Chapter Five: Advanced Risk Analysis: Firm Risk and Market Risk

Introduction
Firms invest in assets with the expectation that they will achieve adequate returns from their
investment. As the matter of fact, expectation may not be realized. There is uncertainty
associated with the cash flow estimates. This uncertainty is termed as risk.
Definition of Risk and Return
Risk: is the probability or likelihood that actual results (rates of return) deviates from expected
returns. It is the variability of returns associated with a given investment. The word risk is
usually used interchangeably with uncertainty.

Return: is the total gain or loss experienced on behalf of the owner of an investment over a
given period of time. It is calculated by dividing the asset’s change in value plus any cash
distributions during the period by its beginning of period investment value.
Ct +( Pt −Pt−1)
R=
Pt −1
Where,
R = actual, expected, or required rate of return
Pt = price (value) of asset at time t.
Pt-1 = price (value) of asset at time t-1.
Ct = cash flow (dividend) received from the asset investment in time period t-1 to t.
 The return R, reflects the combined effect of changes in value, P t – Pt-1 or capital gain and
cash flow C, or yield realized over the period t, the beginning value P t-1, and the ending value
Pt, are not necessarily realized values.
Example 1
The price of XYZ company stock trading in London on May 29, 2012 was £0.77. The price at
close of trading on May 28, 2013 was £1.39. No dividends were paid. Compute the holding
period return for the stock.
Example 2
The price of IBM stock trading in New York on May 29, 2012 was $80.96. The price on May 28,
2013 was $87.57. A total of $0.61 was paid in dividends over the year in four payments of $0.15,
$0.15, $0.15 and $0.16. Compute the holding period return for the stock.

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Expected Returns and Risk for Individual Securities
Risk (uncertainty) has to do with the future. So to measure risk, we use data from a probability
distribution. Probability distribution lists the set of possible returns that can occur at a specific
time and their associated probabilities of occurrence. Because the possible returns are mutually
exclusive, the probabilities sum to 1 or 100%. Probability distributions are prepared based on
past data, industry trends and ratios, and forecasts of the general economy of the country.
 From a probability distribution, the following measures are obtained.
1) Expected rate of return
2) Standard deviation or variance
3) Coefficient of variation.
 Under conditions of risk a separate probability distribution is used for each year.

1) Expected rate of return (R)

 Expected rate of return is the return expected to be realized from an investment.
 It is the mean value of the probability distribution of possible returns.
 It is the sum of the probability distribution of each outcome (return) and its associated

n
probability.R=∑ ( ri ) ( pi) Where, ri = possible return in year i.
i=1

Pi = probability of occurrence of ri.

n = number of possible returns.
Or, R = p1r1 + p2r2……+ pnrn where, p1,p2…. P n = is the probability of the ith outcome.
r1, r2..... rn = is the ith possible outcome (return).
2) Standard Deviation (δ)
 Standard deviation is the most common statistical indicator of an asset’s risk (stand alone
risk).
 It measures the dispersion of the probability distribution around its expected value.
 It measures the variability of a set of observations.
n
Standard deviation (δ) =
√∑i=1
( ri−R ) (pi)

Example: A financial analyst is analyzing two investment alternatives of Z&Y. The estimated
rates of return and the chance of occurrence for the next year are given below:

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 State of the market Probability of the state Rate of return
Z Y
Recession 0.20 22% 5%
Average 0.60 14% 15%
Boom 0.20 -4% 25%
Required: Compute the expected rate of return and standard deviation for each security.
Solution:

 The larger standard deviation indicates a greater variation of returns and thus a greater
chance that the expected return will not be realized.
 The larger the Standard deviation (δ), the higher the risk, because Standard deviation (δ) is a
measure of total risk.
5.1. Investment Diversification and Portfolio Analysis
Portfolio: is a collection or a bundle of investment assets. If you hold only one asset, you suffer
a loss if the return turns out to be very low. If you hold two assets, the chance of suffering a loss
is reduced and returns on both assets must be low for you to suffer a loss.

