2201AFE Corporate Finance

Week 9: Return, Risk and the Security Market Line Readings: Chapter 11

Agenda
Last Lecture Return, Risk and the Security Market Line
Key Concepts and Skills

Real World Application

Estimating Microsofts Beta

Last Lecture
Returns
Holding Period Returns Averages: Arithmetic Mean & Geometric Mean

Risk
Variance Standard Deviation

There is a reward for bearing risk

Positive risk-return relationship Risk Premium

Efficient Market Hypothesis: weak, semi-strong, strong

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Return, Risk and the Security Market Line

Chapter 11

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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Key Concepts and Skills

Expected Returns and Variances
Probabilities

Portfolios
Risk and Returns The principle of diversification

Risk: Systematic and Unsystematic The Security Market Line (SML) Capital Asset Pricing Model (CAPM) Reward to Risk Ratio

Expected Returns
Consider an asset which has many possible future returns, returns that are not equally likely. What is the average return? What is the expected return? Average or Expected returns is based on the average of all possible future returns weighted by their probabilities. Suppose there are T possible returns, and that R1 has probability p1 of occurring, R2 has probability p2, , and RT has probability pT . Then:
E(R) piR i
i 1 iT

E(R) p1R 1 p2R 2 pTR T

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Example: Expected Returns

Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns?
State Probability Stock C Stock T

Boom Normal Recession

0.3 0.5 ???

15% 10% 2%

25% 20% 1%

RC = 0.3(0.15) + 0.5(0.10) + 0.2(0.02) = 9.99% RT = 0.3(0.25) + 0.5(0.20) + 0.2(0.01) = 17.7%

Variance and Standard Deviation

Variance and standard deviation still measure the volatility of returns. Using unequal probabilities for the entire range of possibilities. Weighted average of squared deviations.
VAR 2 pi[R i E(R)]2
i 1 T

VAR 2 p1[R 1 E(R)]2 p2[R 2 E(R)]2 ... pi[R i E(R)]2 SD VAR 2

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Example: Variance and Standard Deviation

Consider the previous example. What are the variance and standard deviation for each stock?
E(R)C = 9.9% and E(R)T = 17.7% Stock C:
2 = 0.3(0.15-0.099)2 + 0.5(0.10-0.099)2 + 0.2(0.02-0.099)2 = 0.3(0.051)2 + 0.5(0.001)2 + 0.2(-0.079)2 = 0.3(0.002601) + 0.5(0.000001) + 0.2(0.006241) = 0.0007803 + 0.0000005 + 0.0012482 = 0.002029
2 0.002029 0.045044 4.5%

Stock T:
2 = 0.3(0.25-0.177)2 + 0.5(0.20-0.177)2 + 0.2(0.01-0.177)2 = 0.3(0.073)2 + 0.5(0.023)2 + 0.2(-0.167)2 = 0.0015987 + 0.0002645 + 0.0055778 = 0.007441
2 0.007441 0.086261 8.63%
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Quick Quiz
Consider the following information:
State Probability ABC Inc.

Boom

0.25

15%

Normal Slowdown Recession

0.50 0.15 0.10

8% 4% -3%
E(R) p1 R 1 p 2 R 2 p T R T

What is the expected return?

What is the variance?

VAR 2 p1[R 1 E(R)]2 p 2[R 2 E(R)]2 ... p i[R i E(R)]2

What is the standard deviation?

SD VAR 2

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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?
Companies Amount invested Weights

CBA WOW TLS

$2,000 $3,000 $4,000

BHP

$6,000

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Portfolio Expected Returns

The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio (see example 11.3) Method 1:
Step 1: calculate E(Rasset) based on probability of state
E(R asset ) p1R 1 p2R 2 ... pn R n

Step 2: calculate E(RP) based on weights of assets

E(R P ) w 1E(R 1 ) w 2E(R 2) ... w n E(R n )

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Portfolio Expected Returns

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 (see example 11.4) Method 2:
Step 1: calculate E(RP) in each state, eg. boom or bust
E(R P ,state ) w 1 R 1 w 2R 2 ... w n R n

Step 2: add the state returns weighted by each probability

E(R P ) p1E(R state1 ) p2E(R state2) ... pn E(R state n )

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Example: E(RP)
Consider the following information
State Probability Asset X Asset Z

Boom Normal Recession

0.25 0.60 0.15

15% 10% 5%

10% 9% 10%

What are the expected return for a portfolio with an investment of $6,000 in asset X and $4,000 in asset Z?

