Time Value of Money,

Risk, return and the CAPM

2nd meeting (Ch. 4 and 6)

Time value of money

Diversifiable and market risk
The CAPM / SML

Time Value of Money, Risk and Return, and

1 CAPM
 Time Value of Money
Money has a time value. It means that rupiah today is
worth more than rupiah in the future.

It can be expressed in multiple ways:

A dollar today held in savings will grow.

A dollar received in a year is not worth as much as a dollar

received today.

Time Value of Money, Risk and Return, and

5-2 CAPM
 Compound interest vs. Simple interest
Compound Interest – interest generated not only
from initial investment but also from interest

Simple Interest – interest generated only from

initial investment

In finance compound interest is usually used.

Time Value of Money, Risk and Return, and

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 Future value vs. Present value
Future Value – Amount to which an investment will
grow after earning interest.
Present value – the value worth today for an amount
you will receive (or pay) in the future.

We will review the present value since it will be

applied more often in corporate finance.

Time Value of Money, Risk and Return, and

4 CAPM
 Present values (PV)
Some cases often found in corporate
finance;
PV of multiple cash flows
PV of Annuity;
Ordinary annuity
Annuity due
Perpetuity

Time Value of Money, Risk and Return, and

5 CAPM
 PV of Multiple CF:
Drawing time lines; CF1 = Rp100, CF2 = Rp75, and CF3
= Rp50

Uneven cash flow stream

0 1 2 3
10%

PV=? 100 75 50

Can you identify, in real world, what situation

usually involves such CF?
Time Value of Money, Risk and Return, and
6 CAPM
 What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
i%

CF CF CF
Annuity Due
0 1 2 3
i%

CF CF CF
Time Value of Money, Risk and Return, and
7 CAPM
 The timing is different but the number of CF is the
same
Slide 7 shows that;
The CF is identical for each period. That is, CF1 = CF2 =
CF3 = CFn = CF
The CF of ordinary annuity occur at the end of the period,
but for annuity due is at the beginning of the period.
However, the number of CF is identical, that is, 3 times.
The PV of annuity due is higher.

In real world, what situation usually involves such

CF?
Time Value of Money, Risk and Return, and
8 CAPM
 Perpetuity
Perpetuity is similar to annuity but the n is infinity
(n = ∞)
0 1 2 3 ∞

PV=? CF CF CF CF

Can you identify, in real world, what situation

usually involves such CF?

Time Value of Money, Risk and Return, and

9 CAPM
 Return
The rate of return on an investment can be
calculated as follows:
Amount received - Amount invested
Return 
Amount invested

For example, a stock was bought at a price of

Rp10,000. after one year it paid dividend of Rp500
and sold at the price of Rp11,000. The rate of
return for this investment is:
(500  11,000) - 10,000
Return   15%
10,000

Time Value of Money, Risk and Return, and

10 CAPM
 What is investment risk?
Two types of investment risk
Stand-alone (total) risk
Systematic (market) risk
Stand alone risk is related to the probability of
actual return deviates from the expected return.
The greater the probability, the riskier the
investment.
Systematic risk shows that the relevant riskiness of
a stock is its sensitivity to the market portfolio.

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11 CAPM
 How to measure total risk
 Total risk is measured by standard deviation or variance of
return.
 If we have the probability of occurrence for each return
(remember the statistics course), then;
 Expected return, or E(r) = Σpi ri
 Variance of return, or σ2r = Σpi [ri – E(r)]2
 And standard deviation of return, or σr = √ σ2r

 The following investments (see slide 13) have the same

expected return (=15%), but B has higer total risk (σB =
14.24%; σA = 10.95%). Notice that BI certificate has zero
SD of return, therefore it is called risk free investment.
Time Value of Money, Risk and Return, and
12 CAPM
 Investment alternatives
Economy Probability BI Stock of Stock of
certificate Firm A Firm B
Recession 0.1 9.0% -5.0% -11.0%
Below average 0.2 9.0% 5.0% 2.0%
Average 0.4 9.0% 15.0% 15.0%
Above average 0.2 9.0% 25.0% 28.0%
Boom 0.1 9.0% 35.0% 41.0%
Expected return 9.0% 15.0% 15.0%
σ of return 0% 10.95% 14.24%

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13 CAPM
 Comments on standard deviation as a measure
of risk
 Standard deviation (σ ) measures total, or stand-alone, risk.
i
 The larger σ the lower the probability that actual returns
i
will be closer to expected returns.
 Larger σ is associated with a wider probability distribution
i
of returns.
 Difficult to compare standard deviations, because return
has not been accounted for.

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 Figure 1:
Risk and (Expected) Returns
Expected return
E(R)

A B
0.15

SD
0 0,101 0,142

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 The relationship between risk and return
Figure 1 shows that A is preferred than B (and C is
preferred than B).
But which one is preferred between A and C?
To obtain a formula that explains the relationship
between risk and return, the systematic (market) risk is
used.