By diversifying, or investing in multiple assets that do not move proportionately in the same
direction at the same time, you reduce your risk.
 It is the total portfolio risk and return that is important. The risk and return of individual
assets should not be analyzed in isolation; rather they should be analyzed in terms of how
they affect the risk and return of the portfolio in which they are included.
 The goal of the financial/investment manager should be to create an efficient portfolio, one
that maximizes return for a given level of risk or minimizes risk for a given level of risk.
Expected return on a portfolio (rp)
 Expected return on a portfolio is the average of the returns of the assets weighted by the
proportion of the portfolio devoted to each asset.

 For a portfolio of securities, the expected return rp, is

n Where, Ri=¿the expected return for security i.

rp =∑ ( Ri ) (Wi)
i=1

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 Wi = the proportion of funds invested in security i.
n = the total number of securities in the portfolio.

Example: Consider a portfolio of two stocks A and B with expected returns of 16%, 12%, and
the portfolio consists of 60% stock A and 40% of stock B.
Required: what is the expected return on this portfolio?
Solution:

5.2. Portfolio Related Risk Measures

Portfolio risk (δp)
Unlike the expected return, the portfolio risk, as measured by its standard deviation, is not a
weighted average of the standard deviations of the assets making up the portfolio. A
portfolio’s standard deviation depends not only on the risk of the individual securities, or
assets, but also on the correlations between their returns.
Correlation (co-movement): refers to the association of movement between two numbers.
It measures the degree of linear relationship to which two variables, such as returns on two
assets, move together. Correlation takes on numerical values that range from +1 to -1. While
the positive or negative sign indicates the direction of the co-movement and the absolute
value of the correlation indicates the relative strength of the association. The closer the
correlation coefficient is to +1 or -1, the stronger the association.
 If the variables move together, they are positively correlated (a positive correlation
coefficient).
 If the variables move in opposite direction, they are negatively correlated (a negative
correlation).
 A correlation of zero indicates that no relationship between the variables, that is they are
unrelated.
 A correlation of +1.0 indicates that the returns move up and down together, the relative
magnitude of the movements is exactly the same (perfect positive correlation).

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 If correlation is between 0.0 and +1.0, the returns usually move up and down together, but
not all the time. The closer the correlation is to 0.0, the lesser the two sets of returns move
together.
 A correlation of -1.0 implies that they move exactly opposite to each other. (Perfect negative
correlation).

……………. ……

……………. ……………….. …………

……………. …………………….. …………

Portfolio risk Portfolio risk Portfolio risk

A) Positive correlation B) Negative correlation C) Zero correlation

∑ pi ( rx−Rx ) (ry−RY )
CorrXY = i=1
δXδY
Example: Consider a portfolio of two investment ventures under three deferent economic
climates.

State of the economy Probability of Rate of return

X Y
the state
Bad 0.2 0% -10%
Average 0.6 10% 10%
Good 0.2 20% 40%
Required: Calculate CorrXY.

SOLUTION:

COVARIANCE OF RETURNS
 Covariance measures how closely security returns move together. The covariance between
possible returns for securities J and K,δJK .

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 When we consider two assets in the portfolio, we are concerned with the co-movement of
security movement.
 It can be positive Covariance, negative Covariance, zero Covariance, and non- Covariance.

δJK = rJKδJδK
Where, rJK = the expected correlation between possible returns J and k.
δJ =¿The standard deviation for security J, and
δK =¿The standard deviation for security K
The standard deviation of a portfolio (δp) is:
n n
= √∑ ∑
j=1 k=1
( wj ) (Wk ) δJK

Where, n = the total number of securities in the portfolio

wj=¿The proportion of funds in security j
Wk = The proportion of funds in security k
δJK =¿ The covariance between possible returns for security j&k

n n
= √∑ ∑
j=1 k=1
( wj ) (Wk ) δJδK r JK

Example: The following information is available.

Stock A Stock B

Expected return 16% 12%

Standard deviation 15% 8%

Coefficient of correlation 0.60

What is the expected return and risk of a portfolio in which stock A and B have weights of 0.60
and 0.40 respectively.