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Example: E(RP) Method 1

Weight X = 0.6, Weight Z = 0.4 First way of calculating E(RP): Step 1: Calculate the expected return of each asset based on each probability of state occurring: E(RX) = (0.250.15) + (0.60.10) + (0.150.05) = 0.105 E(RZ) = (0.250.10) + (0.60.09) + (0.150.10) = 0.094 Boom Normal Recession

Step 2: Calculate the E(RP) based on the weights of each asset: E(RP) = 0.60.105 + 0.40.094 = 0.1006 (10.06%)
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Example: E(RP) Method 2

Weight X = 0.6, Weight Z = 0.4 Second way to calculate E(RP): Step 1: Calculate the E(RP) in each state based on each asset weight:
E(RP)Boom = (0.60.15) + (0.40.10) = 0.13 E(RP)Normal = (0.60.10) + (0.40.09) = 0.096 E(RP)Recession = (0.60.05) + (0.40.10) = 0.07

Step 2: Calculate total E(RP) using probabilities as weights:

E(RP) = pB E(RBoom) + pN E(RNormal) + pR E(RRecession) E(RP) = (0.250.13) + (0.60.096) + (0.150.07) = 0.0325 + 0.05756 + 0.0105 = 0.1006 (10.06%)
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Portfolio Variance with Probabilities

1. Compute the portfolio return for each state (step 1): E(RP,state) = w1R1 + w2R2 2. Compute the expected portfolio return using probabilities as for a single asset (step 2): E(RP) = p1 E(Rstate1) + p2 E(Rstate2) + p3 E(Rstate3) 3. This E(RP) becomes the mean 4. Compute the deviations of each state from the mean, then square the deviation: [E(RP,state) E(RP)]2 5. Multiply the squared deviation with probability of each state, then sum: (pstate [E(RP,state) E(RP)]2)
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Example: Variance & SD

Variance: (pstate [E(RP,state) E(RP)]2) Portfolio return in each state (boom, normal, recession) and twoasset (X and Z) total portfolio return. E(Rp)boom = 13% E(Rp)normal = 9.6% E(Rp)recession = 7% E(Rp) = 10.06% Variance: = 0.25(0.13-0.1006)2 + 0.6(0.096-0.1006)2 + 0.15(0.07-0.1006)2 = 0.00021609 + 0.000012696 + 0.000140454 = 0.00036924

SD 0.00036924 0.019215619 1.92%

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Example 2: E(R), Variance & SD

Consider the following information:
Invest 50% of your money in Asset A
State Probability Asset A Asset B Portfolio

Boom Bust

0.40 0.60

30% -10%

-5% 25%

12.5% 7.5%

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

What are the expected return and standard deviation for the portfolio?
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Example 2: E(R), Variance & SD Asset

E(Rasset) = (pstate1 Rasset) + (pstate2 Rasset) VAR = [pstate (Rasset E(Rasset)2]

SD VAR 2
Asset A: E(RA) = 0.4(0.30) + 0.6(-0.10) = 6% Variance(A) = 0.4(0.30-0.06)2 + 0.6(-0.10-0.06)2 = 0.02304 + 0.01536 = 0.0384

SD(B) 0.0384 0.196 19.6%

Asset B: E(RB) = 0.4(-0.05) + 0.6(0.25) = 13% Variance(B) = 0.4(-0.05-0.13)2 + 0.6(0.25-0.13)2 = 0.01296+0.00864 = 0.0216

SD(B) 0.0216 0.147 14.7%

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Example 2: E(R), Variance & SD Portfolio

Calculate the Expected return of portfolio in each state:
E(Rp)state = (wasset A RA state) + (wasset B RB state) E(Rp)boom = 0.5(0.30) + 0.5(-0.05) = 0.125 E(Rp)bust = 0.5(-0.10) + 0.5(0.25) = 0.075

Then the overall Expected portfolio return:

