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HO 1 Review Of Risk And Returns Page| 1

COMPONENTS OF RISK
Stand-Alone Risk = Market Risk + Firm-Specific Risk
= Non-diversifiable Risk + Diversifiable Risk
= Systematic Risk + Non-systematic Risk

EFFECT OF MARKET DIVERSIFICATION TO FIRM-SPECIFIC AND MARKET RISKS

TWO BASIC RULES IN BASIC RISK MANAGEMENT

1 REQUIRE RETURNS AT LEAST EQUAL TO THE RISK ONE IS WILLING TO TAKE.

TO MEASURE RISK IS TO MEASURE RETURN


2
THE EXPECTED VALUE OF RETURNS

Expected value describes the numerical average of a probability distribution of estimated future cash receipts
from an investment project. This method is employed to estimate the most likely amount of future cash receipts
by:
(1) Estimating the various amounts of cash receipts from the project each year under different assumptions or
operating conditions
(2) Assigning probabilities to the various amounts estimated for one year, and
(3) Determining the mean value. The expected present value of all, future receipts could then be determined
by summing the expected discounted value of all years.

The GREATER the Expected Value or Pay-off, the BETTER. (i.e. given the same amount of Investment Risk to
be absorbed, a wise investor will select the project with the higher return.)

VARIOUS MEASUREMENTS OF RISK

1. Variance (σ2) is a measure of the dispersion of a distribution around its expected value. It may be measured
using the “standard deviation” or the “coefficient of variation”.*
n
½
 (ki  kˆ )2 Pi .
i 1

* when ungrouped data then variance = sum of squared differences divided by (n-1)

Prepared by: Ms. Jackqui R. Moreno, CPA, MBA


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The HIGHER the σ2, the HIGHER the risk.

σ
2. Standard deviation (represented by the symbol, “ ”) is another measure of the tightness of a distribution
around its mean, is often used as an alternative to variance. The standard deviation is found by taking the square
root of the variance.

 (k
i 1
i  kˆ ) 2 Pi .

* when ungrouped data then standard deviation = square root of the sum of squared differences divided by (n-1)

The smaller the standard deviation, the tighter the distribution and the lesser it is associated with the investment.
The HIGHER the σ, the HIGHER the risk.

3. Coefficient of variation (CV) is a better measure of total risk than the standard deviation, especially when
comparing investments with different expected returns

CV = Standard Deviation = Standard Deviation


Mean Return Expected Return

THE INVESTMENT WITH THE HIGHER CV HAS MORE TOTAL RISK PER UNIT OF EXPECTED RETURN.

4. Beta Estimation(β) of an individual stock is the correlation between the volatility (price variation) of the
stock market and the volatility of the price of the individual stock. The beta is the measure of the
undiversifiable, systematic market risk.

Security Market Line (SML) is the line on s graph that shows the relationship between risk as measured by
beta and the required rate of return for individual securities. The slope of the regression line is defined as the
beta coefficient.

The SML commonly adopts the CAPM model: SML: ki = kRF + (kM – kRF) β i .

The following interpretations are made when given a value of beta:


If β = 1.0, then the Asset is an average asset.
If β > 1.0, then the Asset is riskier than average.
If β < 1.0, then the Asset is less risky than average.
1
Most stocks have betas in the range of 0.5 to 1.5.

Beta is affected by an entity’s capital structure. The beta we use in the CAPM is the levered one, in case the
entity uses debt financing. The Hamada equation below is used to compute for new beta shall there be
changes in capital structure.
β u= Current, levered β .
[1 + {(1-tax rate)(Debt/Equity)}]


For a portfolio:
The expected return is equal to the WEIGHTED AVERAGE returns of the assets in the
portfolio.
The variance of a 2-asset portfolio is equal to
=wi2 (σi) 2 + w22 (σ2) 2 + 2 (wi)(σi) (w2)(σ2) (r2)
=wi2 (σi) 2 + w22 (σ2) 2 + 2 (wi) (w2)(Cov)
The standard deviation is equal to the square root of the variance of the portfolio.

5. Covariance (Cov) is a measure of the general movement relationship between two variables. It is usually
measured in terms of correlation coefficient and asset allocation.

1
Can a beta be negative? Answer: Yes, if beta is negative. Then in a “beta graph” the regression line will slope downward. Though, a
negative beta is highly unlikely.