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 Diversification reduces risk
But investors do diversify their investments.
Portfolio theory (Harry Markowitz, 1950s) shows
that (1) diversification reduces risk, but (2) risk
cannot be eliminated completely by diversification.
This is due to (1) correlation among investment
returns generally < 1, and (2) all investment
opportunities are affected by the same factor, e.g
market condition.
See ilustration in Excel file
(FinMan_02_Risk_Return_2016_Aug).

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 How diversification reduces risk
Av. SD
0.1200

0.1000

0.0800

Av. SD
0.0600

0.0400

0.0200

0.0000
0 2 4 6 8 10 12

Time Value of Money, Risk and Return, and

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 Correlation matrix of returns
r.AALI r.ASII r.BMRI r.UNVR
r.AALI 1
r.ASII 0.678 1
r.BMRI -0.039 0.338 1
r.UNVR -0.227 0.036 0.496 1

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 Addition of a stock reduces risk but cannot
completely eliminate it
 σp decreases as stocks added, because they would not be perfectly
correlated with the existing portfolio.
 Eventually the diversification benefits of adding more stocks dissipates
(after about 20 stocks).
σ(%)
company specific (unsystematic) risk
stand alone (total) risk, σp

market (systematic) risk

0 20 #stocks in portfolio

Time Value of Money, Risk and Return, and

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 Breaking down sources of risk
Stand-alone risk = Market risk + Firm-specific risk

Market risk – portion of a security’s stand-alone

risk that cannot be eliminated through
diversification. Measured by beta.
Firm-specific risk – portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.
Therefore the relevant measure of risk is market
risk (beta) of investment

Time Value of Money, Risk and Return, and

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 Diversification cannot completely eliminate
risk
Why?
Because all stocks are affected by the same
factor, that is market.
Consequency;
Unsystematic risk is not relevant to measure
risk, only systematic (market) risk that relevant.
How to measure market risk?
Market risk measures sensitivity of changes in
stock price due to changes in market. The
parameter is called beta (β).

Time Value of Money, Risk and Return, and

22 CAPM
 How to measure beta (β)?
Statistically beta is coefficient of excess return of a
stock to excess return of market. (See excel file
FinMan_02_Beta_2016_Aug)

Time Value of Money, Risk and Return, and

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 Capital Asset Pricing Model (CAPM)
(Sharpe, 1960s)
 Because risk now is measured by β, the relationship
between expected return [E(r)] and risk (β) can be
expressed with β as horizontal axis, and E(r) as vertical
axis.
 Two investment opportunities, i.e risk free investment ,
with βf = 0 and rate of return = rf, and market portfolio with
βM = 1 and rate of return of E(rM), can be shown in the
figure.
 The line that shows the relationship between beta and
ecpected return is termed as Security Market Line (SML).

Time Value of Money, Risk and Return, and

24 CAPM
 Security Market Line (SML)

E(r)

SML

E(rM) M

rf

β
0 βM = 1.0

Time Value of Money, Risk and Return, and

25 CAPM
 SML equation
 The SML can be expressed as;
 E(ri) = rf + [E(rM) - rf]βi

 Brigham et.al uses the following notations

 ri = E(ri) = required rate of return for investment i.
 rRF = rf = risk free rate of return.
 rM = E(rM) = risk of return of market portfolio.
 βi = systematic risk of investment i.

 [E(rM) - rf] measures market risk premium, which

empirically around 4 – 8% annually. Fernandez et. al
(2014) found that on the average market risk premium in
Indonesia in 2014 is 7.9%.
Time Value of Money, Risk and Return, and
26 CAPM
 Illustrating SML
 Suppose market risk premium or [E(rM) - rf] = 6%.
 Risk free, represented by SBI, rf = 9%
 If βASII = 1,40 (see excel file) then
 E(rASII) = 9% + 1,4 (6%) = 17,4%
 If βAALI = 1,61 (see excel file) then
 E(rAALI) = 9% + 1,61 (6%) = 18,66%

Checking your understanding:

 For the next meeting, by using the method as illustrated in excel, estimate
AALI and ASII betas for the year 2015. Use BI rate of 7,5% per annum or
0,625% per month.
Time Value of Money, Risk and Return, and
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 Factors that change the SML
Change of risk free (r )
f
SML moves upward (downward) if r increases
f
(decreases)
Change of market risk premium [MRP]
If MRP increases (due to the increase of market
uncertainty that lead to the increase of investors’ risk
aversion)then the MRP slope increases.
Similar reason applies for the decrease of market
uncertainty.

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 Tests and critiques of CAPM
 The CAPM has been tested extensively. Some results support
the model others do not
 Statistical tests have problems that make verification almost
impossible.
 CAPM/SML concepts are based upon expectations, but betas
are calculated using historical data. A company’s historical data
may not reflect investors’ expectations about future riskiness.
 Some argue that there are additional risk factors, other than the
market risk premium, that must be considered.
ki = kRF + (kM – kRF) βi + ???
 To accomodate the critiques the following models have been
developed, i.e Extension of CAPM, Arbitrage Pricing Model,
Three factors model, etc.
 In practice, however, the model is still applied extensively

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