Solution:

n
rp =∑ ( Ri ) (Wi) = (0.60x.16) + (0.40x0.12)= 0.144= 14.4%
i=1

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
δp = √ [ ( WA ) 2 ( δA ) 2+ ( WB ) 2 ( δB ) 2+ ( 2 ) ( WA ) ( WB ) ( rAB ) ( δA ) ( δB ) ]

δp = √ [ ( 0.6 ) 2 ( 15 ) 2+ ( 0.4 ) 2 ( 8 ) 2+ ( 2 ) ( 0.6 ) ( 0.4 ) ( 0.60 ) ( 0.15 ) ( 0.08 ) ]

δp = √ [( 0.36 x 225)+(0.16 x 64)+2(17.28)]

δp = √ 125.80 = 11.21%

Exercise: Calculate the expected return and variance of a portfolio comprising two securities,
assuming that the portfolio weights are 0.75 for security 1 and 0.25 for security 2. The expected
return for security 1 is 18% and its standard deviation is 12%. While the expected return and
standard deviation for security 2 is 22% and 20% respectively. The correlation between the two
securities is 0.50.

Types of risk: Systematic and Unsystematic

 The total risk of a portfolio, measured by its standard deviation, declines as more assets are
added to the portfolio. Adding more assets to the portfolio can eliminate some of the risk, but
not all of it.
 The total risk can be divided in to two parts. These are:
1) Diversifiable (Unsystematic or Firm-specific) risk
 It is the portion of an asset’s risk that is attributable to firm-specific, random causes, such as
strikes, lawsuits, product development new patent, regulatory actions, and loss of a key
account.
 It is avoidable or diversifiable risk, because these events occur somewhat independently, they
can be largely diversified away so that negative events affecting one firm can be offset by
positive events for other firms.
 They are irrelevant risks (called unique risk).

2) Non-diversifiable (Systematic or Market) risk

 It is attributable to market factors (such as war, inflation, international incidents, impact of
monetary and fiscal policies, and political events) that affect all firms. This risk cannot be
eliminated through diversification. It is unavoidable risk. They are relevant risks.

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 Total security risk = non-diversifiable risk + diversifiable risk
Because non-diversifiable risks remain, whether or not a portfolio is formed, the only relevant
risk is non-diversifiable risk. That is, the only risk a well diversified portfolio has the non-
diversifiable risk. Therefore, the contribution of any asset to the riskiness of a portfolio is its non-
diversifiable risk.

5.3. Portfolio Theory and Capital Budgeting

The development of the theoretical relationship between risk and expected return is built partly
on portfolio theory. Portfolio theory deals with the selection of portfolios that maximize expected
returns consistent with individually acceptable levels of risk. Each security has its individual
systematic – non diversified risk, measured using coefficient beta which indicates how the price
of security / return on security depends upon the market forces.

The Security Market Line (SML)

SML- specifies the relationship between the expected return and beta of a security. Each security
can be described by its SML; they differ because their betas are different and reflect different
levels of market risk for these securities.

In market equilibrium, an individual security’s expected rate of return and its systematic risk will
have a linear relationship. This relationship is depicted below:

Expected Return (%)

SML (Capital Allocation Line)
Rm

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 Risk Premium (Compensation for risk)

Rf ……………………………. ………………

Risk free rate

Systematic risk (beta) 1.0

Fig 5.1. Security Market Line (SML)

Risk and Required Rate of Return

Required rate of return: is the minimum expected rate of return that would induce an
investor to acquire it. There is a direct relationship between an asset’s risk and its expected
rate of return.
 As we have seen in this chapter, the standard deviation is a measure of total risk. However,
the market doesn’t pay for the unsystematic risk, but for the systematic risk as measured by
beta.
 The beta of a portfolio is simply a weighted average of the betas of securities comprising the
portfolio. It is a measure of systematic risk in the portfolio.
The Capital Asset Pricing Model (CAPM)
 The CAPM (Capital asset pricing model) can be applied, like for individual securities, to
portfolios to determine their expected returns.
 The CAPM states that in equilibrium, only the systematic (market risk) is priced, and not the
total risk; investors do not required to be compensated for unique risk.

