Managerial

Finance FIN300
Fall 2021

Finance Department
 Managerial Finance: Course Map
Part 2: Fixed Income
Part 1: The Company
Securities: An Part 3: Shares and Part 4: Projects and Part 6: Financial
and its reporting
Introduction to Derivatives their Valuation Decisions
environment
Valuation

Chapter 16:
Chapter 1: Central
Distribution to
Concepts in Finance Chapter 4: The Time Chapter 6: Risk and Chapter 10: Project
Shareholders:
and Financial Value of money Return Cost of Capital
Dividends and
Management
Repurchases

Chapter 2:
Chapter 18: Public and
Understanding Chapter 11: Capital
Chapter 5: Bonds and Chapter 8: Valuation of Private Financing: Initial
Financial Statements Budgeting: Evaluation
Bond Management Shares and Companies Offerings and Seasoned
Part 1: The Overall of Cash Flows
Offerings
Structure

Chapter 3:
Understanding
Financial Statements
Part 2: Analyzing and
Managing the Accounts
 Part 3: Shares and Derivatives

Chapter 6 Risk and Return

Reference in textbook
pp. 159-182
 Outline
• Introduction with a Caution
• Defining a Return
• Measuring Risk and Return for Discrete
Distributions
• Using Historical Data to Estimate Risk
• Risk in a Portfolio Context
 1. Introduction
• Finance has been founded on modelling risk and return.

• But, modelling risk and return is subject to a few constraints:

• The estimate of the share price is subjective
• The required rate of return (interest rate) is not always accurate

• Nevertheless, models that we are working with today are the best we
currently have
 2. Defining a Return
• Investment returns measure the financial results of an
investment

• Returns may be historical or prospective (anticipated)

• Returns can be expressed in:

• Money terms.
• Percentage terms.
 2. Defining a Return
Application:
You buy ten shares for 1000 euros. The share pays no dividends but at the end
of one year you will sell the share for 1100 euros.

Euro return = amount to be received (end value) – amount invested (start value)
Euro return = 1100 – 1000 = 100 euros

end value−start value end value

Rate of return = = −1
start value start value

1100−1000
Rate of return = = 0.1 𝑜𝑟 10%
1000
 3. Measuring Risk: The Single-Investment
Case
• Investment risk is exposure to the chance of earning less than
expected.

• The greater the chance of a return far below the expected

return, the greater the risk.
 3. Measuring Risk: The Single-Investment
Case

Weights
are set by 𝐸 𝑟
= 0.1 × −14%
human
+ 0.2 × −4%
judgement + 0.4 × 6%
+ 0.2 × 16%
+ 0.1 × 26%
= 6%
Scenarios
that an
investor
might face

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐸 𝑟 = 𝑝1 𝑟1 + 𝑝2 𝑟2 + ⋯ + 𝑝𝑛 𝑟𝑛

 3. Measuring Risk: The Single-Investment
Case
• What is the stand-alone risk? It is the risk of each asset held by itself.

• For a single asset, the stand-along risk is measured by its standard

deviation: dispersion of possible outcomes. In other words, it provides
an idea to how far above or below the expected value the actual value
is likely to be.

• The standard deviation σ is equal to the square root of the variance σ2

 3. Measuring Risk: The Single-Investment
Case
Variance formula
𝑛
2
𝜎2 = ෍ 𝑝𝑖 𝑟𝑖 − 𝐸 𝑟
𝑖=1
Standard deviation formula
𝑛
2
𝜎= ෍ 𝑝𝑖 𝑟𝑖 − 𝐸 𝑟
𝑖=1
3. Measuring Risk: The Single-Investment
Case
Scenario Probability Return 𝒑𝒊 𝒓𝒊 𝒓−𝑬 𝒓 𝟐 𝟐
𝒓−𝑬 𝒓 𝒑𝒊 𝒓 − 𝑬 𝒓

Worst case 0.10 -14% 0.1 × −14%

Poor case 0.20 -4% 0.2 × −4%
Most likely 0.40 +6% 0.4 × 6%
Good case 0.20 16% 0.2 × 16%
Best case 0.10 26% 0.1 × 26%
𝑬 𝒓 =6%

Variance = 0.012
Standard deviation = 0.1095 or 10.95%
This can be interpreted as an average spread around the expected value
 3. Measuring Risk: The Single-Investment
Case
• Investments with bigger standard deviations have more risk.

• High risk does not mean you should reject the investment, but:
• You should know the risk before investing
• You should expect a higher return as compensation for bearing the risk.
 4. Using Historical Data to Estimate Risk
• Analysts often use discrete outcomes to analyze risk for projects.
• But for investments, most analysts normally use historical data rather than
discrete forecasts to estimate an investment’s risk unless it is a very special
situation.
• Most analysts use:
• 48 to 60 months of monthly data, or
• 52 weeks of weekly data, or
• Shorter period using daily data.
• Use annual returns here for sake of simplicity.
 4. Using Historical Data to Estimate Risk:
Formulas
𝑛
1 2 2
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑉𝐴𝑅 = 𝜎 = ෍ 𝑟𝑖 − 𝑟ҧ
𝑛−1
𝑖=1

𝑛
1 2
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑆𝑇𝐷𝐸𝑉 = 𝜎 = ෍ 𝑟𝑖 − 𝑟ҧ
𝑛−1
𝑖=1

Where 𝑟𝑖 is the sample set of 𝑛 past returns; 𝑟ҧ is the average or mean of

the sample set of past returns.
 4.1 Calculating the Risk of a Single
Portfolio
Year 𝒓𝑨 𝒓𝑩