E(Rp) = (pstate1 E(Rp)state1) + (pstate2 E(Rp)state2) E(Rp) = 0.4(0.125) + 0.6(0.075) = 0.095

Then the Variance of the portfolio:

VARp = [pstate (E(Rp)state E(Rp))2] VARp = 0.4(0.125 - 0.095)2 + 0.6(0.075 - 0.095)2 = 0.00036 + 0.00024 = 0.0006

Then the Standard Deviation of the portfolio:

SD 0.0006 0.02449 2.45%

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Risk and Portfolio Theory

Risk Averse Investors: Require a higher average return to take on a higher risk. Portfolio theory assumptions:
Investors prefer the portfolio with the highest expected return for a given variance or the lowest variance for a given expected return.

Expected returns and variances of portfolios derived from historical returns, variances, and co-variances of individual assets in portfolio.

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Covariance and Correlation Coefficient

Covariance is an absolute measure of the degree to which two variables move together over time relative to their individual mean (average).
Cov 1 ,2 (R
1

R 1 )(R 2 R 2) T

Cov 1 ,1

(R

R 1 )(R 1 R 1 ) T

Var

Correlation Coefficient, , is a standardised measure of the relationship between the two variables, ranging between -1.00 to +1.00
Correlation Coefficient 1 ,2 1,2 Cov 1 ,2 1 ,2 1 2
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Cov 1 ,2 1 2

Portfolio VAR & SD for a 2-Asset Portfolio

2 2 2 2 VAR 2 w w p 1 1 2 2 2w 1 w 2Cov 1 ,2 (Co var iance) 2 2 2 2 VAR 2 w w p 1 1 2 2 2w 1 w 2 1 2 1 ,2 (Correlation )

SD P 2 P

In order to reduce the overall risk, it is best to have assets with low positive or negative correlation (covariance).
The smaller is the covariance between the assets, the smaller will be the portfolios variance.

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Example: Risk of 2-Asset Portfolio

Consider these two assets that have equal weights of 0.50 in the portfolio, and with the following returns and standard deviation:
E(R1) = 30% and 1 = 0.20 E(R2) = 15% and 2 = 0.12 Correlation Coefficient = 0.10
2 2 2 2 2 w w p 1 1 2 2 2w 1 w 2 1 21 ,2

p2 = (0.5)2(0.2)2 + (0.5)2(0.12)2 + 2(0.5)(0.5)(0.2)(0.12)(0.1)

= 0.01 + 0.0036 + 0.0012 = 0.0148

P 0.0148 0.1216 = 12.16% (lower risk for 22.5% portfolio return)
0.50.3 + 0.50.15 = 0.225 or 22.5%
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Diversification
The Principle of Diversification: states that spreading an investment across many types of assets will eliminate some but not all of the risk. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. Size of risk reduction depends on co-variances between assets in the portfolio. However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion.
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Two Types of Risk

Systematic or Non-Diversifiable Risk:
That portion of an assets risk attributed to the market factors that affect all firms and cannot be eliminated through the process of diversification.

Unsystematic or Diversifiable Risk:

That portion of an assets risk which is firm specific and can be eliminated through the process of diversification.

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Total Risk
Total risk = Systematic risk + Unsystematic risk The standard deviation of returns is a measure of total risk. For well-diversified portfolios, unsystematic risk is very small. Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.

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Systematic Risk Principle

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.

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Measuring Systematic Risk =

We use the beta coefficient to measure systematic risk. Beta measures the responsiveness of a security to movements in the market. Cov A,m Market beta m = 1 A 2 m Therefore if:
A= 1, the asset has the same systematic risk as the overall market. A < 1 implies the asset has less systematic risk than the overall market. A > 1 implies the asset has more systematic risk than the overall market.
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Capital Asset Pricing Model (CAPM)

The capital asset pricing model defines the relationship between risk and return. 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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CAPM
E(RA) = Rf + A[E(RM) Rf] Where:
E(RA) = expected return on asset A Rf = risk free rate A = beta of asset A E(RM) = expected return on the market

