5.2 Risk and Return Flashcards
Return ON Investment (ROI)
Return - (minus) Amount Invested
Rate of Return
Return on Investment/
Amount Invested
Two Basic Forms of Risk
Systematic Risk (Market Risk): Risk faced by ALL firms. Economy, etc. It is UNDIVERSIFIABLE
Unsystematic Risk (Non-Market or Company (Specific) Risk) : Diversifiable through Portfolio diversification
Other Forms of Risk (not Systematic/Unsystematic)
PIF-C
PIF-L
Credit Risk: Risk ISSUER OF DEBT will default
Foreign Exchange Risk: Risk FX will be affected by Exchange Rates
Interest Rate Risk: Risk Investment will fluctuate in value due to interest rate change
Industry Risk: risk to INDUSTRY. Airlines due to fuel prices.
Political Risk: probability of Risk due to govt action. (Expropriation). Can be reduced by making foreign entity dependent on Domestic corp for Technology, etc.
Financial Risk: Risk based on markets (due to interest maybe)
Purchasing Power Risk: General increase in cost will reduce what can be bought for same dollars
Liquidity Risk: security can’t be sold on short notice for its market value
Risk Averse v Risk Neutral v Risk Seeking
Averse: Disutility of Loss exceeds Utility of Gain
Neutral: Disutility of Loss equals Gain
Seeking: Utility of Gain exceeds Disutility of Loss
List of Financial Instruments by Risk (Low to High)
T12S,
T Bonds First Mortgage Bonds 2nd Mortgage Bonds Subordinated Debentures Income Bonds Preferred Stock Convertible Preferred Stock Common Stock
Indifference Curve
An investor curve that shows investment returns on X axis. Risk on Y axis. Different risk and returns are plotted. ON the same curve it doesn’t matter which is selected. Steeper the Curve, more risk averse.
Maturity Matching
Making sure securities will not have to be sold unexpectedly. Maturity of Funds coincides with the need for the funds.
Uncertain Cash Flows of an Investment=
Cash Flows Certain
Then need to consider Marketability and Market Risk
Certain = Maturity is most important
Hedging
Offsetting Commitments to minimize risk of adverse price movements
Natural Hedge
Buying different investments whose performance cancels each other (Insurance is a natural hedge)
Pair Trading: long and short positions
Sometimes: Stocks and Bonds
Futures Contracts
- to hedge commodities
- agreement to buy/sell commodities at a price in a later month
- Can be bought/sold on margin (risky..leverage)
Expected Rate of Return
Sum of all probabilities by Weight
Standard Deviation (and risk)
The wider the standard deviation (variance) the great the risk
Security Risk (individual) v Portfolio Risk
- Should evaluate Risk based on portfolio not individual stock
- Risk is NOT average of the Standard Deviations of the stocks. because stocks are imperfectly correlated, combining stocks is LESS than the Average of the Standard Deviations.
Correlation Coefficient
Degree to which any TWO variables are correlated 1.0 to - 1.0.
- Perfect negative correlation = perfect hedges of each other (risk ELIMINATED)
Covariance
Covariance of a Two Stock Portfolio =
Correlation Coefficient x Std Deviation1 x Std Deviation2
Risk and Diversification (Diversifiable)
Specific Risk: (Divirsifiable, Unsystematic, Residual, Unique) regarding a company’s operations (new products, patents, competitor activities) can be reduced through DIVERSIFICATION
Diversification works 20-30 stocks and then benefits decline to near zero with 40 Stocks.
Risk and Diversification (Market or Undivirsifiable or Systematic)
Risk of the STOCK MARKET as a whole. Things that affect ALL stocks like the NATIONAL ECONOMY
BETA of an individual Stock
Effect of an individual stock on the VOLATILITY of a portfolio measured by it’s beta. 1.0 = perfectly positively correlated to MARKET portfolio. 20% market change = 20% Stock change. Less than 1.0 moves differently 20% Market and security 10% = .5 Beta
More than 1.0 means more volatile.
