Corporate Finance

Term III, Section A

Class Notes 4

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2018-March 2019
Risk & Return
 Risk Return Trade-off

Puts & Calls

Expected Return

Common
Financial
Stocks
Futures

Warrants

Corporate Bonds

Risk Free Rate

Risk
A $1 Investment in different types of portfolios :1926-1997 (Year end 1925 = $1)

Smallest 20% NYSE

S & P 500

20 yr maturity govt.bonds

3 month t - bills
Risk & Return
Risk & Return
 Annual Rates of Return 1926-20051

Nominal Real Avg.

Std.Dev of Risk
Securities Avg.Annual Annual
Returns Premium
Returns Returns

Small-company stocks 17.40% 32.90% 14.30% 13.60%

Large-company stocks 12.30% 20.20% 9.20% 8.50%
L.T. Corporate Bonds 6.20% 8.50% 3.10% 2.40%
L.T. Govt. Bonds 5.80% 9.20% 2.70% 2.00%
Intermediate Term Govt. Bonds 5.50% 5.70% 2.40% 1.70%
U.S.T- Bills 3.80% 3.10% 0.70% 0.00%

Average Inflation 3.10%

1 U.S. data (Ibbotson and Sinquefield (2006)

 Efficient Financial Markets

Market Efficiency : Market price is the consensus estimate of the value

 Efficient markets utilize all available information regarding the

economy, financial markets and the specific company
 Market prices of individual securities adjust very rapidly to new
information
 New information can result in a change in the intrinsic value of a
security
 Subsequent security price movements follow random walk
 Random walk means one cannot use past security prices to predict
future prices in such a way as to profit on average
 Nobel Prize in Economics - 2013

• Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen shared the 2013
Nobel Prize in Economic Sciences for at times conflicting research on how
financial markets work and assets such as stocks are priced.

• The winners represent a “very interesting collection because Fama is the

founder of the efficient-market theory and Shiller at least is one of the
critics of it,” said Robert Solow (winner of the Nobel economics prize in
1987)

• "It must affect your thinking somehow that they really believe in markets. I
think that maybe he has a cognitive dissonance. His research shows that
markets are not efficient. So what do you do if you are living in the
University of Chicago? It's like being a Catholic priest and then discovering
that God doesn't exist or something, you can't deal with that, you've got to
somehow rationalise it." (Robert Shiller)
 Efficient Financial Markets (cont’d)

Market efficiency  the unpredictability of unanticipated portion

of return

• Unanticipated portion is the difference between actual return and

expected return based on intrinsic value

• Over a sufficient no. of observations the unanticipated portion does not

systematically differ from zero

The three forms of efficiency as defined by Fama:

• Weak
• Semi-strong
• strong
 Efficient Financial Markets (cont’d)
STAGES OF EFFICIENCY

Weak form market efficiency

• Unanticipated return is not correlated with previous unanticipated return,
i.e. market has no memory

Semi strong form market efficiency

• Not correlated to with any publicly available information

Strong form market efficiency

• Not correlated with any information either publicly available or insider
information

Paradox of Efficient Market Theory

The hypothesis that stock markets are efficient will be true only if a sufficiently
large no. of investors disbelieve its efficiency and behave accordingly
 Security Portfolios

PORTFOLIO RETURN
For a portfolio of two or more securities the expected return is

m
rp   rj A j
j1
where
rj is the expected return on security j,
Aj is the proportion of total funds invested in security j,
m is the total no. of securities

Expected return for a portfolio is a weighted average of expected

returns for securities making up that portfolio
 Security Portfolios (cont’d)

Portfolio Risk

Portfolio risk depends on riskiness of the securities and also the relationship among
those securities. Selecting securities having little relationship one can reduce risk

State Probability of state Return on security Return on security

occurring A B
Boom .25 28% 10%
Normal .50 15 13
Recession .25 -2 10
Expected Return 14.0 11.5
Std. Deviation 10.7 1.5
 Security Portfolios (cont’d)
The returns for a portfolio consisting of equal investments in both securities