Prepared by: Ms. Jackqui R. Moreno, CPA, MBA


HO 1 Review Of Risk And Returns Page| 3

=
Solved Illustrative Problem on the Various Measurement of Risks
Problem:
Demand for the Probability of this Rate of Return on stock
company's products demand occurring if this demand occurs
Company 1 Company 2
Strong 0.30 100% 20%
Normal 0.40 15% 15%
Weak 0.30 -70% 10%
1.00

Given the preceding data, solve for the following:


a. Expected or Average Stock Return of each of the Companies 1 and 2
b. Variance of Stock returns of each of the Companies 1 and 2
c. Standard Deviation of Stock returns of each of the Companies 1 and 2
d. Coefficient of Variation of Stock Returns of each of the companies
e. Covariance
f. Assuming that you are to invest 30% of your investment funds in Company 1 and 70% in Company 2, and their
r2 is 0.351 compute for the:
(1) Variance of the 2-Asset Portfolio
(2) Standard Deviation of the 2-Asset Portfolio

Answer:
a. Expected Returns
Demand for the Probability of this Rate of Return on stock Average Rate of
company's products demand occurring if this demand occurs Return
COMPANY 1
Strong 0.30 100% 30%
Normal 0.40 15% 6%
Weak 0.30 -70% -21%
1.00 15%

Demand for the Probability of this Rate of Return on stock Average Rate of
company's products demand occurring if this demand occurs Return
COMPANY 2
Strong 0.30 20% 6%
Normal 0.40 15% 6%
Weak 0.30 10% 3%
1.00 15%

b. Variance of Stock returns of each of the Companies 1 and 2


Demand for the Probability of this Rate of Return on stock Average Rate of
company's products demand occurring if this demand occurs Return
COMPANY 1
Strong 0.30 100% 30%
Normal 0.40 15% 6%
Weak 0.30 -70% -21%
1.00 15%

Demand for the Probability of this Rate of Return on stock Average Rate of
company's products demand occurring if this demand occurs Return
COMPANY 2
Strong 0.30 20% 6%
Normal 0.40 15% 6%
Weak 0.30 10% 3%
1.00 15%

c. Standard Deviation of Stock returns of each of the Companies 1 and 2


=Rate of Return - Expected Rate of Return

Demand for the Probability of this Deviation from k hat Squared deviation Sq Dev X Prob.

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company's products demand occurring COMPANY 1

Strong 0.3 85% 72.25% 21.68%


Normal 0.4 0% 0.00% 0.00%
Weak 0.3 -85% 72.25% 21.68%
Sum: 43.35%
Std. Dev. = Square root of sum 65.84%
Probability of this
demand occurring COMPANY 2
Strong 0.3 ??? ??? ???
Normal 0.4 ??? ??? ???
Weak 0.3 ??? ??? ???
Std. Dev. = Square root of sum 0.0387

d. Coefficient of Variation

Std. Deviation ÷ Expected return = CV


COMPANY 1 65.84% 15% 4.39
COMPANY 2 ???? 3.87% ???? 15% ??? 0.258

e. Covariance
Correlation S.D. Cov
Company 1 0.351 65.84% 0.351 x 0.6584 x 0.0387
Company 2 0.351 3.87%

f. Portfolio S.D. given the asset mix

σ2= ???(0.3)2 (0.6584)2+(0.7) 2(0.0387)2+2(0.3)(0.7)(0.6584)(0.0387)(0.351) = 0.043504292


σ = ???0.208576825

The Capital Asset Pricing Model (CAPM)


ks = kRF + (kM – kRF)b.
Notes to remember on CAPM application:
1. The ks is equal to the required rate of return.
2. kRF = Risk-free rate ; The preferred proxy for kRF is the Rate on long-term Treasury bonds.
3. b = The stock's beta coefficient is used as the measure of risk.
4. kM = The required rate of return on the market, or an "average" stock.
5. Key Assumptions under CAPM model:
a. Individuals diversify and hold portfolios
b. To test the CAPM, one has to observe and be able to measure this efficient market portfolio.
c. The risk of a security is the risk it adds to the portfolio
d. Everybody holds the market portfolio
e. The covariance between an asset "i" and the market portfolio (Covim) is a measure of this added risk.
The higher the covariance the higher the risk.