Can be calculated by
Variance of Return on Market
Beta of PORTFOLIO
Wtd Average of Betas of INDIVIDUAL SECURITIES
Factors on INDIVIDUAL stock’s Beta
- Debt To Equity (Financial Leverage)
- Operating Leverage (Fixed Costs to Variable Costs)
- Characteristics of the industry it operates
CAPM (Capital Asset Pricing Model)
To measure the risk an individual Security contributes to the risk of Portfolio
Quantifies the Risk of a Security by relating the Risk to Average RETURN on the Market
Beta is applied to the Rm over Rf
Rs = Rf + B (Rm-Rf)
Rf = Time Value
RM - RF is the Market Risk Premium
Problems with CAPM
a. hard to estimate Rf in different Economic Conditions
b. CAPM is single period (don’t use over 1 year)
Value at Risk (VaR)
Technique to determine Max Gain or Loss using a bell curve. Within a certain period, at a given level of confidence.
Highest point = most probable event
- 96 standard deviation = 95%
- 57 = 99%
Cash Flow At Risk and Earnings at Risk use the same principal
Basis Points
300 Basis Points = 3%
Spontaneous Financing
- Trade Credit
- Accrued Expenses (Wages paid after employees Work)
Annualized Cost of not taking a Discount
Discount % x Days in Year
————— ——————
1- Disc % total pmt period - Discount Period
Term Loans and Lines of Credit
most used after spontaneous
- increased risk of insolvency
- risk that short term debt might not be renewed
- contractual restriction such as Compensating Balance
Effective Interest Rate
Usable Funds
or without dollar amounts
Interest Rate
- 0 - Stated Rate
Prime Rate
Rate for best customers
Simple Interest Loan
Interest paid at the end of the loan
Loan Amt x Stated Rate = Interest Expense
Effective Rate and Nominal Rate are the same
Interest Expense
____________
Usable Funds = effective AND nominal
Discounted Loan
Interest is paid AT THE BEGINNING of the loan.
The USABLE FUNDS are Loan Amt - Interest (paid at beginning of loan)
Usable Funds
- 0- Int Rate ==== Loan Amt
1 -.08 = 97,286
EFFECTIVE RATE =
Net Interest Expense 7286
—————————— ————–
Usable Funds 90,000 = 8.696%
Compensating Balance
Forced to keep a balance at bank
1 - Comp Balance % ……….Loan Amount =
Stated Rate
——————–
1 - Compensating Balance %»_space;>Effective Rate
Discounted Loan with Compensating Balance
Effective Rate =
Stated Rate --------------------------------------------------------- 1 - Stated Rate - Compensating Balance %
Line of Credit with Commitment Fee
A line of credit, but there is a fee on the unused balance
Annual Cost =
Interest on Average Balance + Commitment Fee on Unused portion
(Avg Bal x Stated Rate) + (Credit Limit -Avg Bal) x committe fee % to get unused
Banker’s Acceptances
short term financing
- A depositor puts money in the bank, bank accepts (guarantees) pmt to the holder of the draft of the face value or holder can sell it at a discount
_ Difference between face and proceeds received is interest expense
Commercial Paper
- short term unsecured Notes Payable in denominations of 100K
- issued by large corps, pensions, banks
- usually below Prime
Pros: Broad Distribution, Large amount of funds,
Avoids costly financing arranagements
Cons: Impersonal market, Limited by the excess liquidity of corporation
ANNUALIZED RATE =
Net proceeds x Number of Terms per yr
Secured Financing
- Pledging Receivables (eg)
- Bank will lend on a percent of receivables
Trust Receipt: Inventory is collateral (Held in Trust by the bank) paid with proceeds of sale to the lender.
Chattel Mortgage: secured by Personal Property. (Equipment or Livestock)
Floating Lien: Also secured by inventory (the composition changes since it is not a specific item)
Maturity Matching
Equalized the Asset acquired with the Debt used to finance
Long Term Financing (Leases)
Leases; Right to Use for a stated period of time (for long lived assets without tying up large amts of capital
since it has interest expense, after tax cash outflows
Net Advantage to Leasing:
PV of Debt Financing v PV of Leasing
Convertible Securities (why is it cheaper)
Cheaper than straight Common so cheaper cost of capital due to it’s enticement
Warrants (Stock Purchase)
Used to Lower the cost of debt
- the right to by shares at a specified price
Retained Earnings
- Lowest cost of capital since no issuance costs
- The cumulative Accrual Income - Dividends
