 6.17
6.45 6.5
6.88
7.52 7.62
8.58
8.81 8.85
9.39
9.71
10.29
10.97
0
1
2
3
4
5
6
7
8
9
10
11
D
e
n
m
a
r
k
B
e
l
g
i
u
m
S
w
i
t
z
e
r
l
a
n
d
S
p
a
i
n
C
a
n
a
d
a
N
o
r
w
a
y
I
r
e
l
a
n
d
U
K
N
e
t
h
e
r
l
a
n
d
s
A
v
e
r
a
g
e
U
S
A
S
w
e
d
e
n
S
o
u
t
h

A
f
r
i
c
a
A
u
s
t
r
a
l
i
a
G
e
r
m
a
n
y
F
r
a
n
c
e
J
a
p
a
n
I
t
a
l
y
Risk premium, %
Country
THE SOURCE OF EXTRA RETURNS
Risk drives higher returns
But small stocks consistently appear to offer
abnormally high returns. Why?
Liquidity risk?
Recent research: Abnormal realised return mainly
driven by a few highly successful small stocks who
become big stocks
US Rates of Return 1926-1997
Source: Ibbotson Associates
-60
-40
-20
0
20
40
60
26 30 35 40 45 50 55 60 65 70 75 80 85 90 95
Common Stocks
Long T-Bonds
T-Bills
Year
P
e
r
c
e
n
t
a
g
e

R
e
t
u
r
n

P
e
r

Y
e
a
r

Shares offer volatile returns (declining post 1980)
Bond volatility increases post 1980
DIVIDEND YIELD (1900-2006)
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
D
i
v
i
d
e
n
d

Y
i
e
l
d
,

%
AUSTRALIAN DATA
Average rates of Return for Government Bonds, and Ordinary Shares for
Australia 1882 - 1987
Portfolio Average Annual Rate
of Return (Nominal)
%/yr
Average Annual
Rate of Return
(Real) %/yr
Average Risk Premium
( over bonds) %/yr
10-Year Bonds 5.21
Shares 13.06 9.56 7.85
Source: R. R. Officer, in Ball et. al. 1989.
VOLATILITY IN AUSTRALIAN SHARES
73 75 77 79 81 83 85 87 89 91 93 95
-30
-20
-10
0
10
20
30
40
50
60
70
Total Return Percent
73 75 77 79 81 83 85 87 89 91 93 95
Year
Total returns, price changes plus dividends, for the Australian stockmarket. (Source:
Datastream Australian Market Index - Total Returns)
MEASURING RISK
1 1
4
10
12
20
17
24
13
3
2
0
4
8
12
16
20
24
-
5
0

t
o

-
4
0
-
4
0

t
o

-
3
0
-
3
0

t
o

-
2
0
-
2
0

t
o

-
1
0
-
1
0

t
o

0
0

t
o

1
0
1
0

t
o

2
0
2
0

t
o

3
0
3
0

t
o

4
0
4
0

t
o

5
0
5
0

t
o

6
0
Return %
# of Years
Histogram of Annual US Stock Market Returns
(1900-2006)
HISTOGRAM OF AUSTRALIAN TOTAL RETURNS
1973-96
0
2
4
6
8
- 4 0 - 1 0 2 0 5 0 8 0
T o t a l R e t u r n
N u m b e r o f O b s e r v a t i o n s
o O b s e r v a t i o n s
Spread is measured by variance
MEASURING RISK (VOLATILITY)
Variance - Expected (Average) value of squared
deviations from mean. A measure of volatility
__
units
are % squared.
Standard Deviation - Square root of variance. A measure
of volatility
__
units are %.
Example: Two coins are flipped: For each head that
comes up you get back your starting balance plus 20
percent, and for each tail that comes up you get back
your starting balance less 10 percent. Four possibilities
exist:
Head + head: You gain 40 percent.
Head + tail: You gain 10 percent.
Tail + head: You gain 10 percent.
Tail + tail: You lose 20 percent. Mean = 10%
MEASURING RISK
Coin Toss Game-calculating variance and standard
deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
MEASURING RISK
Diversification - Strategy designed to reduce
risk by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that
firm. Also called diversifiable risk.
Market Risk - Economy-wide sources of risk
that affect the overall stock market. Also
called systematic risk.
MEASURING PORTFOLIO RETURN
Portfolio rate
of return
=
fraction of portfolio
in first asset
x
rate of return
on first asset
+
fraction of portfolio
in second asset
x
rate of return
on second asset
(
(
(
(
)
)
)
)
+ ...

=
=
n
i
i i
p
r E x r E
1
] [ ] [
In General:
Portfolio returns are calculated as a simple weighted average, BUT
Portfolio risks are NOT a simple weighted average, because of
diversification.
PORTFOLIO DIVERSIFICATION & RISK
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
The on average effect of increasing the
number of securities in a portfolio
MEASURING RISK
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Market risk
Unique
risk
The on average effect of increasing the
number of securities in a portfolio
Approx. 20%
BHP
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
R
E
T
U
R
N

%
NEGA CORRELLA
-20.00
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
R
E
T
U
R
N

%
Portfolio
0
1
2
3
4
5
R
e
t
u
r
n

%
Half your
portfolio in
BHP
and half in
Nega
Corrella
eliminates
all
risk
Diversification
COMPUTING PORTFOLIO RISK
2
2
2
2
2 1 12 2 1
12 2 1
2 1 12 2 1
12 2 1 2
1
2
1
x
x x
x x
2 Stock
x x
x x
x 1 Stock
2 Stock 1 Stock
=
=
The variance of a two share portfolio is the sum of these
four boxes:
Covariance, o
12

PORTFOLIO RISK
Example
Suppose you invest $60 in Budget Horse Power,
Bhp, at an expected return of 15% and $40 in
Coles Mire at an expected return of 21%. The
expected return on your portfolio is:
(0.6 x 0.15) + (0.4 x 0.21) = 17.4%
Assume that bhp has a standard deviation of
returns of 28% with Coles Mire at 42%. Assume
the correlation in returns is 0.4.