State Probability of states Return on portfolio %

occurring
Boom .25 19
Normal .50 14
Recession .25 4

The expected Return for the portfolio above is

19(.25) +14(.5) + 4(.25) = 12.75%

However the standard deviation of the portfolio is

[(.19 - .1275)2 X .25 + (.14 - .1275)2 X .5 + (.04 - .1275)2 X .25]1/2 = 5.4%

The portfolio SD is less than the weighted average of individual SD which is 6.1%.
This is due to the relationship or covariance between the returns of the two
securities
 Security Portfolios (cont’d)
The standard deviation of a probability distribution of expected portfolio
returns is
m m
p   x x 
j 1 k 1
j k jk

m = total no. of securities in the portfolio

xj = proportion of total funds invested in security j
xk = proportion of total funds invested in security k
sjk = covariance between possible returns for securities j and k
where
 jk  r jk j  k
rjk is the expected correlation between the returns of security j & k
 Portfolio Risk-2
1 2 3 4 5 ……… n
1 ….
2
3
Stock 4
5
:
:
n
Stock
The shaded boxes (diagonal cells) contain variance terms ; the remainder (off
diagonal cells) contain covariance terms.
To calculate variance of an N-stock portfolio we must add the entries in a
matrix like this
 Portfolio Risk-1
Example: Suppose we invest $55 in Bristol-Myers (BM) and $45 in McDonald’s
(MD). Assume the expected dollar return on the BM is 10% and on MD it is
20%. T he expected dollar return on our portfolio is 5.5+9.0=14.5. The portfolio
rate of return is therefore 14.5/100=14.5%.
Assume a correlation coefficient of 0.65 between BM and MD and that the
standard deviation of BM is 17.1 and that of McDonald's is 20.8. The standard
deviation of the portfolio can be computed by the methodology below as 17.04
Bristol-Myers McDonald’s
x1x212
Bristol-Myers x12120.552 * 0.55 * 0.45 * 0.65 * 17.1 * 20.8
17.12
x1x212
McDonald’s 0.55 * 0.45 * 0.65 * x2222=0.452 * 20.82
17.1 * 20.8

Portfolio variance is = 2.91%. Portfolio standard deviation is square root of variance =

(2.91% )0.5 = 17.04%
(as compared to 18.77% if there were perfect correlation)
 Portfolio Risk-2

Bristol-Myers McDonald's
Return 10.0% 20.0%
Std Dev 17.1% 20.8%

weights BM 55.0% 55.0% 55.0% 55.0%

MD 45.0% 45.0% 45.0% 45.0%
rBM,MD 100.0% 80.0% 50.0% 20.0%
Portfolio  18.77% 17.80% 16.25% 14.54%

Weighted Avg.  18.77%

Portfolio  declines as
The weighted average 
correlation coefficient
is equal to the portfolio 
declines
when correlation
coefficient is = 1
 Limits to Diversification

N  N1  * avg.varian ce  ( N 2  N ) N1  * avg.covari ance

2 2
Portfolio Variance =
 1
N * avg.var.  1  N1 * avg.covar.
as N  , the above expression limits to :
avg.covar.
 Limits to Diversification (2)

Portfolio standard deviation

0
5 10 15
Number of Securities
 Security Portfolios (cont’d)
Two Security Efficient Set

The efficient set for different combinations of two securities A and B with
expected return of 12% and 18% and SD of 11 & 19 % assuming expected
correlation between the two returns is .20 is now illustrated.
The table below shows the relationship between expected returns and risk when
the proportions in each security are varied

Portfolio Proportion of A Proportion of B Portfolio Return% Portfolio SD%

1 1.0 0 12 11.00
2 0.8 0.2 13.2 10.26
3 0.6 0.4 14.4 11.02
4 0.4 0.6 15.6 13.01
5 0.2 0.8 16.8 15.79
6 0 1.0 18.0 19.00
 Security Portfolios (cont’d)
Opportunity Set for Investment an a Two Security Portfolio

