FIN2014 Lecture 7

FINANCIAL Introduction to risk & return: Capital Asset

Pricing Model
MANAGEMENT
 Recap from previous lecture(s)

• We have learned how to spend money via capital investment decisions, now
we learn how to raise it.

• There are two types of capital a firm can raise

• Equity (shares)
Investors
• Debt (bonds)

• In this lecture, we focus on equity capital using capital asset pricing model
 Learning Objectives

1. Understand the concept of risk and return

2. Be able to describe and understand risk premium
3. Be able to compare and contrast between unsystematic risk and systematic risk
4. Discuss how Beta can be used to measure the systematic risk of a security
5. Use the Capital Asset Pricing Model to calculate the expected return for a risky
security
6. Understand the relationship between CAPM and NPV
 Firm’s interaction with the market: measuring cost of equity

• One of the reason shares are more difficult to value than bond is because rate of return
required by the market is not easily observed, so we use cost of equity (Recall Lecture 3)

• In this lecture, we use Capital Asset Pricing Model (CAPM) to obtain the cost of
equity/return on equity
• This Nobel-prize winning theory contains many important intuition to help think
through the cost of equity
• The amount equity investor charge for risk has two components: the quantity of risk of
a given stock and the price of that risk. It also considers compensating additional risk
with risk premiums

But how do we think about risk in this setting?

 1. Introduction to risk & return

2. Compensation for risk: Risk Premium

3. Identifying types of risk: Unsystematic & Investor’s

systematic risk perspective

4. Eliminating unsystematic risk through

Lecture portfolio diversification
structure
5. Measure remainder (systematic) risk:
Introducing Beta

6. Put together: Capital Asset Pricing Model

7.Application: CAPM and NPV

Introduction to risk Risk and return
& return

• Basic intuition  The high risk, high return

• What determines the required rate of return for an investor? The required rate of return
depends on the risk of an investment.

• Risk refers to the variability of possible returns associated with a given investment
• E.g., Future cash flows are not promised & uncertain (variability = risk)

•So, how do we know one investment is riskier than another? What returns should we expect from
financial assets, and what are the risks of such investments?

•This perspective is important to understand how to analyze and value risky investment projects
Introduction to risk &
return Common measures for risk
• Risk and return is a main consideration in investments.
• Investors must compare the expected return of an asset with the risk associated with it
• Therefore, high returns are required to compensate for high risk
•In Finance, volatility is used as one of the ways to measure the risk of the security

𝑛
• Variance 𝜎 =∑ ( 𝑅𝑖 − 𝑅
2 ∗ 2
) 𝜋
𝑖 =1

• Standard deviation
𝜎 =√𝜎 2
Introduction to risk
& return The relationship between risk & return

These financial assets offers

different degree of risks.
From Treasury bills (lowest risk,
lowest returns), to Small stocks
(highest risk, highest return)
Compensation for
risk: Risk Premium Compensating for risk: Risk Premium

• Risk Premium is described as the rate of return on an investment above the risk-free rate

• Compare securities average returns with one another. One such comparison involves government-
issued securities. These are free from much of the variability.
• E.g. government-issued securities, Treasury bills is short-term and virtually free of any default
over its short life. Thus, the rate of return on such debt is risk-free, and it will be used as the
benchmark.

• For example : A comparison involves the risk-free returns on Treasury bills and the very risky
returns on common stocks. The difference between these two can be interpreted as a measure of
excess return on the average risky asset

• It is called “excess” return because it is the additional return an investor earns by moving from a
relatively risk-free investment to a risky one.
• Because it can be interpreted as a reward for bearing risk, it is called risk premium
Compensation for
risk: Risk Premium Example: Average annual returns and risk premiums

Investment Average returns Risk Premium

Large-company stocks 12.3% 8.5%
Small-company stocks 17.4% 13.6%
Long-term corporate 6.2% 2.4%
bonds
Long-term government 5.8% 2.0%
bonds
U.S Treasury bills 3.8% 0%

The risk premium on Treasury bills is shown as zero because they are
assumed to be riskless
 Identifying types of
risk: Unsystematic & Risk: Systematic & Unsystematic risk
systematic risk

• The unanticipated part of the return (also known as uncertainty), that portion resulting from
surprises, is the true risk of any investment. After all, if we always receive what we expect, then
the investment is perfectly predictable and, by definition, risk-free.
• In other words, the risk of owning an asset comes from surprises – unanticipated events.

• There are important differences between the types of risk.