Assumptions of CAPM
 There are many investors;
 Investors are price takers and they can’t influence the market individually;

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
  All investors are looking ahead over the same(one-period) planning horizon;
 Information is freely and instantly available to all investors;
 Each investor cares only about expected return and standard deviation;
 All investors have the same beliefs about the investment opportunities;
 Taxes and transaction costs are irrelevant;
 Investors can borrow and lend at the one risk-free rate.
 To determine the expected return for a portfolio under CAPM, we do have two alternatives.
The 1st alternative: to determine the expected return for individual securities and take their
weighted average to get the portfolio expected return.
The 2nd alternative: to determine the weighted average of the betas of the securities making
up the portfolio and insert their portfolio beta in the CAPM formula.
Example: Consider a two security portfolio consisting of securities A and B with betas of 1.3
and 0.7 respectively. Suppose that the expected return on treasury securities is 6% and the
expected return on the market portfolio is 12%. Assume you invested 30% of your fund in
security A and 70% of your fund in security B.
Required: Determine the expected return on the portfolio using two alternatives.
 According to the CAPM, the required rate of return of a security is influenced by risk free
rate and a premium to compensate for the security risk.
Alternative 1: first determine individual securities expected return.
Expected return for security A = Rf + bA (Rm – Rf)
Where, Rf = the risk-free rate of return, which is generally measured by the return on
Treasury bill.
 Treasury bills offer risk-free rate, as they do not have risk of default. The government
guarantees them.
bA = the beta coefficient for asset A (security A)

Rm = the expected rate of return on the market portfolio (a portfolio that contains all risky
financial assets (example stocks, bonds, options) and all risky real states (example precious
metals, jewelry, real estate, stamp collections).

RA = Rf + bA (Rm - Rf)
= 6% + 1.3 (12% - 6%) = 13.8%

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 Expected return for security B (RB) = Rf + bB (Rm – Rf)
= 6% + 0.7 (12% - 6%) = 10.2%

 Thus, the expected return for the portfolio (rp) is:

E(rp) = WARA + WBRB = (0.3 X 13.8%) + (0.7 X 10.2%) = 11.28%

Alternative 2: we need to compute the beta of the portfolio first

n
Bp = ∑ (Wi ) (Bi), where, BP =beta of the portfolio
i=1

Wi = the proportion of funds invested in security i, and

Bi = the beta of security i.
Bp = WABA + WBBB = (0.3 X 1.3) + (0.7 X 0.7) = 0.88

E(rp) = Rf +Bp (Rm - Rf) = 6% + 0.88 (12% - 6%) = 11.28% this is the same as that
obtained using alternative 1.
According to CAPM, a security is correctly priced if its expected rate return lies on the
SML. If an individual security has an expected return – risk combination that places it above
the SML, it will be undervalued in the market. That is, it provides an expected return that is
higher than the rate required by the market for the systematic risk involved. As a result, the
security will be attractive to investors. The price of such securities will rise and the expected
return will decline until the security lies on the SML since there is increased demand for such
stocks.
If an individual security’s expected return lies below the SML, it is said to be overpriced.
This security is not attractive and investors holding it will divest it. The supply for such
stocks will increase, and the price will fall and the expected return of the security will rise
until the security lies on the SML.

Example:

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 At present, suppose the risk-free rate is 10% and the expected return on the market portfolio
is 15%. The expected returns for four stocks are listed together with their expected betas.
Stock Expected Return (%) Beta
NIC 17 1.3
EIC 14.5 0.8
UIC 15.5 1.1
NIBC 18 1.7

Required:

a. Determine the required rate of return according to CAPM

b. Based on the information given and your result in (a), which stocks are overvalued and
undervalued?
c. If the risk- free rate were to rise 12% and the expected return on the market portfolio rose
to 16%, will the stock of NIC be overvalued or undervalued or correctly priced?
(Assume the expected returns and betas stay the same)
Solution:
a) Required rate of return using CAPM = Rf + b(Rm - Rf)= 10% + 1.3(15%-10%) =
RNIC = 16.5%
R EIC = 10% +0.8(15%-10%) = 14%
RUIC = 10% + 1.1(15%-10%) = 15.5%
RNIBC = 10% + 1.7(15%-10%) = 18.5%
b)

