Chapter 10 Fin 325, Section 04 - Spring 2010 Washington State University

1. Estimating Risk and Return Chapter 10 Fin 325, Section 04 - Spring 2010 Washington State University

2. 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

3. 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)

4. Example:

5. We can also use a distribution of returns to characterize risk Example:

6. 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. Firm-specific risk can be diversified away

7. Table 10.1 illustrates the historic market risk premium over time • Return on S&P 500 Index minus the T-bill rate

8. 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 NobelPrize in Economic Sciences in 1990

9. 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

11. 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)

12. 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

14. 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

15. 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)

17. 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%

18. 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

19. 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 (y-axis) versus the overall market (on the x-axis). The slope would be the beta.

20. 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

21. 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

22. 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

23. 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

25. 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

26. 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 semi-strong form levels

27. 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

28. 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 Wal-Mart will grow at a constant 12 percent. i = $1.00/48 + 0.12 = 14.1 percent