BU7506 — Corporate Finance

Lecture 4 Slides

Caroline Kirrane, CFA, MBA

Deconstructing Finance
20th October 2023
 Agenda
– Efficient Market Hypothesis
– Risk and return
– Portfolio Theory and CAPM
– GFC

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 What is a Market?

Price Discovery

Supply vs
Demand

Competition

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 What is an Efficient Market?

Prices fully reflect

Efficient all available
information

Prices reflect only

Inefficient some information
but not all

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 Implications of Efficient Markets
• Because information is reflected in prices
immediately, investors should only expect to
Returns obtain a normal rate of return.

• Firms should expect to receive fair value for

securities that they sell. Fair means that the price
Valuations they receive from issuing securities is the present
value.

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 What Efficient Markets Look Like

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 Efficient Capital Markets
Investor Rationality

Investors react rationally to all new

information.

Independent Deviations from Rationality

Many individuals are as irrationally optimistic

as they are rationally optimistic.

Arbitrage

Irrational investor behaviour is completely

offset by the trading of rational arbitrageurs.

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 Forms of Market Efficiency
• Past Prices
Weak Form Wea
k

Semi-Strong
Form Semi
• Public
- Information
Stron
Strong Form g

• All
Stron Information
g

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 Common Misconceptions
• Wrong!
Dart throwing just as • Investors still have to worry about risk and
effective as stock picking diversification.

• Wrong!
Price fluctuations are • Prices are random because new information is released
predictable randomly.

Markets can’t be efficient • Wrong!

because only a subset of • Only a subset of investors are needed to take advantage
shareholders trade of arbitrage opportunities.

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 Risk and Return
Systematic
Risk

Total Risk

Unsystematic
Risk

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 Systematic Risk
– Risk inherent to market, undiversifiable, market risk or volatility risk
– Cannot be mitigated by diversification
– Can be mitigated by hedging or good asset allocation strategies
– Underlies other risks like industry risk
– Incorporates interest rate risk, inflation, recession, war, major economic
changes
– Affects overall market but not equally!
– Measured by Beta – responsiveness of stock’s return to market movements

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 Unsystematic Risk
– Nonsystematic risk, specific risk, diversifiable risk, residual risk, unique risk,
asset-specific risk (stock-specific)
– Can be reduced through diversification
– Examples: new large competitor, regulation, management changes, product
recall, strikes, legal proceedings, natural disasters, flawed business model,
liquidity issues
– Types/Categories: business, financial, operational, strategic, legal and
regulatory
– Subtract systematic risk from total risk

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 Risk and Return
• The return an individual expects
Expected Return a security to earn over a period

• Volatility of a security’s returns

Variance/Standard
Deviation

• The relationship between

Covariance/Correlation returns of two securities

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 Risk Premium

Risk premium = Expected return minus risk free rate

Aka: excess return on risky asset

Why does this make sense?

What does this tell us about
risk vs reward?

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 Expected Return and Variance
– Predicted average return of an asset
– Can use probability weighted distribution to predict returns

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 Expected Return and Variance

Expected Return
0.20  0.10  0.30  0.50
 0.175  17.5%  RA
4
0.05  0.20  0.12  0.09
 0.055  5.5%  RB
4
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 Expected Return and Variance

Expected Return
0.20  0.10  0.30  0.50
 0.175  17.5%  RA
4
0.05  0.20  0.12  0.09
What assumption is being  0.055  could
How  model
5.5%this RB be
made here? 4 improved?

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 Expected Return and Variance
– Variance is average of the squared differences (deviations) between actual
returns and expected returns
– Why squared?
– Mathematically better – otherwise average is just zero

=
n-1

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 Expected Return and Variance

Variance Supertech
Var(RA) = (-0.2 - 0.175)2 + (0.1 - 0.175)2 + (0.3 - 0.175)2 + (0.5 - 0.175)2
4
= 0.140625 + 0.005625 + 0.015625 + 0.105625
4
= 0.2675
4 = 0.066875
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 Expected Return and Variance

Variance Slowburn
Var(RB) = (0.05 - 0.055)2 + (0.2 - 0.055)2 + (-0.12 - 0.055)2 + (0.09 - 0.055)2
4
= 0.000025 + 0.021025 + 0.030625 + 0.001225
4
= 0.0529
4 = 0.013225
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 Variance and Standard Deviation
– Standard deviation is the square root of variance
• Variance is average of the squared differences between actual returns
and expected returns (deviation)
– More easily understood than variance because it’s on a more familiar scale
(same scale as returns)
– Low standard deviation = values more likely to be close to mean value
– High standard deviation = values more likely to be further from mean value