BRIEF EXERCISES ON RETURNS, STANDARD DEVIATION AND VARIANCES

1. The following table summarizes the annual returns you would have made on two companies: Scientific
Atlanta, a satellite and data equipment manufacturer, and AT&T, the telecommunications giant, from 1999 to
2008.
Scientific Scientific Scientific
Year Atlanta AT&T Year Atlanta AT&T Year Atlanta AT&T
1999 80.95% 58.26% 2003 32.02% 2.94% 2007 11.67% 48.64%
2000 -47.37% -33.79% 2004 25.37% -4.29% 2008 36.19% 23.55%
2001 31.00% 29.88% 2005 -28.57% 28.86%
2002 132.44% 30.35% 2006 0.00% -6.36%

a. Estimate the average and standard deviation in annual returns in each company.
The average return over the ten years is 27.37% for Scientific Atlanta and 17.8%
for AT&T. The standard deviations are 51.36% and 27.89% respectively.
b. If the correlation of these two investments is 0.54069, estimate the variance of a portfolio composed, in
equal parts, of the two investments.
c.

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HO 1 Review Of Risk And Returns Page| 5

d.
e.
f.
g.
h.
i.
j. The variance of a portfolio composed equally of the two investments equals (0.
k. 5)2 (51.36)2 +(0.5)2 (27.89)2 +2(51.36)(27.89)(0.5)(0.5)(0.54) = 1240.68; the standard deviation is 35.22%
The variance of a portfolio composed equally of the two investments equals (0.5) 2 (51.36)2 +(0.5)2 (27.89)2
+2(51.36)(27.89)(0.5)(0.5)(0.54) = 1240.68; the standard deviation is 35.22%

2.

2. Zuni-GAS is a regulated utility serving Northern Luzon. The following table lists the stock prices and
dividends on Unicorn from 1999 to 2008.
Year Price Dividends Year Price Dividends Year Price Dividends
1999 36.10 3.00 2003 26.80 1.60 2006 28.50 1.60
2000 33.60 3.00 2004 24.80 1.60 2007 24.25 1.60
2001 37.80 3.00 2005 31.60 1.60 2008 35.60 1.60
2002 30.90 2.30

a. Estimate the average annual return you would have made on your investment 8.25%
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
s.
t.
u.
v.
w.
x.
y.
z.
aa.
bb.
cc.
dd.
ee.
ff.
gg.
hh.
ii.
jj.
kk.
ll.
mm.
nn.
oo.
pp.

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qq.
rr.
ss.
tt.
uu.
vv.
ww.
xx.
yy.
zz.
aaa.
bbb.
ccc. b. Estimate the standard deviation and variance in annual returns. 42.49%

3. Assume you have all your wealth (P1 million) invested in the Vanguard 500 index fund, and you expect to
earn an annual return of 12 percent with a standard deviation in returns of 25 percent. Because you have become
more risk averse, you decide to shift P200,000 from the Vanguard fund to Treasury bills. The T bill rate is 5%.
Estimate the expected return and standard deviation of your new portfolio. The expected return on the new portfolio =
0.2(5) + (0.8)12 = 10.6% The standard deviation of returns on the new portfolio = 0.8(25) = 20%
ILLUSTRATIVE PROBLEMS ON EXPECTED RETURNS, BETA, AND RISK PREMIUMS: SET A
In December 200B, AAA’s stock had a beta of 0.95. The Treasury bill rate at that time was 5.8%. The firm had a
debt outstanding of P1.7B and a market value of equity of P1.5B; the corporate marginal tax rate was 36%. The
registered risk premium at December 200B is 8.5%.
Requirements:
a. Estimate the expected return on the stock.
b. Assume that a decrease in risk-free rate occurs and is attributed to an improvement in inflation rates,
but that by January of 200C, the inflation rate deteriorates or increases by 1.25%, compute for the
required rate of return of a marginal investor. 2
Therefore, the risk-free rate becomes 7.05% (i.e. 5.8% + 1.25%).
= 7.05% + β {(14.3 + 1.25) – 7.05}
= 7.05% + 0.95{15.55 – 7.05}
= 15.13%
c. Assume that marginal investors become more risk-averse and thus require a change in the risk
premium by 4%, what will be the effect on their required rate of return? 3
= 5.8% + {0.95(8.5%+ 4%)}
= 17.68%
d. The current beta is 0.95. This is assumed to be a levered beta since this has been registered even if
there is outstanding debt of P1.7B. Compute for the unlevered beta by using this model:
= 0.95 .
[1+ {1-0.36}{1.7/1.5}]
=0.95 / 1.7253 = 0.55
e. How much of the risk measured by beta in “g” above can be attributed to (1) business risk, and (2)
financial leverage risk?
Therefore, the business risk is = 0.55, while the financial leverage risk is = 0.40 (0.95-0.55).

