risk and return measurement for investment decisions
TRANSCRIPT
Risk and Return MeasurementFor
Investment Decisions
7/20/2009 Applied Finance 2
INTRODUCTION
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Risk
Systematic risk
Unsystematic risk
Operating risk
Currency risk
Political risk
Market risk
ReturnCorrelation
Hedging
Portfolio
Beta
Leverage
Diversification
CAPM
Key Terms
Larry’s Riskless Stock Strategy
“No Downside – No Upside”
Utility Stocks
Middle East Crisis
Questioning oneself…
Zero Risk??
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CORE OF THE STORY
Stock with stable earning are low risky then volatile earning
Stock with more stable earning to be underpriced by the market
Stock with more stable earning generate less volatile return for stockholders
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STORY CONTINUED
The Power of Story…
Categorizing Investment Stories…
• Great Companies
• Growth Stocks
• Loser Stocks
Stories for the Risk Seekers…
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RISK DIVERSIFICATION
Diversified Stock → Lesser Risk
Global Diversification
- Investing in Multiple Countries
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Measurement of Volatility in Earnings
1st measure• Stocks that deliver the same earnings
2nd measure
• Shifting towards stable growth earnings
3rd measure• Focuses only on decreasing earnings
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Stable Businesses with No Competition
Assume that you are analyzing a company with
the following cash flows for the next five years.
Assume also that the cost of equity is 13.625%
and the firm can borrow long term at 10%. (The
tax rate for the firm is 50%). The current market
value of equity is $1,073 and the value of debt
outstanding is $800.
Discounted Cash Flow Valuation
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Discounted Cash Flow Valuation
Year Cash Flow (in $) Interest (l-t) (in $)Cash Flow to the Firm (in
$)
1 50 40 90
2 60 40 100
3 68 40 108
4 76.2 40 116.2
5 83.49 40 123.49
Terminal Value 1603.008 2363.008
Method 1: Discount CF to Equity at Cost of Equity to get value of equity
Method 2: Discount CF to Firm at Cost of Capital to get value of firm
Errors??
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Risk Hedging
The manager can leave the firm exposed to risks and assume that its
stockholders in the firm will be able to diversify away the risk…
magnitude of the risk and the impact that it can have on the overall firm’s
earnings and value
extent to which different investments the firm mat have in different parts of
the world may result in diversification of some or a great portion of the risk
degree to which investors in the firm can diversify away the risk on their own
by holding portfolios that include stocks that are affected both positively and
negatively by exchange rate movements
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Combining a Hedge Fund with Equities
Suggestion is that all so-called
market neutral hedge funds should
be required to report in detail on
their correlations with major asset
classes. That way, investors would
have a reliable piece of
information to help them decide
whether they are truly likely to
gain significant benefits from
something claiming to be a hedge
fund.
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The Payoff To Risk Management
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Risk and Return Portfolio Analysis
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Table: 1.1 Calculating the Mean Absolute Deviation
Event P Return % E(Return) σ P*σ Average Absolute Deviation
(1) (2) (3) (4)=(2)*(3) (5) (6)=(2)*(5) (7)=|(6)|
A .20 -10 -2.0 -25.0 -5.0 5.0
B .40 25 10.0 10.0 4.0 4.0
C .30 20 6.0 5.0 1.5 1.5
D .10 10 -1.0 -5.0 -0.5 0.5
Total 15.0 0 10.0
Table: 1.2 Calculating the Standard Deviation
Event P σ σ2 Weighted Average σ2
(1) (2) (3) (4)=(3)2 (5)= (2)*(4)
a .20 -25.0 625.0 125.0
b .40 10.0 100.0 40.0
c .30 5.0 25.0 7.5
d .10 -5.0 25.0 2.4
Variation=Weighted Average σ2= 175.0
Standard Deviation=Square Root of σ2= 13.2287
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Table 2.1 Returns in Portfolio and Security Risks
Event P Return on Security X Return on Security Y Return on Portfolio
(1) (2) (3) (4) (5)=(3)*0.6 + (4)*0.4
a 0.20 -10% 5.0% -4.0%
b 0.40 25 30.0 27.0
c 0.30 20 20.0 20.0
d 0.10 10 10.0 10.0
Table: 2.2 Summary Measures
Security X Security Y Portfolio
Expected Return 15.0 20.0 17.0
Variance of Return 175.0 95.0 135.8
Standard Deviation of Return 13.72287 9.7468 11.65
Table: 2.3 Covariance and Correlation
Event P σX σYProduct of Deviation Probability Times Product of Deviation
(1) (2) (3) (4) (5) = (3) * (4) (6) = (2) * (5)
A 0.20 -25.0% -15.0% 375 75.0
B 0.40 25 10.0 100 40.0
C 0.30 20 0 0 0
D 0.10 10 100 50 50.0
Covariance 120.0
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Table:3.1 Two Securities with equal returns
Event P Return on Security X% Return on Security Y% Return on Portfolio
(1) (2) (3) (4) (5) = (3)X0.6*(4)X0.4
A 0.20 -10.0 -10.0 -10.0
B 0.40 25.0 25.0 25.0
C 0.30 20.0 20.0 20.0
D 0.10 10.0 10.0 10.0
Expected Return 15.0 15.0 15.0
Variance of Return 175.0 175.0 175.0
Standard Deviation of Return 13.2287 13.2287 13.2287
Table: 3.2 Two Securities with Offsetting returns
Event P Return on Security X% Return on Security Y% Return on Portfolio
(1) (2) (3) (4) (5)
a (2) (3) 40.0 10.0
b 0.20 -10.0 -20.0 10.0
c 0.40 25.0 -5.0 10.0
d 0.30 20.0 10.0 10.0
Expected Return (%) 15.0 -0.5 10.0
Variance of Return 175.0 37.47 0
Standard Deviation 13.2287 6.1217 0
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Conclusion
Slowing Up of the Problems
Alternative Measures of Earning Stability
Price Earning
Ratio
Expected Growth
Rate
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References
Books:
Financial Management; by: Paresh Shah
Investment Management; by: V.K. Bhalla
Investment Fables; by: Aswath Damodaran
Practical Financial Modeling; by: Jonathan Swan
In the Wonderland of Investment; by: AN Shanbag
Valuation; by: McKinesy & Co., Inc;Tom Copland; TimKoller; Jack Murrin
The Intelligent Investor; by: Graham
Web Links:
http://www.wikipedia.com
http://www.investopedia.com
http://www.wikianswers.com
http://www.investorwords.com
7/20/2009 21Applied Finance
Articles:
Hedge Funds: Risk and Return; by: Burton G. Malkiel and Atanu Saha; in:
Financial Analysts Journal Volume 61 • Number 6 ©2005, CFA Institute