SECURITY B
EXPECTED RETURN

Minimum variance point (80:20) is the one with

the lowest standard deviation that comes by
varying the mix of securities held. No one would
want to own a portfolio with a lower expected
return than that provided by the minimum
variance portfolio
MINIMUM VARIANCE PORTFOLIO
The efficient set is the portion of the curve from
minimum variance part to 100% of security B. It is
SECURITY A not possible to be either above or below the
opportunity set line

STANDARD DEVIATION
 Security Portfolios (cont’d)

Opportunity Sets for Two Security Portfolios with Different Correlation

Coefficients

SECURITY B
EXPECTED RETURN

CORRELATION = 1.00

CORRELATION = .60

CORRELATION = .20

SECURITY A

STANDARD DEVIATION
 Security Portfolios (cont’d)

Hypothetical Opportunity Set for Portfolios of Multiple Securities

Expected Return

Opportunity set

Minimum
Variance
Portfolio

Standard deviation
 Security Portfolios (cont’d)
Hypothetical Indifference Curves

INCREASING UTILITY
EXPECTED RETURN

STANDARD DEVIATION

1 U = utility
U  E (r )  A 2 E ( r ) = expected return on the asset or portfolio
2 A = coefficient of risk aversion
2 = variance of returns
 Security Portfolios (cont’d)
SELECTION OF OPTIMAL PORTFOLIO WHEN RISK FREE ASSET EXISTS

BORROWING
m n
EXPECTED RETURN

OPPORTUNITY SET

LENDING
Rf

STANDARD DEVIATION
 Security Portfolios (cont’d)
SELECTION OF OPTIMAL PORTFOLIO WHEN RISK FREE ASSET EXISTS

BORROWING
m n
EXPECTED RETURN

X OPPORTUNITY SET

LENDING
Rf

STANDARD DEVIATION
 Optimal Portfolio When Risk Free Asset Exists

Risk free asset  future return assured

Assumption :
Borrowing and lending at risk free rate possible
• Efficiency frontier  the straight line shown in the figure
• Portfolio considered is the portfolio at the point of tangency with
opportunity set of portfolio returns can be considered to be the Market
Portfolio
• Proportion of risky portfolio ‘m’ and proportion of loans and borrowings
given by any point on the straight line
• Left of ‘m’  risk free asset + portfolio ‘m’
• Right of ‘m’  only portfolio ‘m’----- increase in the level with borrowed
funds
 Market Portfolio (1)

Exp. Ret. Std. Dev.

Market Portfolio rm m
Rm
Risk Free Security rf
Rp

Assume a portfolio on the line connecting the risk free

Rrf
security and the market portfolio.

Assume an optimal portfolio on this line with :

Standard Deviation: p
Expected return: rp

Let w, be the quantum invested in the risky security

 Market Portfolio (2)

rp  wrm  (1  w)rrf
 p  ((1  w)   w   2w(1  w)rrfp rf  m )
1
2 2 2 2 2
rf m

 p  (w  m )
2 2 12 Rm

 p  w m
Rp

p Rrf
w
m

Also, the slope of the line connecting the risk free security
and market portfolio is : Sharpe’s measure
(rm  rrf ) for portfolio
evaluation
( m   rf )
(rp  rf ) /  p
Since σ rf  0,
(rm  rrf )
Slope 
m
 Optimal Portfolio When Risk Free Asset Exists

Overall expected return =

(W) * (expected return on risky asset) + (1-W) * (risk free rate)

Where,
W  proportion of total wealth invested in ‘m’
1-W  proportion of total wealth invested in risk free asset
W > 1, if borrowing is involved (Investor borrows at the risk free rate and
buys the market portfolio)
0≤ W ≤ 1, if lending is involved (Investor buys the risk free asset – in various
proportions -as part of his/her investment strategy)

• Portfolio ‘x’ defines optimal investment policy i.e. lending at risk free rate
and investment in portfolio ‘m’
• If borrowing is not possible then efficient set is the line Rf mn
• Optimal portfolio is point of tangency with highest indifference curve
 Multiple Security Portfolio Analysis and Selection