ILLUSTRATIVE PROBLEMS ON EXPECTED RETURNS, BETA, AND RISK PREMIUMS: SET B


1. Use the SML to calculate the required returns.
Securities Expected Returns Beta
A 17.4% 1.29
B 13.8 0.68
C 1.7 -0.86
D (T-bills) 8.0 0.00
Market 15.0 1.00

Hint:
A. Assume kRF = 8%. B. Note that kM = kM is 15%. (Equil.)

2
The inflation adjustment shall cause a change in both the risk-free rate and the old market return.
3
The change in the investors’ behavior in avoiding risk shall cause only the “risk premium” to change.

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C. RPM = kM – kRF = 15% – 8% = 7%.

Required rates of return:


kA = 8.0% + (15.0% – 8.0%)(1.29)
= 8.0% + (7%)(1.29)
= 8.0% + 9.0% = 17.0%.

kM = 8.0% + (7%)(1.00) = 15.0%.


kB = 8.0% + (7%)(0.68) = 12.8%.
kT-bill = 8.0% + (7%)(0.00) = 8.0%.
kC = 8.0% + (7%)(-0.86) = 2.0%.

When the required returns by the investors (i.e. what they demand) is less than what is expected (i.e. “promised”
to them), then the investors can call it a “bargain”, wherein the securities are undervalued.

2. Which of the securities are overvalued? fairly valued?


Securities Expected Required Remarks
Returns returns
A 17.4% 17.0% Undervalued / bargain
Market 15.0 15.0 Fairly valued
B 13.8 12.8 Undervalued /bargain
D(T-bills) 8.0 8.0 Fairly valued
C 1.7 2.0 Overvalued

3. Calculate beta for a portfolio with 50% A Securities and C Securities


bp= Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.

4. How much will be the required return on the A/C portfolio is:
kp = Weighted average k
= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

kp= kRF + (kM – kRF) bp


= 8.0% + (15.0% – 8.0%)(0.22)
= 8.0% + 7%(0.22) = 9.5%.

5. If investors raise inflation expectations by 3%, what would happen to the SML?
INCREASE (PARALLEL)
6. If inflation did not change but risk aversion increased enough to cause the market risk premium to increase by 3
percentage points, what would happen to the SML?
SLOPE IS STEEPER

ILLUSTRATIVE PROBLEMS ON EXPECTED RETURNS, BETA, AND RISK PREMIUMS: SET C


1. Safecorp which owns and operates grocery stores across the Philippines, currently has P50 million in debt and
P100 million in equity outstanding. Its stock has a beta of 1.2. It is planning a leveraged buyout (LBO) , where it
will increase its debt/equity ratio of 8. If the tax rate is 40%, what will the beta of the equity in the firm be after
the LBO?
Unlevered Beta = 1.20 / (1 + (1-0.4) (50/100)) = 0.923076923
New Beta = 0.923 (1 + (1-0.4) (8)) = 5.35

2. Novell which had a market value of equity of P2 billion and a beta of 1.50, announced that it was acquiring
WordPerfect, which had a market value of equity of P 1 billion, and a beta of 1.30. Neither firm had any debt in
its financial structure at the time of the acquisition, and the corporate tax rate was 40%.
a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was financed with equity.
Unlevered Beta for Novell = 1.50 ! Firm has no debt
Unlevered Beta for WordPerfect = 1.30 ! Firm has no debt
Unlevered Beta for Combined Firm = 1.50 (2/(2+1)) + 1.30 (1/(2+1)) = 1.43

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This would be the beta of the combined firm if the deal is all-equity.
b. Assume that Novell had to borrow the P 1 billion to acquire WordPerfect. Estimate the beta after the
acquisition.
If the deal is financed with debt,
New Debt/Equity Ratio = 1/2 = 0.5
New Beta = 1.43 (1 + (1-.4) (0.5)) = 1.86

Therefore, the risk-free rate becomes 7.05% (i.e. 5.8% + 1.25%).


= 7.05% + β {(14.3 + 1.25) – 7.05}
= 7.05% + 0.95{15.55 – 7.05}
= 15.13%
Therefore, the business risk is = 0.55, while the financial leverage risk is = 0.40 (0.95-0.55).

 jrm

Prepared by: Ms. Jackqui R. Moreno, CPA, MBA