Transcript Chapter 10

Estimating Risk and Return
Chapter 10
Fin 325, Section 04 - Spring 2010
Washington State University
1
Introduction
 Financial managers and investors make
investment decisions based on their
expectations about future risk and return
 In chapter 9, we characterized risk and
return in historical terms
 Expected return is a forward-looking
return calculation
2
Expected Returns
 Economists predict future economic conditions
based on probabilities
 E.g. 70 percent chance of a good economy and 30
percent chance of a recession
 A stock analyst predicts the return on a particular
company’s stock in the event of a good or bad
economy
 The expected return combines the possible
returns with the probability that the returns will
occur
Expected return = (p1 x Return1) + (p2 x
Return2) + … + (ps x Returns)
3
 Example:
State of
economy
Probability of Stock return
state
in given state
p x Return
Recession
20%
-15%
-3.0
Normal
50%
9%
4.5
Boom
30%
16%
4.8
Expected Return
6.3%
4
 We can also use a distribution of returns to
characterize risk
 Example:
State of
economy
p
R
E(R)
R-E(R)
(R-E(R))2
p x (R-E(R))2
Recession
20% -15%
6.3%
-21.3%
0.045369
0.009074
Normal
50%
9%
6.3%
2.7%
0.000729
0.000365
Boom
30%
16%
6.3%
9.7%
0.009409
0.002823
Variance
0.012261
Std Dev
11.07%
5
Risk Premium
 Treasury bill offers a low return with no risk
risk-free rate
 Investors who take on risk expect a higher return
 The risk premium is the reward investors require for
taking risk
 An investor’s required return:
 Required Return = Risk-free Rate + Risk Premium
 The market only rewards the market risk. Firmspecific risk can be diversified away
6
 Table 10.1 illustrates the historic market risk
premium over time
 Return on S&P 500 Index minus the T-bill rate
7
Asset Pricing
 The attempt to specify an equation that relates a
stock’s required return to an appropriate risk
premium is know as asset pricing
 The best known asset pricing model is the Capital
Asset Pricing Model, or CAPM
 Developed in the 1960s by William Sharpe and John
Lintner
 Sharpe won Nobel Prize in Economic Sciences in
1990
8
 The CAPM starts with modern portfolio theory
 Figure 10.1 illustrates the relationship between
expected returns and total risk (measured by
standard deviation)
 When a risk-free asset is introduced in the graph
in panel B, the straight line between the risk-free
asset and the tangent of the efficient frontier
dominates all the risky portfolios, even the
efficient frontier
9
10
Capital Market Line
 The point of tangency is called the market
portfolio, and the straight line is called the
Capital Market Line (CML)
 The market portfolio represents ownership in all
traded assets, so this portfolio represents
maximum diversification
 An investor’s portfolio represents a mix of the
risk-free asset and the market portfolio. The
portfolio moves along the CML by changing the
mix. In order to attain a point beyond the
market portfolio, the investor would have to
borrow (use financial leverage)
11
Beta
 Beta measures the co-movement between a stock
and the market portfolio
 The beta of the overall market is 1
 Stocks with betas greater than 1 are considered
riskier than the market portfolio and are called
aggressive stocks
 Stocks with betas less than 1 are less risky than
the market portfolio and are called defensive
stocks
12
13
 Consider the beta for DuPont from table 10.2.
DuPont's beta is 1.10, meaning that the company’s
returns are 10% more sensitive (on average) than
the overall market. If the market is up 5%,
DuPont’s return will be expected to be up
approximately 5.5% on average. The same thing
works in the negative direction. If the market is
down 3%, we would expect that DuPont’s return
would be down around 3.3% on average
14
Security Market Line
 Beta represents the amount of market risk for a
stock
 Investors will demand a higher risk premium to
invest in a stock with a high beta
 The Security Market Line (SML) represents the
relationship between required return and risk
(required return increases as risk increases),
where risk is measured by beta
 when beta = 0, the asset has no risk and therefore
the required return is equal to the risk-free rate
(i.e. there is no risk premium)
15
16
Capital Asset Pricing Model (CAPM)
 The equation of the SML results in the CAPM:
Required Return = Rf + β(RM – Rf )
 Example: We expect the market portfolio to
earn 12%, and T-bill yields are 5%. Home
Depot has a beta of 1.08. Calculate Home
Depot’s required return
Required Return = 5% + 1.08(12% - 5%) = 12.56%
17
Portfolio Beta
 The beta for a portfolio of stocks is simply the
weighted average of the individual stock betas
 The weights represent the market value of the
investment in each stock
 p  (w1  1 )  (w2   2 )  ...
18
Finding Beta
 The easiest way to find betas is to look them up.
Many companies provide betas:
 Value Line Investment Survey
 Hoovers
 MSN Money
 Yahoo! Finance
 Zacks
 Run a regression of the company return (yaxis) versus the overall market (on the x-axis).
The slope would be the beta.
19
Capital Market Efficiency
 The risk and return relationship rests on
the underlying assumption that stock
prices are generally “correct”
 Conditions necessary for an efficient
market:




Many buyers and sellers
Low barriers to entry
Free and available information
Low transactions costs
 U.S. stock exchanges appear to meet the
efficiency conditions
20
Efficient Market Hypothesis
 Weak-form efficiency
 Current prices reflect all information derived
from trading, i.e. past prices and volume
 Semi-strong-form efficiency
 Current prices reflect all public information,
such as financial statements, news, analyst
opinions
 Strong-form efficiency
 Current prices reflect all information, even
including private information that has not yet
been released to the public
21
Weak-Form Efficiency
 Technical analysis relies on price and volume
charts to make predictions about future prices
 If markets are weak-form efficient, then prices
would already reflect this type of information
 Technical analysis would be futile
22
Semi-Strong-Form Efficiency
 Stock prices already reflect any information that is
available to the public, including to stock analysts
 Analyzing a stock using public information, called
fundamental analysis, would not be useful in
identifying mispriced stocks
 Another implication is that stock prices would
quickly and accurately reflect any new
information relevant to the company
23
24
Strong-Form Efficiency
 If markets are strong-form efficient, then even
private, insider information would not allow an
investor to “beat the market” by trading on this
information since it is already incorporated into
the stock price
25
Is the Stock Market Efficient?
 This question continues to be actively studied and
debated
 Research has shown that markets are probably
not strong-form efficient
 Insiders seem to be able to earn abnormal returns
 Research has shown that markets are more likely
to efficient at the weak-form and even the semistrong form levels
26
Behavioral Finance
 Finance researchers have found that people often
behave in ways that are very likely irrational
 Sometimes too optimistic, and other times too
pessimistic
 This behavior may drive stock prices away from
their correct price
 It leaves open the possibility that capital markets
may not represent efficient markets if buyers and
sellers do not always make rational choices
27
Alternative to the CAPM
A popular alternative to the CAPM is the
constant growth model
 Example: Wal-Mart is expected to pay a $1
dividend this year, and the current price of WMT
stock is $48 per share. Analysts believe that WalMart will grow at a constant 12 percent.
i = $1.00/48 + 0.12 = 14.1 percent
28