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    Week 9 - Decc01

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    This document summarizes key concepts from Chapters 5-7 about risk and return in capital markets. It discusses the historical performance and risk levels of different asset classes like stocks, bonds and treasury bills. It also explains how diversification can reduce risk for investors and the difference between specific risk that affects individual assets versus market risk that cannot be diversified away. Finally, it covers methods for measuring portfolio risk like variance and standard deviation.

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    Week 9 - Decc01

    Uploaded by

    ccapgomes
    13 views4 pages
    This document summarizes key concepts from Chapters 5-7 about risk and return in capital markets. It discusses the historical performance and risk levels of different asset classes like stocks, bonds and treasury bills. It also explains how diversification can reduce risk for investors and the difference between specific risk that affects individual assets versus market risk that cannot be diversified away. Finally, it covers methods for measuring portfolio risk like variance and standard deviation.

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    Week 9 - decc01

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    This document summarizes key concepts from Chapters 5-7 about risk and return in capital markets. It discusses the historical performance and risk levels of different asset classes like stocks, bonds and treasury bills. It also explains how diversification can reduce risk for investors and the difference between specific risk that affects individual assets versus market risk that cannot be diversified away. Finally, it covers methods for measuring portfolio risk like variance and standard deviation.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    13 views4 pages

    Week 9 - Decc01

    Uploaded by

    ccapgomes
    This document summarizes key concepts from Chapters 5-7 about risk and return in capital markets. It discusses the historical performance and risk levels of different asset classes like stocks, bonds and treasury bills. It also explains how diversification can reduce risk for investors and the difference between specific risk that affects individual assets versus market risk that cannot be diversified away. Finally, it covers methods for measuring portfolio risk like variance and standard deviation.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 4

    Chapter 5 + 6

    Corporate Finance
    Chapter 7: Introduction to Risk and Return

    Capital Market History

    Historical Performance of 3 portfolios of US securities

    US treasury bills US government bonds US common stocks


    - No risk of default
    - Stable prices because of - Long-term maturity - Depends on all the ups and downs
    short maturity - Price fluctuates as of the issuing companies
    - Some uncertainty about interest rates vary - Biggest risk and return
    inflation
    The higher the risk of the investment, the bigger the return.

    We need to look back over a long period of time like this to measure average rates of return, because
    the annual rates of return for common stocks fluctuate so much that averages over short periods are
    meaningless.

    → The only way to gain insights from historical rates of return is to look at very long periods.

    Arithmetic Averages

    If the cost of capital is estimated from historical returns or risk premiums, we should
    use arithmetic averages, and not compound annual rates of return.

    ∑𝑃𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑟'𝑠
    𝑟 (1 𝑦𝑒𝑎𝑟) = 𝑁º 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑟'𝑠

    ∑𝑃𝑟𝑜𝑏. 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑜𝑟 𝑒𝑎𝑐ℎ 𝑦𝑒𝑎𝑟


    𝑟 (> 𝑦𝑒𝑎𝑟𝑠) = 𝑁º 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

    Expected rate of return

    Carolina Gomes → decc01


    Chapter 5 + 6

    We cannot assume that the expected rate of return will be like the same and use
    averages calculated in the past, because they’re not likely to stay stable overtime.

    𝑟𝑚 = 𝑟𝑓 + 𝑛𝑜𝑟𝑚𝑎𝑙 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

    rm: expected rate of return on the market portfolio.


    rf: sum of the risk-free interest rate (interest rate of treasury bills)

    We assume that the normal risk premium is stable, and that it can be measured by past
    averages, but it’s hard to estimate it exactly and to make sure that the investors are
    demanding the same rate of return today.

    Reasons why the risk premium may be overstating investors’ demand today:

    If there has been a downward shift in the return that investors have required, then past
    returns will provide an overestimate of the risk premium.

    1. Historical risk premium reflects past political and economic risks that are way
    more stable and less likely to happen today. This means that investors today don’t
    expect such a high rate of return because their profit is way more secured.