Stock Expected Return CAPM Valuation

based RR
NIC 17% 16.5% Undervalued
EIC 14.5 14 Undervalued
UIC 15.5 15.5 Correctly
priced
NIBC 18 18.5 Overvalued

c) Required rate of return(NIC stock) = 12% +1.3 (16%-12%) = 17.2%

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
The expected return for NIC stock was given as 17 percent which is less than that required by the
market, 17.2%. Thus, NIC’s stock is overvalued.

Limitations of the CAPM,,,,,,,,,,,,,,,,,,,,,,,,,,,

5.4. Capital Asset Pricing Model (CAPM) and Capital Budgeting

Regardless of the method of evaluation adopted (be it NPV, IRR or PI), the cost of capital should
reflect the project’s risk. The cost of capital is the rate of return required by suppliers of capital
(Creditors and owners). Suppliers of capital will require a higher rate of return to provide funds
to finance risky projects. As we have discussed in this chapter, the cost of capital is the sum of
the risk free-rate and compensation for risk.
Example: Suppose a corporation is examining two capital projects. The beta for project A is
1.05 and for project B is 0.08. The expected return on the market is 16 percent and the risk free
rate is 7 percent. Project A is expected to return 15.7 percent and project B is expected to return
17.5 percent. What is the cost of capital for project A and B? Which project is feasible?

Solution:
For project A
Cost of capital = Rf + b (Rm - Rf) =7% +1.05(16%-7%) = 16.45%
For project B
Cost of capital = Rf + b(Rm - Rf) = 7% +0.8(16%-7%) = 14.2%
In order to decide the feasibility of the project, we need to compare the expected return on the
project with its required rate of return (cost of capital).

For project A For project B

Expected return 15.7% 17.5%
Cost of capital 16.45% 14.2%

Here, we can notice that the expected return for project A is less than the minimum required rate
return on the project. Hence, the project is not feasible. Whereas, the expected rate of return for
project B is greater than the minimum required rate of return on the project. Hence, the project is
feasible.

Risk and Return- Diversification

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
The principle of diversification

 Diversification results from combining securities whose returns are less than perfectly
correlated in order to reducing portfolio risk.
 As noted before, the portfolio expected return is simply a weighted average of the individual
security expected return, no matter the number of securities in the portfolio. Thus,
diversification will not systematically affect the portfolio return, but it will reduce the
variability (standard deviation) of returns.
 In general, the less the correlation among security returns, the greater the impact of
diversification on reducing variability. This is true no matter how risky the securities of the
portfolio are when considered in isolation.

δp Total risk

Diversifiable

(Unsystematic) risk

Non-diversifiable (systematic) risk

Number of securities in the portfolio

Fig.5.2. Portfolio risk and the level of diversification.
 The figure shows that when we spread our investment across many different assets, our
portfolio risk will be reduced assuming that the securities return is less than perfectly
correlated.
 The area that is labeled “unsystematic risk” is the part that can be eliminated by
diversification. As we add more and more securities in the portfolio, the portfolio risk

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 decreases up to a point. This point is a minimum level of risk that cannot be eliminated by
diversification. This minimum level of risk is labeled “systematic risk” in the figure.
Diversification and unsystematic risk
Holding a portfolio of assets could eliminate some or all of the unsystematic risk.
Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets
has almost no unsystematic risk.
Diversification and systematic risk
Unlike unsystematic risk, systematic risk cannot be eliminated by diversification. A
systematic risk affects all assets. As a result, a systematic risk cannot be eliminated
regardless of the number of securities in the portfolio; rather investors share this risk between
or among themselves. Thus, for a well diversified portfolio, the unsystematic risk is
negligible. For such a portfolio, essentially all of the risk is systematic.

Investment Management: Chapter Five: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.