Part 2

Risk

CORPORATE FINANCE (PSBV026NABB)

Nóra Felföldi-Szűcs, PhD

Department of Finance, Corvinus
University of Budapest
2021 FALL
 10/25/21

This Course – the structure

Foundations of Corporate Finance
1. Time 2. Risk 3. Analysis
! Utility
! The nature of risk ! Financial Statements
! Correlation & diversification ! Ratios
! Portfolio return and standard
deviations
! Portfolio Theory
! Systematic and issuer-specific
risk
! Capital Asset Pricing Model &
Beta
! Capital Structures
 Part 2.1
Risk: Modern Portfolio Theory

CORPORATE FINANCE (PSBV026NABB)

Nóra Felföldi-Szűcs, PhD

Department of Finance, Corvinus
University of Budapest
2021 FALL
 FNÁ1

Topics Today
Single Asset Risk
Multiple Asset Risk
Utility functions
Modern Portfolio Theory
1. Decision: Capital Allocation
2. Decision: Asset Allocation

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Risk and investors
Which one would an average risk investor choose if the initial investment is the same for the two
opportunities?

• 100.000 USD next year

• 50.000 USD with a probability of 50% or 150.000 USD with a probability of 50% next year

" Investors are risk averse

" required return is higher for risky investments: RISK PREMIUM
" present value of risky cash flows in the future is LOWER

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

Risk in finance 200

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Random Variable for Time Series
Prices or Returns?
Security Prices Security Returns
15%

10%

De-composition 5%
3,000
0%
Feb 92 Jul 97 Jan 03 Jul 08 Dec 13 Jun 19
-5%

Cumulation -10%

(compounding) -15%
300
-20%
Feb 92 Jul 97 Jan 03 Jul 08 Dec 13 Jun 19
S+P 500
S+P 500
We generally use Returns not Prices
 Measuring Risk
VARIATION OF RETURNS (income, price gains) aka PRICE VOLATILITY measures RISK

• NOT using Absolute Deviations from the mean

• very bad math e.g. compounding risk over several time periods

• Variance (average Squared Deviations from the mean)

• better math: Variances ADD
• higher weight for outliers

• Standard Deviation (square-root of the variance)

• a more intuitive measure

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Single Asset Returns: Mean and Variance
Ex Post Ex Ante
Concept Symbol (average ….) (expected…)
n
Mean Return μ, or E(r) 1 ! piri
! ri x
n
1
n
Variance σ2, or Var 1 ! pi (ri − r)̅ 2
! (ri − r)̅ x
2
n
1
Standard Deviation σ, or SD Var Var

Where
pi = probability of a state
ri = return at a certain state
r̅ = mean return
(NB in Statistics, estimates of σ2 and σ are slightly different)
Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Example
Probability Distribution
45%
Event Probability Outcome Squared Expected Squared + 1σ
40% - 1σ
(Utility) Deviation Deviation 35%
i.e. -1.1 i.e. +1.1
A 0.1 1 (1 - 3)2 0.1 x 4 30%

B 0.2 2 (2 - 3)2 0.2 x 1 25%

C 0.4 3 (3 - 3)2 0.4 x 0 20%

15%
D 0.2 4 (4 - 3)2 0.2 x 1
10%
E 0.1 5 (5 - 3)2 0.1 x 4
5%
Expectation all Outcomes (Σ) 3 1.2
0%
0 1 2 3 4 5
i.e. the Variance = 1.2

So the standard deviation ≈ √1.2 = 1.1

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Portfolio risk
In a portfolio, returns add, but risk does NOT add.

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Portfolio risk: Expected return and variance of portfolios
Expected return of a portfolio: equals the weighted average of the elements’ returns, where the
weights are calculated as the portion of their part in the portfolio.
E(r) = Σ ws*rs
Variance of a portfolio:

б² = ΣsΣt ws*wt*Covst = ΣsΣt ws*wt* бs*бt*ρst

• Expected returns are ADDITIVE
• Variances are ADDITIVE
• Standard Deviations NOT additive

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Correlation metrics
• Covariance measures the direction of the (linear) relationship between two variables

• (Linear) Correlation Coefficient, a standardised version of the Covariance, measures strength of the
relationship between two variables :

Ex Post Ex Ante
Concept Symbol (average ….) (expected…)
Cov (A, B), n
Covariance 1 ! pi (riA − r$A) (riB −$
rB)
! (riA − r$A) (riB −$
rB) x
or CovAB n
1
Correlation ρAB CovAB
Coefficient σAσB

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Correlation & Causation
• Intuitively the correlation is the extent that two variables are related to one another
Variable 1 Variable 2
Hours of preparation Exam results
Parents’ height Children’s height
# Sunny days Sugar content of grapes
• Graphically Correlated Monthly Returns
Uncorrelated Returns
4% Last month 6%
3% DJI
2% 4%
1% 2%
0%
-10% -5% -1% 0% 5% 10% 0%
-2% This -10% -5% 0% 5% 10%
-2% S+P
-3% Month
500
-4% -4%
-5%
-6% -6%

BUT Correlation does NOT imply Causation

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
Portfolio variance

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

Combination of two risky assets

Example Correlation Coefficient = .4

Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Standard Deviation = Portfolio = 28.1%
Return = weighted avg = Portfolio = 17.4%
Let’s Add stock New Corp to the portfolio

