Corporate Finance

2013/9/29

Zan Yang
zanyang@tsinghua.edu.cn 08 - 62794059

Department of Construction Management

Todays contents

Investment in Portfolio Theory of Capital Asset Market Theory of Asset Pricing Capital Asset Price Model (CAPM)

Rosss Book Chapter 9 and 10

Return and Risk - Characteristics of securities Expected Return: the return that an individual expect a security to earn over the next period. It is only an expectation, the actual return may be either higher or lower Variance (Standard Deviation): the most common measure of risk. It is a measure of the squared deviations of a securitys return from its expected return. Standard deviation is the square root of the variance Covariance and Correlation: a measure of the interrelationship between two securities

Return and Risk - Characteristics of individual securities

Example: Suppose financial analysts believe that there are four equally like states of the economy: depression, recession, normal and boom times. The returns on the Supertech Company are expected to follow the economy closely, while the return on the Slowpoke Company are not. The return predictions are as follows:
Supertech Returns Depression Recession -20% 10% Slowpoke Returns 5% 20%

Normal
Boom

30%
50%

-12%
9%

Return and Risk - Characteristics of individual securities

Expected Return: probability weighted average of its return in all scenarios. Pr(s) the probability of scenario S, r(s) the return in scenario SE(r) expected return is

E (r ) Pr(s)r ( s)
s

For Supertech Company,

= 0.25 20% + 0.25 10% + 0.25 30% + 0.25 50% = 0.175

Return and Risk - Characteristics of individual securities

variance: expected rare of the squared deviations from the expected return.
= = ( ) =

( )

= 0.25 (0.2 0.175)2 +0.25 (0.1 0.175)2 +0.25 (0.3 0.175)2 +0.25 (0.5 0.175)2 = 0.066875

Standard deviation:

= =
( ) = = 0.066875 = 0.2586

Return and Risk - Characteristics of individual securities

The same method for evaluating Slowpoke Company.

Expected Return: Variance:

= 0.25 5% + 0.25 20% + 0.25 (12%) + 0.25 9% = 0.055

2 = = 0.25 (0.05 0.055)2 +0.25 (0.2 0.055)2 +0.25 (0.12 0.055)2 +0.25 (0.09 0.055)2 = 0.013225

Standard deviation:
( ) = = 0.013225 = 0.1150

Return and Risk - return and risk for portfolio

Portfolio: combination of securities

= 2 2 + 2 + 2 2

= + = ( ) ( ) + ( ) = ( ) =0.25(-0.2*0.05+0.1*0.2-0.3*0.12+0.5*0.09)-0.175*0.055 =-0.004875

Return and Risk - return and risk for portfolio

Theory of Asset Pricing Diversification and the measurement of risk

Expected return / Standard deviation Slowpoke: 5.5/11.50=0.478 Supertech: 17.5/25.86=0.677 = 12.7/15.44=0.823

By taking we can be better off than by taking A or B alone because the movements in the stocks tend to offset each other

Theory of Asset Pricing Diversification and the measurement of risk II

This principle is known as diversification

The example is special because it allows all risk to be

eliminated--the variables always move in exactly opposite directions, they are perfectly negatively correlated, i.e. AB = -1

Return and Risk - correlation

Game - What a kind of investor you are?

1. After 60 days of your investment, the price decrease by 20% Keep everything unchanged, what would you like to do?
a. Sale it and try another investment to avoid further loss b. Do nothing and just wait c. A good opportunity for investing more

2. After 30 days of your investment in fund, the price increased by 25%. Keep everything unchanged, what you would like to do? a. Sale it and save it b. Keep it c. buy more

Game - What a kind of investor you are?

3. You have a 15years long tem investment for your pension. What would you like to do? a. Invest in less risky funds to keep the principle b. Invest in both bond and stock for the security and growth c. Invest in high risky capital asset for it potential benefits in 5 10 years 4. You win a lottery. You have to decide in which way you want money a. 20000RMB b. 50% opportunity of 50000RMB c. 20% opportunity of 15000RMB

Game - What a kind of investor you are?

5. You have a good investment opportunity, but you have to borrow money, will you do that? a. never b. Perhaps c. Definitely
6. You have an opportunity to buy primary share from your company. Before it is listed in the stock market in 3 years, you are not allowed to sale the share and you will not get any dividend . But you may get 10 times earning after the stock is listed, how much will you buy the share? a. zero c. four months salary b. two months salary

Theory of Asset Pricing - Risk Behavior of Investor ( holding expected income the same) Risk averse: if an increase in the standard deviation of their income makes them worse off

Risk neutral: if an increase in the standard deviation of their income does not make them worse or better off
Risk loving: if an increase in the standard deviation of their income makes them better off

Risk Averse

Risk Lover

Theory of Asset Pricing Diversification and the measurement of risk I

Theory of Asset Pricing -The Efficient Frontier I

Theory of Asset Pricing -The Efficient Frontier II

The variance of the return on a portfolio with many securities is more dependent on the co-variances between the individual securities than on the variances of the individual securities.

efficient set

represents the opportunity set or feasible set when many securities are considered

Theory of Asset Pricing -Covariances of stocks

The riskiness of stocks due to business cycle is known as market risk or systematic risk, and it cannot be diversified away.
Changes in factors affecting a single firm are called unique or unsystematic risk.

Theory of Asset Pricing -Market and Unique Risk Hence it is market or systematic risk which is important for portfolio risk Even though a stock may have high variance, it may be much more desirable than a security with lower variance and the same expected return because it has lower market risk In order to get rid of unique risk we need to hold stocks in portfolios. If we are holding stocks in portfolios we know that the standard deviation of a stock is no longer the appropriate measure of risk

Theory of Asset Pricing -Covariances of stocks

Relationship between Expected Return and Risk for a Portfolio of One Risky Asset and One Riskless Asset

Theory of Asset Pricing -Covariances of stocks

In a world with homogeneous expectations, all investors would hold the portfolio of risky assets represented by point A.

Theory of Asset Pricing -The Market Risk of a Security: Beta ()

Theory of Asset Pricing -The Market Risk of a Security: Beta () Why is beta defined relative to the market portfolio ?
The reason this is a useful benchmark is because it is the portfolio where the amount of unique risk that is diversified away is maximized

Portfolios that have a very small amount of unique risk are called well-diversified portfolios

Theory of Asset Pricing - CAPM

Expected Return of Security

Example
The stock of Aardvark Enterprises has a beta of 1.5 and that of Zebra Enterprises has a beta of 0.7. The risk-free rate is 7 present, and the difference between the expected return on the market and the risk-free rate is 9.5 percent. The expected returns on the two securities are:
Expected Return for Aardvark: 21.25% = 7% + 1.5 9.5% Expected Return for Zebra: 13.65% = 7% + 0.7 9.5%

Capital Asset Price Model -Derivation of the CAPM

Major Assumption:

Everybody has the same beliefs about the means and standard deviations of all stocks

Everybody's perception of the efficiency locus of all stocks in the market is therefore the same

Capital Asset Price Model - CAPM Intuition

CAPM provides us with a way of pricing risky securities It also provides us with a way of arriving at an opportunity cost of capital for an asset which we can use to calculate NPV

Capital Asset Price Model - CAPM Intuition II

Quiz?
Which is more risky, investing in gold prospecting or electric utilities? Answer: Electric utilities Would you ever invest in a security whose average return is larger than that on T-bills? Answer: Yes