Markowitz mean-variance maxim

A portfolio is not efficient if there is another portfolio with

• Higher expected return and lower standard deviation

• Higher expected return and same standard deviation or
• Same expected return and lower standard deviation

If a portfolio is not efficient then there is always a possibility of

• Increasing expected return without increasing the risk

• Decrease the risk without decreasing expected return or
• Achieve a better combination of increased expected return and decreased
risk by switching to a portfolio on the efficient frontier
 Capital Asset Pricing Model (CAPM)
(Developed by William F Sharpe and John Lintner in the 1960’s)

Assumptions

• Capital markets are highly efficient where investors are well informed
• Zero transaction costs
• Negligible restrictions on investment and no taxes
• No investor is large enough to effect the market price of the stock
• Investors are in general agreement about the likely performance and risk of
individual securities
• Their expectations are based on common holding period, say, one year
• Investment opportunities are of two types

1. A risk free security whose return over the holding period is known with
certainty for example government securities
2. A market portfolio of common stocks
 Characteristic Line
Excess Return on Stock +
. Unsystematic
. .
. . . Risk
. .. . .
. . . .. .
. .
.. . .. .
. .
a . .. . b. .. .
- . . . .. . +
. . . . . . .
. . . . . .. . . Excess Return on
. . .
. . Market Portfolio
. . . . . .
. .
. .
. . Slope of the Characteristic Line is b (BETA)
The intercept is a (APHPA) – this is
“normally” expected to be zero
-
 CAPM – Basic Proposition

Expected Return =
Risk Free Rate + Premium Based on Systematic Risk

Total Risk =
Systematic Risk + Unsystematic Risk

Risks effecting securities Risks UNIQUE to a company –

OVERALL  cannot be independent of economic, political and
diversified - measured by R2 other macro factors  CAN be
diversified - measured by (1-R2)
 Computation of b

 Availability of published data on b

 Can be computed either using a historical approach or with forecasts

Note : There is a need sometimes to adjust b s for the reversion process – a

tendency for the b to revert eventually to the b of the market portfolio (1.0) or
the b of the industry
 Capital Asset Pricing Model (cont’d)

Std. Dev on Portfolio Return

Total Risk

Market Portfolio  limit to attainable diversification

Unsystematic Risk

Systematic Risk

No. of securities in portfolio

 Security Market Line

Expected Return

Market Portfolio
rm
Risk Premium

rf

Risk free return

Systematic Risk(Beta)
1.0

r j  r f  (rm  r f ) * b
 Beta

r j  r f  (rm  r f ) * b

b  Cov jm / varm
 r jm * j * m /  m
2

r jm *  j
bj 
m

Reward to Risk Ratio is the same for the over all market
Treynor’s
measure for
portfolio
Rj  Rf evaluation
 Rm  R f
bj (rp  rf ) / b p
Systematic & Non Systematic Risk (CAPM)

Total Risk =
Systematic Risk + Unsystematic Risk

2 2 2 2
𝜎𝑖𝑡 = 𝛽𝑖𝑡 𝜎𝑚𝑡 + 𝜎𝑒𝑖𝑡

𝜎𝑖𝑡 = Total Risk of firm i (Std. Dev)

𝜎𝑚𝑡 = Market Risk (Std. Dev)

𝜎𝑒𝑖𝑡 = Error (Std. Dev)

𝛽𝑖𝑡 = Beta of the firm i

 Implications

• Only Systematic Risk b , is relevant to the rational and well

diversified investor
• Greater the b greater is the risk
• The SML can provide signals for buying under-valued shares and
selling over-valued shares
• The return corresponding to the firm’s b should be used in the
dividend capitalisation model

 b ‘s are additive  the b of a portfolio is simply a weighted

average of the b ‘s of the securities comprising the portfolio
 Apparent dichotomy of Low Total Risk – High Systematic Risk vis-
à-vis High Total Risk – Low Systematic Risk
 Portfolio Beta