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 Variance and Standard Deviation

Variance and Standard Deviation

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 Covariance and Correlation
– Covariance is the average of the product of the deviations (differences)
from expected returns for each stock in each period

=
n-1

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 Covariance and Correlation

Covariance
Cov(RA, RB) = (-0.2 - 0.175) (0.05 - 0.055) + (0.1 - 0.175)(0.2 - 0.055) +
(0.3 - 0.175) (-0.12 - 0.055)+ (0.5 - 0.175) (0.09 - 0.055)
4
= 0.001875 – 0.010875 - 0.021875 + 0.011375
4
= -0.0195
4 = -0.004875
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 Covariance and Correlation
– Correlation standardises covariance into a more understandable number
– Correlations are between -1 and +1
– Correlation is the covariance of two assets divided by the product of their
standard deviations
– When two assets have a correlation of 1, it means they move in similar
standard deviation movements, not necessarily similar absolute movements

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 Covariance and Correlation

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 Covariance and Correlation

Correlation
Corr(RA, RB) = -0.004875
0.2585 * 0.115

= -0.004875
0.0297275

= -0.1639
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 Risk and Return For Portfolios
– Gets more complicated as risk of a portfolio is not just the weighted average
of the standard deviations of component stocks

– WHY?

– Investment theory / financial markets

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 Security Market Line
– The line that results when we plot expected returns vs Beta
– Shows relationship between systematic risk and expected return
– After NPV, arguably most important finance concept

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 Security Market Line
– Imagine we have a market portfolio (all assets) => expected return will be
E(Rm)
– Because it has all assets, it must have a beta of 1
– Visualisation of the CAPM

– SML = E(Rm) – Rf = E(Rm) – Rf

Bm

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 SML

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 SML

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 SML

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 CAPM – Capital Assets Pricing Model
– Rearranges SML to:

E(Ri) = Rf + B (Rm – Rf)

Time Value of Money Market Risk Premium

Asset Beta

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 CAPM Uses
– Used extensively to price risk
– Used to estimate expected returns from assets given required return
– Used to back out cost of capital (equity) for company
– Useful for comparison of securities
– Used to value stocks and portfolios

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 Challenges to CAPM
– Uses broad market indices as “market portfolio” is unobservable (Rolls)
– Fama French – Five-Factor-Model
• Beta – market risk
• Size – smaller cap stocks earn higher return than higher cap stocks
• Value – low p/b stocks outperform high p/b stocks
• Profitability – high operating profit margin perform better
• Investment – high asset growth stocks have lower returns

– Arbitrage Pricing Theory – multi-factor model => asset returns predicted

using linear relationship between asset’s expected returns and
macroeconomic variables

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 Global Financial Crisis
– 2007 – 2008 – worst global recession since 1929 Great Depression
– Predatory lending practices (sub-prime mortgages), high risk concentrations
at banks, housing bubble burst
– Derivatives, particularly sub-prime mortgages were re-rated in market
– September 2008 Lehman Brothers collapse sparked a banking crisis
– Preconditions: repeal of parts of Glass-Steagall 1999
– Regulatory failure – markets, credit rating agencies
– Sparked European debt crisis

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 Global Financial Crisis
– All 3 major Icelandic banks collapsed
– Greek government bond crisis late 2009 (2009 gov debt +11% vs reported)
– IMF bailout loans 2010, 2012 and 2015
– Irish debt crisis – bank guarantee issued late 2008, Jan 2009 Anglo-Irish
nationalised
– Bank solvency questioned, declines in credit, money market freezes in late
2008
– Global economies slowed, credit tightened, international trade declined,
housing markets declined, unemployed soared, businesses failed
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 Global Financial Crisis
– Deleveraging accelerated the crisis and unveiled cross-correlation of banks
– Central bank response – stimulus – quantitative easing
– “buyer of last resort”
– Goal: pump lending money back into broken/frozen banking systems
– Why? Nowhere down for rates to go
– Inflation rates were low or negative = usual CB tools didn’t work
– Effect – makes money very cheap

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 Global Financial Crisis

THEMES?

FINANCE CONCEPTS?

FINANCE LESSONS?

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Thank You