PORTFOLIO RISK
2 2 2
2
2 2 2
1
42 40
42 28 4
40 60
42 28 4
40 60
28 60
) ( ) (. x
.
. . x x
Mire Coles
.
. . x x
) ( ) (. x Bhp
Mire Coles Bhp
2
2
2 1 12 2 1
2 1 12 2 1
2
1
=

=

=
=
o
o o
o o
o
Example
Suppose you invest $60 in Budget Horse Power, Bhp, at an expected return of 15%
and $40 in Coles Mire at an expected return of 21%. The expected return on your
portfolio is: (0.6 x 0.15) + (0.4 x 0.21) = 17.4%
Assume that Bhp has a standard deviation of returns of 28% with Coles Mire at 42%.
Assume the correlation in returns is 0.4.
PORTFOLIO RISK
Example
Suppose you invest $60 in Budget Horse Power, Bhp, at an expected return of 15%
and $40 in Coles Mire at an expected return of 21%. The expected return on your
portfolio is: (0.6 x 0.15) + (0.4 x 0.21) = 17.4%
Assume that Bhp has a standard deviation of returns of 28% with Coles Mire at 42%.
Assume the correlation im returns is 0.4.
Portfolio variance = [(.60)
2
x (28)
2
] + [(.40)
2
x (42)
2
] + 2(.60 x .40 x .4 x 28 x 42)= 790
The standard deviation is: 790 = 28.1 percent
With a correlation of -1 the standard deviation is zero
With a correlation of +1 the standard deviation is 33.6%
= .60*28 + .40 *.42 ie. the weighted average!
GENERAL PORTFOLIO FORMULAE
N SECURITY PORTFOLIOS

=
=
i
i i
p
r E x r E
1
] [ ] [

= =
N
i
N
j
ij j ix x
1 : 1
o
RETURN:
VARIANCE =
N
PORTFOLIO RISK
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
4
5
6
N
1 2 3 4 5 6 N
share
share
To calculate
portfolio
variance add
up the boxes.
Note that the
variance
(diagonal)
terms get
relatively less
important as
N gets bigger.
INDIVIDUAL SECURITIES AND PORTFOLIO RISK
The risk a security contributes to a portfolio
depends on its weight in the portfolio and its
covariance with the portfolio,o
ip
.

Risk of security i relative to the portfolio is:



Proportion of portfolio risk contributed by security i
is: x
i
|
ip
2
) (


p
ip
ip
o
o
| =
COVARIANCE AND THE MARKET PORTFOLIO
Beta relative to the market (all asset) portfolio
= Covariance with market/variance of market



The variance of a well diversified portfolio depends
on the market (beta) risk of the securities in the
portfolio.
2
) (


m
m i
m i
o
o
| =
Usually just
written as |
i

BETA AND UNIQUE RISK
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P 300, is used to
represent the market.

Beta - Sensitivity of a stocks return to the
return on the market portfolio.
BETA AND TOTAL RISK
beta
Expected
return
Expected
market
return
10% 10% - +
-10% +10%
share
Copyright 1996 by The McGraw-Hill Companies, Inc
-10%
1. Total risk =
diversifiable
(unique) risk +
market risk
2. Market risk is
measured by beta,
the sensitivity to
market changes.
REFRESH OF BETA CALCULATION
(1) (2) (3) (4) (5) (6) (7)
Product of
Deviation Squared deviations
Deviation from average deviation from average
Market Anchovy Q from average Anchovy Q from average returns
Month return return market return return market return (cols 4 x 5)
1 -8% -11% -10% -13% 100 130
2 4 8 2 6 4 12
3 12 19 10 17 100 170
4 -6 -13 -8 -15 64 120
5 2 3 0 1 0 0
6 8 6 6 4 36 24
Average 2 2 Total 304 456
Variance =
m
2
= 304/6 = 50.67
Covariance =
im
= 456/6 = 76
Beta () =
im
/
m
2
= 76/50.67 = 1.5
Calculating the variance of the market returns and the covariance
between the returns on the market and those of Anchovy Queen. Beta is the ratio of
the variance to the covariance (i.e., =
im
/
m
2
)
BETA AND PORTFOLIO VARIANCE
Total variance for a security = Systematic
variance due to the market + Residual
(unsystematic) variance due to unique firm
specific events

Similarly

Where


o | o o
c i i m i
2 2 2 2
= +
o | o o
c p p m p
2 2 2 2
= +
| |
p i
i
N
i
x =
=

1
BETA AND PORTFOLIO VARIANCE AND
DIVERSIFICATION
For a well diversified portfolio o
2
c p
is
approximately zero, so:
This is exactly true for the market portfolio
o | o
x
i
|
i
o
p
p m
m
i
N
2 2 2
2 2
1
~
~
=
(
)