Amount Portfolio
Stock Invested Weights Beta
(1) (2) (3) (4) (3)  (4)
Haskell Mfg. $ 6,000 50% 0.90 0.450
Cleaver, Inc. 4,000 33% 1.10 0.367
Rutherford Co. 2,000 17% 1.30 0.217
Portfolio $12,000 100% 1.034
 Implications for Valuation of the Firm

Discount rate = risk free rate + premium

all things being equal,

systematic risk risk premium value of the firm

Unsystematic risk also effects valuation when some assumptions

with respect to CAPM do not hold
 Measuring Betas

Dell Computer

Dell return (%)

(Price data – Aug 88- Jan 95)

R2 = .11
b = 1.62

Market return (%)

Slope determined from plotting the
line of best fit.
 Testing the CAPM-1
Beta vs. Average Risk Premium
Avg Risk Premium
1931-65 Security
30 Market Line

20 Investors

10 Market
Portfolio
0
Portfolio Beta
1.0
10 investors each with a holding of 10% of NYSE stocks with 10 % of b’ s. For
eg., Investor 1 has the stocks with the lowest 10% b’ s, Investor 2 has the next
lowest 10% b’ s, and so on (source : F.Black,”Beta and Return,” Journal of
Portfolio Management 20 (Fall 1993) pp 8-18)
 Testing the CAPM-2
Beta vs. Average Risk Premium

Avg Risk Premium

1966-91

30

20 Security
Investors Market Line
10

Market
0 Portfolio
Portfolio Beta
1.0
(source : F.Black,”Beta and Return,” Journal of Portfolio Management 20 (Fall 1993) pp
8-18)
 Testing the CAPM-3

Company Size vs. Average Return

Average Return (%)

25

20

15

10

5
Company size
0
Smallest Largest
(source : E.F.Fama and K.R.French,”The Cross-Section of Expected Stock Returns,”
Journal of Finance 47 (June 1992) pp 427-465)
 Testing the CAPM-4

Book-Market vs. Average Return

Average Return (%)

25

20

15

10

5
Book-Market Ratio
0
Highest Lowest
(source : E.F.Fama and K.R.French,”The Cross-Section of Expected Stock Returns,”
Journal of Finance 47 (June 1992) pp 427-465)
 Other Problems with CAPM
 Assumption of homogenous expectations is not valid

 Market equilibrium is also effected by transaction costs  Greater the costs less
the transactions to make efficient portfolios  Bands of portfolios exist on the sides
of the efficient set

 Greater the transaction costs wider the bands

 Efficient portfolio can be acheived only ot the nearest stock or bond

 Expectations of investors can also differ due to information asymmetry and costs
involved

 True market portfolio should consist of all assets---stocks, bonds, real estate, and
human capital  Proxy market index is only a subset of true market portfolio
 Key Issues

 Is b the ONLY reason that expected returns differ ?

 CAPM concerned with expected returns or actual returns ?

 Simplicity

 Workable alternative with superior empirical evidence has not

yet been advanced
Issues in Valuation
 Challenges to EMH (1)

• Investors are not “fully rational”. They exhibit “biases” and use
simple “heuristics” (rules of thumb) in making decisions.

• Empirical Evidence on investor behavior:

– investors fail to diversify.
– investors trade actively
– Investors may sell winning stocks and hold onto losing stocks
– extrapolative and contrarian forecasts.
 Challenges to EMH (2)

• Weak form of market efficiency supported to a certain extent.

• Challenges:
– Excess market volatility
– Stock price over-reaction: long time trends (1-3 years) reverse
themselves.
– Momentum in stock prices: short-term trends (6-12 months)
continue.
– Size and B/M ratio (stale information) may help predict returns.
 Summary

• Investor behavior does have an impact on the behavior of financial

markets. – the precise extent is not known

• In addition to key economic drivers of the market, “social” and

“psychological” must also be taken into account for fully explaining
market behaviour.