Slide strategic financial management l04

STRATEGIC FINANCIAL MANAGEMENT
Hurdle Rate: The Basics of Risk II
KHURAM RAZA


First Principle and Big Picture


The Basics of Risk
Defining the Risk
Equity Risk and Expected Returns
Measuring Risk
Rewarded and Unrewarded Risk
 The Components of Risk
 Why Diversification Reduces the Risk

Measuring Market Risk
The Capital Asset Pricing Model
The Arbitrage Pricing Model
Multi-factor Models for risk and return
Proxy Models

The Risk in Borrowing



The Determinants of Default Risk
Default Risk and Interest rates


The Basics of Risk

Defining the Risk
Equity Risk and Expected Returns
Measuring Risk
Rewarded and Unrewarded Risk
 The Components of Risk
 Why Diversification Reduces the Risk

Measuring Market Risk
The Capital Asset Pricing Model
The Arbitrage Pricing Model
Multi-factor Models for risk and return
Proxy Models

The Risk in Borrowing



The Determinants of Default Risk
Default Risk and Interest rates


Measuring Market Risk


Measuring Market Risk


Mean - Variance Optimization
2
2

2
2
Return


w


w
2 wA wtoB 
p
A
A
B
B  According
A, B A B
Markowitz’s

%

10%

A

B

approach, investors should
A
evaluate portfolios
based on

ρa,b
ρ
their return anda,c risk as
measured
by the Cstandard
B
ρb,c
deviation

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A, B A B  2wB wC  B ,C B C  2wA wC  A,C A C
5%

C

A

To analyze 50 stocks, the input list includes:
n = 50 estimates of expected returns
B
n = 50 estimates of variances
(n2 - n)/2 = 1,225 estimates
5% of covariance's
20%
Risk
1,325 estimates
C
If n = 3,000 (roughly the number of NYSE stocks), we need more
To the risk-averse
wealth
maximizer,

the choices are clear, A dominates B,
than 4.5
million
estimates.
A dominates C.

D


Capital-Asset Pricing Model
Efficient portfolio – a portfolio that has the
smallest portfolio risk for a given level of
expected return or the largest expected return
for a given level of risk
Efficient set (frontier) – Portfolio that offers the
best risk-expected return combinations available
to investors
 Minimum Variance Portfolio
 It represented by the all the
common stocks
 High correlation with all
portfolios excess return over
the risk free rate


CAPM-Assumptions
 Capital Markets are Efficient
 Investor are well informed
 No transaction cost
 No investor is large enough to affect the market price of a stock

 Investors are rational mean-variance optimizers
 Investors are in general agreement
• Performance of individual securities
• Common holding period
 Two types of investment opportunities
 Risky Assets (portfolios of common stocks)
 Risk-free security


CAPM-The Characteristic Line
A line that describes the relationship between an individual security’s returns
and returns on the market portfolio. The slope of this line is beta.


Beta: An Index of Systematic Risk


Over Priced & under priced stocks


The Arbitrage Pricing Model
 Like the capital asset pricing model, the arbitrage pricing
model begins by breaking risk down into two components.
 The first is firm specific and covers information that
affects primarily the firm.
 The second is the market risk that affects all
investment; this would include unanticipated changes in
a number of economic variables, including
 Gross national product,
 Inflation, and

 Interest rates.

ri = ai + bi1F1 + bi2F2 + …+bikFk


Multi-factor Models for risk and return
Multi-factor models generally are not based on
extensive economic rationale but are determined by
the data. Once the number of factors has been
identified in the arbitrage pricing model, the behavior
of the factors over time can be extracted from the data.
These factor time series can then be compared to the
time series of macroeconomic variables to see if any of
the variables are correlated, over time, with the
identified factors.


Multi-factor Models for risk and return
 a study from the 1980s suggested that the following macroeconomic variables
were highly correlated with the factors that come out of factor analysis:
 industrial production,
 changes in the premium paid on corporate bonds over the riskless rate,
 shifts in the term structure,
 unanticipated inflation,
 and changes in the real rate of return.
 These variables can then be correlated with returns to come up with a model
of expected returns, with firm-specific betas calculated relative to each
variable. The equation for expected returns will take the following form:


E(R) = Rf + ß GNP (E(R GNP )-Rf ) + ß i (E(Ri)-Rf) ...+ ßg (E(Rg)-Rf)


Proxy Models
 The Fama-French Three-Factor Model is an advancement
of the Capital Asset Pricing Model (CAPM). Beta is the
brainchild of CAPM, which is designed to determine a
theoretically appropriate required rate of return of any
investment and compare the riskiness of an investment
to the risk of the market.
 Fama and French found that on average, a portfolio’s
beta is the reason for 70% of its actual stock returns.
Unsatisfied, they thought, rightly, that there was an even
better explanation. They discovered that figure jumps to
95% with the combination of beta, size and value.


Proxy Models
They added these two factors to a standard CAPM:

 SMB = “small [market capitalization] minus big”
"Size" This is the return of small stocks minus
that of large stocks. When small stocks do
well relative to large stocks this will be
positive, and when they do worse than
large stocks, this will be negative.
 HML = “high [book/price] minus low”
"Value" This is the return of value stocks
minus growth stocks, which can likewise
be positive or negative.

The Risk in Borrowing
Bounds Ratings

In contrast to the general risk and return models for equity, which evaluate the
effects of market risk on expected returns, models of Borrowing risk measure
the consequences of firm-specific
on promised
returns.
1. risk
Financial
Ratios
 Default Risk
 Return on assets
 Interest Rate Risk
 Debt ratios
 Interest coverage ratio
Interest Rate Risk

Default Risk
2. Contract
termstend to rise in value when
corporates
byrates
a mortgage
Function of firm capacity to Secured
interest
fall, and they fall in value
 Subordinated

when interest
rates rise.
to other
debt Usually, the
generate cash flows from
longerfund
theprovisions
maturity, the greater the
 Sinking
operations and its financial
degree of price
volatility
 Guarantees
by some
other party
 When interest rates rise, new issues
obligations, its depends on
3. Qualitative
Factors
come
market with higher yields
 generate high cash flows Sensitivity oftoearnings
to the
economy
than older securities,
making
those
 more stable the cash flows
 Affected
byones

inflation
older
worth less. Hence, their
 Laborprices
 more liquid a firm’s assets
problems
go down and and vise versa


Potential environmental problems