Note: E(RM) Rf = Market Risk Premium

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Example CAPM
If the beta for IBM is 1.15, the risk-free rate is 5%, and the expected return on market is 12%, what is the required rate of return for IBM? Applying the CAPM:
E(R IBM ) R f IBM[E(R M ) R f ] 0.05 1.15[0.12 0.05] 0.05 1.15[0.07] 0.05 0.0805 0.1305 or 13.05%
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Example CAPM
Consider the betas for each of the assets given earlier. If the risk-free rate is 2.13% and the market risk premium is 8.6%, what is the expected return for each? E(RA) = Rf + A[E(RM) Rf]
Security Beta Expected Return

CBA WOW

2.685 0.195

TLS BHP

2.161 2.434

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Security Market Line (SML)

The security market line (SML) is the graphical representation of CAPM. Shows the relationship between systematic risk and expected return.
Positive slope. The higher the risk, the higher the return.

According to the CAPM, all stocks must lie on the SML, otherwise they would be under or over-priced.

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Security Market Line (SML)

Asset expected return = E(ri)

SML
E(RA)
E(RB) E(RM) Market

A undervalued

= E(RM) RF

B overvalued

RF

M = 1.0

Asset beta = i

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Reward-to-Risk Ratio
SML slope = Reward-to-Risk Ratio of the Market = Market Risk Premium
E(R A ) R f E(R B ) R f E(R M R f ) E(R M R f ) A B M

In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-torisk ratio for the market. If not, assets are undervalued or overvalued.

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Reward-to-Risk Ratio: Example

If RM = 12%, Rf = 6%
Slope E(R M R f ) E(R M R f ) M

(12% 6%) Slope 6% 1 If Asset A has E(RA) = 15%, A = 1.3, and Asset B has E(RB) = 10%, B = 0.8 then: E(R A ) R f 15% 6% 6.9% A 1.3

E(R B ) R f 10% 6% 5% B 0.8 Asset B offers insufficient reward for its level of risk, so B is relatively overvalued compared to A, or A is relatively undervalued.
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CAPM and Beta of Portfolio

If w1, w2, , wn are the proportions of the portfolio invested in n assets 1, 2, , n, the beta of a portfolio (P) can be written:
P w 11 w 2 2 ... w n n w j j
j1 j n

Example: If 30% of a portfolio is invested in asset 1 and the balance in asset 2, and asset 1s beta = 1.7 while asset 2s beta = 1.2, what is the beta of the portfolio (P).
P w 11 w 2 2 0.3(1.7) 0.7(1.2) 1.35
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Example: Portfolio Beta

Consider our previous four securities and their betas:
Security Weight Beta

CBA WOW

0.133 0.200

2.685 0.195

TLS BHP

0.167 0.400

2.161 2.434

What is the portfolio beta?

= 0.133(2.685) + 0.2(0.195) + 0.167(2.161) + 0.4(2.434) = 1.731

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Factors Affecting E(R)

E(RA) = Rf + A[E(RM) Rf] Pure time value of money
measured by the risk-free rate, Rf

Reward for bearing systematic risk

measured by the market risk premium, E(RM) Rf

Amount of systematic risk

measured by beta,

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Quick Quiz
What is the difference between systematic and unsystematic risk? What type of risk is relevant for determining the expected return?

Consider an asset with a beta of 1.2, a risk-free rate of 5% and a market return of 13%.
What is the reward-to-risk ratio in equilibrium? What is the expected return on the asset?

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Real World Application Estimating Microsofts Beta

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Estimating Microsofts Beta

To calculate the parameters for an asset, say a share in Microsoft, we perform a regression of the returns on Microsoft with the returns on the market. Historical data for Microsoft and the Market index (S&P 500) are collected and a time series of both returns are calculated. An OLS regression is then performed. The regression provides values for the parameters and a plot of the observations may be made.
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Example: Microsoft vs S&P500

Monthly Returns: Microsoft and S&P 500 (n = 60)

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Microsoft Return

30 20 10 0 -20 -15 -10 -5 -10 0 -20 S&P 500 Return

Coefficients 2.14 1.30 Standard error 1.21 0.27 t-statistics 1.77 4.76

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Adjusted R2 = 0.27 n = 60
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Next Week
We move to calculating a firms cost of capital, termed the weighted average cost of capital (WACC).

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