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Correlation & Causation
• Intuitively the correlation is the extent that two variables are related to one another
Variable 1 Variable 2
Hours of preparation Exam results
Parents’ height Children’s height
# Sunny days Sugar content of grapes
• 2 Examples Correlated Monthly Returns
Uncorrelated Returns
15% Last month 15%
DJI
10% 10%
5% 5%
0% 0%
-20% -10% 0% 10% 20% -20% -10% 0% 10% 20%
-5% This -5%
S+P
-10% Month -10% 500
-15% -15%

-20% -20%

BUT Correlation does NOT imply Causation

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
Correlation – what it looks like

Source: https://en.wikipedia.org/wiki/Correlation_and_dependence

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Two Risky Assets
The volatility of a portfolio depends on the weights of risky assets and their correlation

rA = 10% sA = 20%
rB = 15% sB = 23%

• Combining risky assets reduces volatility, sometimes below both!

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca- Cola and 35% in Reebok. The expected
dollar return on you CC is 10%, the standard deviation of the return is 31.5%, and on Reebok
the expected return is 20%, and the standard deviation is 58.5%.
• What is the expected return on your portfolio?
• What is the standard deviation of your portfolio, if the correlation coefficient is 1?

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Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Portfolio Risk:Solution
The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%.
The expected return on your portfolio is 6.5 + 7.0 = 13.50%.
Portfolio Variance = [(.65) 2 x(31.5) 2 ] + [(.35) 2 x(58.5) 2 ] + 2(.65x.35x 1x31.5x58. 5) = 1,006.1
Standard Deviation: 1,006.1 = 31.7 %

=
34

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Modern Portfolio Theory
Question of the model:
• How do investors construct their portfolios?
• How do they allocate their money between different assets?

Assumptions of the model:

• Risk averse investors
• Rational decisions
Harry Markowitz (1952)
Nobel Prize (1990)
Conclusion: MPT evaluates an asset based not only
• on its expected return and its risk (~standard deviation) but also
• on its relationship with other investment opportunities, and
• on its correlation structure with other assets.

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Portfolio Construction
The decision process of a portfolio construction:
• Capital allocation:
• Asset allocation: the portion of different risky asset classes (shares, corporate bonds,
property)
• Security selection: selection of securites whithin the given asset classes

Investors aim is the construction of optimal portfolio:

• Obtain the highest return
• At the possible lowest level of risk (see risk aversion)
• Utility function of investor: some prefer more risk and more return, but all want to have the
best return at a given level of risk.

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 1. Decision: Allocating Capital
Possible to split investment funds between safe and risky assets
• Risk free asset: T-bills
• Risky asset: stock (or a portfolio)

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Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Capital Allocation Decision
How to define the weights of risky and risk-free parts in the portfolio?

• Assume we have F risk free and P risky subportfolios.

• We are looking for the weights of the optimal portfolio wP*P + (1-wP)*F considering the
preferences of the individual investor.

• The optimal points in the (E(r); б) space define the Capital Allocation Line (CAL)

Min б² = ΣPΣF wP*wF*CovPF

E(rC) = wP*rP + (1-wP)*rF

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Sharpe ratio and the Capital Allocation Line (CAL)

r – rf
Sharpe Ratio, λ = σ
• And the gradient of the Capital Allocation Line i.e. the combinations of a Risk Free and a Risky
Assets

E(r)
CAL

P
rP –rF
rF
F Gradient λ

σ 40

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 CAL – Capital Allocation Line
Investors

U3
E(r) U2
U1 CAL

rF
F

σ
Preferences of investor

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Frontier portfolios I.
Possible portfolios in case of many assets
Minimal standard deviation at a certain level of return.
If only risky assets are in the portfolio:

49

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Efficient portfolios I.
Maximal return at a given level of standard deviation. The investors will choose from these!
If only risky assets are in the portfolio:

50

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Efficient portfolios II.
If there is risk-free asset as well: the efficient portfolios will be on the steepest CAL.
M: the optimal risky portfolio
max. Sharpe-index

51

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Optimal portfolios
Which portfolio will be chosen?
The efficient portfolio, where the utility is highest.

Optimal portfolios for different investors

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Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Utility for finance
- Utility is a function of return and volatility: U(r, 𝜎)
- Utility increases with r, decreases with 𝜎
- Utility is a convex function of portfolios
if A and B are portfolios with returns and sigmas 𝑟! , 𝑟" , 𝜎! , 𝜎"
and the combined portfolio A+B has 𝑟!#" , 𝜎!#"
U(𝑟!#" , 𝜎!#" ) >= U(𝑟! , 𝜎! ) + U(𝑟" , 𝜎" )
- Utility for individuals: marginal benefit of extra wealth decreases with wealth.

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Utility of Uncertainty (and big money)

Utility of expected value of winnings

Utility of uncertainty of
winnings and big money
Expected utility of winnings
(negative)

Source of image: http://i.ytimg.com/vi/tCreeXzCNRc/maxresdefault.jpg

Uncertainty has NEGATIVE utility

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Portfolio Decision-making Model (Markowitz)
1. Determine the possible risk-return combinations

2. Determine the portfolio with minimal standard deviation – frontier portfolios

3. The optimal combination of risky assets – the steepest CAL

4. Determine the whole portfolio by combining the risk-free asset with the optimally-weighted
risky sub-portfolio – moving on the steepest CAL

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD