Return and risk, CAPM and the Cost of Capital (Chapter 10-12) Flashcards
Chapter 10
Individual securities
Individual securities in investment analysis refer to specific financial assets (stocks, bonds) that investors can buy or sell in the financial markets.
Characteristics of intrest:
* Expected Return
* Variance and Standard Deviation
* Covariance and Correlation (to another security or index)
The return and risk of portfolios
With estimates for expected return and standard deviations we can estimate future returns on individual assets. Correlation and covariance lets us also calculate the future returns for a mixture of assets or a portfolio.
Note that the standard deviation is considerably smaller for our portfolio than for any of the two individual assets. This is due to the extremely negative correlation which provides us with a close to perfect hedge.
The efficient set
The efficient set, or efficient frontier, is a graphical representation of a set of possible portfolios that:
* Minimize risk at specific return levels; and,
* Maximize returns at specific risk levels.
Various correlations:
a) ρ = -1.0, a perfect negative correlation, like the bond/stock-example, provides a perfect diversification and there is one combination that will reduce the risk to 0.
b) ρ = 1.0, a perfect positive correlation, eliminates all diversification advantages.
c) ρ = otherwise will give a curve somewhere in between the two extremes, providing opportunities to diversify, but not perfectly as some risk is still remaining.
The efficient set for many securities:
* Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.
* As we saw earlier, some portfolios are more desirable than others, providing the same expected return at lower risk.
* The section of the opportunity set above the minimum variance portfolio is the efficient frontier.
Optimal portfolio with risk free assets
With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope just touching the efficient frontier. This line is called the Capital Market Line (CML).
All investors have the same CML, but their investment choice depends on their tolerance towards risk:
* If you are risk averse, you will reduce risk by lending money to the bank at the risk free rate, and choose your portfolio somewhere between rf and M.
* A risk neutral will choose portfolio M.
* A risk lover will increase risk by borrowing money at the risk free rate rf and purchase more of the portfolio M, and thus increase expected return but also risk along CML.
Announcements, Surprises and Expected vs. Unexpected returns
Announcement = Expected part + Surprise
It is the surprise component that affects a stock’s price and, therefore, its return. This is very obvious when we watch how stock prices move when an unexpected announcement is
made or earnings are different than anticipated.
Total Return = expected return + systematic portion + unsystematic portion
Systematic and unsystematic risk
Systematic risk:
* Risk factors that affect a large number of assets
* Also known as non-diversifiable risk or market risk
* Includes such things as changes in GDP, inflation, interest rates, etc.
Unsystematic risk:
* Risk factors that affect a limited number of assets
* Also known as unique risk and asset-specific risk
* Includes such things as labor strikes, part shortages, etc.
Diversification and Portfolio Risk
Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. However, there is a minimum level of risk that cannot be diversified away, and that is the systematic portion.
Portfolio risk and number of stocks:
In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.
Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk:
* The risk that can be eliminated by combining assets into a portfolio. Often considered the same as unsystematic, unique, or asset-specific risk
* If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away.
Non-diversifiable risk; Systematic Risk; Market Risk
Capital asset pricing model (CAPM)
CAPM tells us the relationship between the risk of one single asset compared to the risk in the market portfolio. E.g. is asset A more or less risky than the market portfolio? And how will asset A affect the return and risk of my portfolio by combining it with the market portfolio?
The Beta:
* The beta measures an asset’s sensitivity to market fluctuation.
* A low (high) beta indicates low (high) risk.
* An asset with a beta = 2, will have twice as much risk compared to the market portfolio. If the market rises by 1%, the asset will rise by 2%. If the market falls by 2%, the asset will fall by 4%.
* An asset with a beta = 0.5, will have half as much risk compared to the market portfolio.
WACC
The Weighted Average Cost of Capital (WACC) provides us with an estimate of the return required to meet demands from both debtholders and stockholders.