2011 -0.18 -0.24

2012 0.44 0.24

2013 -0.22 -0.04

2014 0.22 0.08

2015 0.34 0.56

𝑟ഥ𝐴 = 0.12 𝑟ഥ𝐵 = 0.12

 4.1 Calculating the Risk of a Single
Investment
Year 𝒓𝑨 𝒓𝑩 𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵

2011 -0.18 -0.24 -0.3 -0.36

2012 0.44 0.24 0.32 0.12

2013 -0.22 -0.04 0.34 -0.16

2014 0.22 0.08 0.1 -0.04

2015 0.34 0.56 0.12 0.44

𝑟ഥ𝐴 = 0.12 𝑟ഥ𝐵 = 0.12

 4.1 Calculating the Risk of a Single
Investment
Year 𝒓𝑨 𝒓𝑩 𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵 𝟐 𝟐
𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵

2011 -0.18 -0.24 -0.3 -0.36 0.09 0.1296

Which share is riskier to
invest in?
2012 0.44 0.24 0.32 0.12 0.1024 0.0144

Answer: the one with the

2013 -0.22 -0.04 0.34 -0.16 0.1156 0.0256 higher standard
deviation, that is A. But
2014 0.22 0.08 0.1 -0.04 0.01 0.0016 the risk levels are close.

2015 0.34 0.56 0.22 0.44 0.0484 0.1936 What if I want invest in
both, what would be the
𝑟ഥ𝐴 = 0.12 𝑟ഥ𝐵 = 0.12 0.3664 0.3648 risk?

0.3664 0.3648
𝜎𝐴2 = = 0.0916 𝜎𝐴 = 0.0916 = 0.3026 𝜎𝐵2 = = 0.0912 𝜎𝐵 = 0.0912 = 0.3019
5−1 5−1
 5. Risk in a Portfolio Context
5.1 Creating a Portfolio
• A portfolio is a collection of assets.
• The weight of an asset is the percentage of the portfolio’s total value that is
invested in the asset.
• The weights assigned to assets should sum to 1.
• If we have a portfolio of 𝑛 shares, the average return of the portfolio for a
particular period is:
𝐸 𝑟 = 𝑤1 𝑟1 + 𝑤2 𝑟2 + ⋯ + 𝑤𝑛 𝑟𝑛
𝑛

𝐸 𝑟 = ෍ 𝑤𝑖 𝑟𝑖
𝑖=1
 5.2 Calculating the Risk of a Portfolio
Year 𝒓𝑨 𝒓𝑩 𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵 𝟐 𝟐 𝒘𝑨 𝒓𝑨
𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵
+ 𝒘𝑩 𝒓𝑩
2011 -0.18 -0.24 -0.3 -0.36 0.09 0.1296 -0.21

2012 0.44 0.24 0.32 0.12 0.1024 0.0144 0.34

2013 -0.22 -0.04 0.34 -0.16 0.1156 0.0256 -0.13

2014 0.22 0.08 0.1 -0.04 0.01 0.0016 0.15

2015 0.34 0.56 0.12 0.44 0.0484 0.1936 0.45

𝑟ഥ𝐴 = 0.12 𝑟ഥ𝐵 = 0.12 0.3664 0.3648 𝐸 𝑟

= 0.12

It is assumed that the investor hold a portfolio consisting of 50% of share A and 50% of share B
 5.2 Calculating the Risk of a Portfolio
Year 𝒓𝑨 𝒓𝑩 𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵 𝟐 𝟐 𝒘𝑨 𝒓𝑨 𝒓−𝑬 𝒓 𝟐
𝒓𝑨 − 𝑟ഥ𝐴 𝒓𝑩 − 𝑟ഥ𝐵 𝒓−𝑬 𝒓
+ 𝒘𝑩 𝒓𝑩
2011 -0.18 -0.24 -0.3 -0.36 0.09 0.1296 -0.21 -0.33 0.1089

2012 0.44 0.24 0.32 0.12 0.1024 0.0144 0.34 0.22 0.0484

2013 -0.22 -0.04 0.34 -0.16 0.1156 0.0256 -0.13 -0.25 0.0625

2014 0.22 0.08 0.1 -0.04 0.0064 0.0016 0.15 0.03 0.009

2015 0.34 0.56 0.12 0.44 0.3136 0.1936 0.45 0.33 0.1089

𝑟ഥ𝐴 = 0.12 𝑟ഥ𝐵 = 0.12 0.628 0.3648 𝐸 𝑟 0.3377

= 0.12

2 0.3377
𝜎 = = 0.0844 𝜎 = 0.0844 = 0.2905 𝑜𝑟 29.05%
5−1
 5.3 The Capital Asset Pricing Model
• Pronounced ‘cap em model’

• Financial studies showed that the standard deviation of an individual share

does not fully measure the risk associated with the share.

• An asset’s risk has two components: (1) diversifiable risk which can be
eliminated by diversification, and (2) market risk, which cannot be
eliminated by diversification
• Investors must be compensated for bearing the market risk

• How to model? CAPM

 5.3 The Capital Asset Pricing Model
• According to CAPM, the expected return of an investment is equal to:

𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝐸 𝑟𝑚 − 𝑟𝑓
Where
• 𝑟𝑓 is the risk free return. It is usually the return on treasury bonds.
• 𝛽𝑖 is a coefficient that indicates whether an investment is more and less “volatile”
than the market as a whole. The measured risk is known as systematic risk.
• 𝐸 𝑟𝑚 is the market return
• 𝐸 𝑟𝑚 − 𝑟𝑓 is called the market risk premium
• 𝛽𝑖 𝐸 𝑟𝑚 − 𝑟𝑓 is called the share (or asset) risk premium
 5.3 The Capital Asset Pricing Model
• AA industries’ share has a beta of 0.8. The risk-free rate is 4% and the
expected return on the market is 12%. What is the required rate of
return on AA’s share? What is the market risk premium? What the
share risk premium?