    2. A rise in stock prices can come from a fall in the risk premium, and if we use this
    price rise in ours measures of past returns, we may be:
    - Overestimating the return that investors required in the past
    - Failing to recognize that the return investors require in the future is lower
    than in the past

    3. Today is easier to diversify investments in different financial markets and


    countries. Because the risk is lower, the expected rate of return is probably lower
    than in the past.

    Dividend Yields and the Risk Premium

    If stock prices are expected to keep pace with the growth in dividends, then the
    expected market return is equal to the dividend yield plus the expected dividend growth:
    𝐷𝐼𝑉1
    𝑟= 𝑃0
    + 𝑔

    Should investors adjust cost of capital to reflect the fluctuations in dividend yields?

    Yield changes are due to:


    > Optimism or pessimism of the investors about g (future growth in dividends)
    > r (required return) was unusually high or low.

    Carolina Gomes → decc01


    Chapter 5 + 6

    This means that very little of the variation is related to the subsequent g, which means
    that the level of yield tell us about the return that investors require.

    → A reduction in the dividend yield means a reduction in the risk premium that investors
    expect over the following years

    So, when yields are relatively low, companies may be justified in shaving their estimate
    of required returns over the next year or so, although when estimating the discount rate
    for longer-term investment the year-to-year fluctuations in the dividend yield can be
    ignored.

    Measuring Portfolio Risk

    To know how to estimate discount rates for assets that don’t fit simple cases (safe and
    average-risk projects) we need to know:

    – How to measure risk


    – The relationship between risks borne and risk premiums demand

    Variance and Standard Deviation:


    Variance Standard Deviation
    The variance of the market return is the expected The standard deviation is the square root of the
    squared deviation from the expected return. variance
    2 ~ ~ 2
    ~ 2 ~
    σ (𝑟𝑚) = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 (𝑟𝑚 − 𝑟𝑚) σ(𝑟𝑚) = σ (𝑟𝑚)
    ~
    𝑟𝑚: actual return
    𝑟𝑚: expected return

    Variance and standard deviation are used to summarize the spread of possible
    outcomes of the risk of an asset, so they’re natural indexes of risk.

    Measuring Variability:
    It’s possible to compare past variability with present, since it’s reasonable to assume
    that portfolios with histories of high variability also have the least predictable future
    performance.

    → Treasury bills have the least variable security, common stocks are the most variable,
    and government bonds hold the middle ground.

    Also, the market variability depends on each country economic and political
    environmental and the period of time of the security:

    – In tranquil years, the standard deviation stays low


    – Market turbulence over shorter daily, weekly, or monthly periods can be very high,
    depending on the time of the year

    Carolina Gomes → decc01


    Chapter 5 + 6

    How Diversification Reduces Risk

    For the most part, individual stocks are more variable than the market indexes. So, why
    doesn’t the variability of the market portfolio reflect the average variability of its
    components? Because diversification reduces variability, even when it’s done in a low
    amount.

    Diversification: act of spreading investment through different opportunities. It works


    because prices of different stocks do not move exactly together: they’re less than
    perfectly correlated.

    > If two invested stocks move in the opposite direction, the risk of one is
    compensated by the profitability of the other, reducing standard deviation.
    The risk that can be eliminated by diversification is called specific risk: it comes from
    the fact that many of the perils that surround an individual company are peculiar to that
    company and perhaps its immediate environment and competitors.

    But there’s also risk that can’t be avoided or diversified, which is the market risk: it
    comes from the fact that there are economywide perils that threaten all businesses.

    Therefore stocks have a tendency to move together and investors are always exposed to
    market uncertainties, no matter how many stocks they hold.

    Specific risk Market risk


    • World economic cycles
    • Company’s risk
    • World crisis
    • Sector’s risk
    • Large-scale pandemic and natural
    • Country’s risk
    catastrophes
    For a reasonably well-diversified portfolio, only market risk matters. Therefore, the predominant source
    of uncertainty for a diversified investor is the market risk.

    Carolina Gomes → decc01

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