Module 7 - Risk in Company Investment Decisions

Question 1

Define SML

Answer 1

The security market line or SML describes the relationship between risk and return as being positive; the higher the risk, the higher the required return.

Question 2

Steps to Calculate standard deviation of portfolio

Answer 2

• To an individual capital supplier, risk is best measured by the standard deviation of rates on return on the entire portfolio of assets
• This is a measure of the extent to which the portfolio’s possible outcomes are likely to be different from its mean or expected average outcome.
• In order to figure out the riskiness of a set of securities one must quote the probabilities of various rates of return or the probability distributions of returns
• The next step is to calculate the mean of these probabilities.
• The result is a reflection of the risk inherent in a portfolio.
• Unfortunately, studies to date show that the empirical relationship between risk (measured as standard deviation of return) and the actual level of return earned is not good.

Question 3

Give Summary: Rish, Return and Diversification

Answer 3

• When individual assets are held in a portfolio, the risk associated with the portfolio is not likely to be simply the average risk of the assets of the portfolio.
• The detailed interactions of individual asset returns, their return distributions, and the return distributions of a portfolio formed from them can be seen by developing the joint probability distribution of the assets in question.
• The risk of individual assets, depending upon how their returns are related, will to some extent cancel each other out when a portfolio of these assets is formed.
• The extent to which that risk will cancel depends upon how positively the returns of the constituent individual assets are related. One way to measure that relatedness is by the correlation coefficient of paired returns of the assets or securities within the portfolio.

Question 4

Explain: Market Model and Individual Asset Risk

Answer 4

• The reduction of risk due to diversification seems to have a limit. Diversification definitely reduces risk, but there is evidently a level of risk (indicated as RiskM) below which portfolios do not go, regardless of how well diversified
• The reason for a minimum level of risk even in a well-diversified portfolio is that there is a common correlation present in all securities, and this limits the amount of diversification possible. This common factor is called the market factor or simply the market (Risk_m).
• The risk that cannot be diversified away is the total risk of the security as if it were held alone (standard deviation of return) multiplied by the extent to which its returns are correlated with the `market´, the common factor.
• Thus a security closely related to the market will have a correlation with the market close to +1 will have a systematic risk close to its standard deviation – not much of its risk will be diversifiable.
• A security with low correlation to the market will have much of its risk diversified away when held in a portfolio with other securities, and thus has a low systematic risk.
• This expression for a beta´ coefficient is also known as a regression´ coefficient. It provides the same information as the previous systematic risk measure, but scaled to the risk of the market as a whole.

Question 5

Explain Beta Coefficient:

Answer 5

• Thus a coefficient expresses the relationship between the return expected from holding a security and that expected from the market as a whole.
• The steeper the slope (the higher the Beta coefficient), the greater will the returns on the security amplify or gear upward (or downward) the returns on the market portfolio.
• The Beta coefficient does not express a perfect relationship between the returns of an individual security and the market as a whole

Question 6

Explain SML in the Market Model:

Answer 6

The market sets required returns (and therefore securities’ prices) as if securities are held in well diversified portfolios, and thus the correct measure of risk is that risk still existing after such diversification. The coefficient is an appropriate measure of this undiversifiable or systematic risk.

The SLM relates the amount of systematic risk inherent in the returns of a security (its β coefficient) to the return required on that security by the market. The relationship is positive in that the higher the systematic risk of the security, the higher its required return.

The SML is located with respect to two important points, the risk-free rate (rf) and the market portfolios risk-return location (m). m has a return of E(r_m) and (by definition) a β coefficient of 1.0

Question 7

SML Summary

Answer 7

1. The total risk of an individual asset or security can be separated into two types of risk, that which can be diversified away, and that which cannot.
2. The risk that cannot be diversified away is related to an underlying `market factor´ that is common to all assets and securities, and is thus a common correlation limiting the amount of risk reduction through diversification that is possible by including a security in a portfolio.
3. This undiversifiable or systematic risk can be measured by the coefficient (standard deviation times correlation with the market) of the security in question.
4. If the financial market sets securities’ returns based upon their risks when held in well diversified portfolios, systematic risk will be the appropriate measure of risk for individual assets and securities, and the SML and Equation 7.1 will dictate the set of risk-adjusted returns available in the market.

• The SML based returns are the opportunity costs of capital suppliers of companies, and thus can form the basis for evaluating company investments.
• These investments must over returns in excess of the capital suppliers opportunity costs in order to be acceptable.

Question 8

Explain WACC and SML

Answer 8

• The WACC of any company is an average of the risk-adjusted rates of return of the company’s various endeavours, including its asset types and associated future cash-flow expectations.
• In order to be correctly acceptable, an investment must offer an expected return in excess of the return depicted on the SML for the investment’s systematic risk level. This means that `good´ investments’ expected returns would plot above the SML, perpendicularly above their systematic risks.

Question 9

Explain Estiate Systematic Risk:

Answer 9

• To use the SML for estimating required returns the amount of systematic risk (size of the coefficient) of a project must be specified. There are many ways to do this:

1. If project is of the same risk as the existing company, and its shares are traded on the stock market, one can merely look up the β coefficient of the company’s shares in one of the financial reporting services that supply such data.
2. If risk differs (+ or -) from the company average, the investment may be similar to another company’s. In such situations, the β coefficient of the other company, with the same systematic risk as the project, can be used. This is also valuable when the shares of the investing company are not traded, but those of a similar company are, and the investment is simply a scale change.

• When market generated β coefficients are unavailable, the systematic risk measure must be constructed artificially. The best approaches to such estimates begin with a β coefficient for the company or division thinking of undertaking the project, and adjusting that coefficient for the differences between the project and the company or division.
• In constructing β coefficients from the characteristics of the investment itself, it is necessary to concentrate upon the underlying factors affecting the returns on the project.
• If the projects revenues are expected to be quite volatile in reaction to overall market activity, relative to the divisional or company average, an adjustment to the β coefficient must be made.
• Similarly, on the cost side, if the fixed costs of a project comprise a relatively high proportion of its cost, the β coefficient of the project must be adjusted upwards, because net results will be more variable wibth high fixed costs – this is described as operational gearing.
• One preliminary adjustment that must be performed when constructing β. If the beginning value (the `benchmark´ coefficient) is from a company that has borrowed money, the systematic risk of that company’s shares is higher than it would be if the company were financed solely with equity capital, and the value must thus be purified of this effect before the other adjustments are made. This is an adjustment for financial gearing and is done by:

Where β_e and β_d are observed equity and debt β coefficients, E and D are their observed market values, and V is the sum of E and D.

• Once β_v is solved it must be adjusted for revenue and operational gearing differences. To adjust for revenue risk differential, β_v is multiplied by the ratio of the investments revenue volatility to that of the company:
• Next β is adjusted for operational gearing
• The final step that remains is to re-adjust the reconstructed and ungeared β coefficient for any financial gearing planned for the project. In order to do so, we must know the β coefficient for the debt that will be issued for the project as well as the gearing ratio. With these two items as well as the ungeared β coefficient of the project, the equity coefficient can be calculated.