• We will distinguish between these two types of events because, as we will see, they have
different implications.
 Identifying types of
risk: Unsystematic & Risk: Unsystematic risk
systematic risk

Unsystematic risk
• An unsystematic risk is one that affects a single asset or small group assets. Because the
risks are unique to individual companies or assets, they are sometimes called
idiosyncratic or asset-specific risk
• For example: Company scandal, CEO retirement
• In an investment portfolio, this risk can be diversified away
 Identifying types of
risk: Unsystematic &
systematic risk
Systematic risk

• A systematic risk is one that influences a large number of assets, each to a greater or
lesser extent. Because systematic risks have marketwide effects, they are sometimes
called market risk.
• Systematic risk concerns uncertainties about general economic conditions (i.e., GDP,
interest rates, inflation). These conditions affect nearly all companies to some degree.
• For example, an unanticipated increase in inflation affects wages and the costs of the
supplies that companies buy – it affects the value of the assets that companies own;
and the it affects the price at which companies sell their products
• Forces such as these, to which all companies are susceptible, are the essence of
systematic risk.
• Therefore, this risk cannot be diversified away
 Eliminating
unsystematic risk How does an investor manage unsystematic risk?
through portfolio
diversification

• Diversification is a process where securities are allocated in way that reduces variability (risk) of an
individual security

Combining a number of
securities Risk
in a portfolio
As the investors’ portfolio gets
By increasing the size of investors’ portfolio by bigger, the risk is going to
considering different types of investments, it average out to eliminate
reduce unsystematic risk. unsystematic risk

When portfolio contains stocks of different companies in different sectors, stock prices will
fluctuate differently. Investing across different sectors reduces the probability of an investor’s
losing significant amount of money. In this case, diversification benefits are achieved
 Eliminating
unsystematic risk
through portfolio How much diversification is possible?
diversification
Portfolio risk

Unsystematic risk By adding more shares into the In a well-diversified portfolio,

Diversifiable risk portfolio, the volatility (standard standard deviation becomes
deviation) averages out, and we can irrelevant
eliminate unsystematic risk

Non-diversifiable risk Systematic risk/market risk

1 20 No. of different shares

 Eliminating
unsystematic risk
through portfolio Correlation and diversification
diversification

• The amount of risk is eliminated in a portfolio depends on the degree to which stocks face
common risk and their prices move together

•To find the risk of a portfolio, investor must know the degree to which stock returns move
together
• Statistical measure: Correlation – represents how strongly two random variables move
together
 Eliminating
unsystematic risk
through portfolio Correlation and diversification
diversification

• When it comes to diversified portfolio, correlation represents the degree of relationship

between the price movements of different assets included in the portfolio.
Example: Choose stocks from
• To achieve diversification benefits (averaging out volatility), ideally two variables should different industries (e.g.,
McDonalds & Intel) so that the
move in opposite directions (negatively correlated; when price of one stock decreases, assets move in opposite
other stock price rises), only then risk reduction are achieved. directions

• When assets in portfolio (e.g. Microsoft and Dell) move in the same direction (perfect
positive correlation), risk is not reduced
What to do with the
remaining risk? Diversification and systematic risk

• We have seen that unsystematic risk can be eliminated by diversifying.

• Systematic risk cannot be diversified away because it affects almost all assets to some degree.
As a result, no matter how many assets an investor puts in a portfolio or how well diversified
the portfolio is, the systematic risk does not go away
• In a well-diversified portfolio, all the of the risk that remains is systematic
Measure remainder
(systematic) risk:
Introducing Beta
The systematic risk principle

• As discussed earlier, we know there that there is a reward for bearing risk.
• The systematic risk principle states that the reward for bearing risk depends only on the
systematic risk of an investment.
• The underlying rationale for this principle is because unsystematic risk can be
eliminated at virtually no cost (by diversifying), there is no reward for bearing it. In
other words, the market does not reward risk that are borne unnecessarily.
• Therefore, no matter how much total risk an asset has, only the systematic risk
portion is relevant in determining the expected return and its risk premium
Summary
To summarize

Total Risk

Unsystematic Systematic

• The remainder market risk after

• Firm-specific risk which can be
eliminated through carefully selected
portfolio of assets (standard deviation
is averaged out as no. of securities
increases)
• Diversification reduces variability and
therefore reduces risk
diversifying portfolio
• As this risk cannot be diversified away,
investors are rewarded/compensated for
taking additional unit of risk. This reward
is called risk premium

• No reward for tolerating risk that can

be eliminated
Measure remainder
(systematic) risk:
Introducing Beta A measure of systematic risk: Beta
• Systematic risk is the crucial determinant of an asset’s expected return. We need a way to
measure the level of systematic risk for different investments.
• The measure used is called Beta coefficient, represented as
• tells us how much systematic risk a particular asset has relative to an average asset

• Specifically, measures the sensitivity of an individual stock to the return of the market portfolio

Security’s price is less volatile than the market

Security’s price moves with the market
Security’s price is more volatile than the market
Measure remainder
(systematic) risk:
Introducing Beta Equity beta vs asset beta

• From a shareholders’ perspective, systematic risk is the sum of business risk and financial risk
• Systematic risk can be assessed by the equity beta of the company
• If the company has debt in its capital structure, the systematic risk reflected by the equity
beta will include both business risk and financial risk
• As such, equity beta is often referred to as levered beta
• If the company is financed entirely by equity, systematic risk reflected by equity beta will be
business risk alone, in which can equity beta is also the same as asset beta

Due to the existence of financial risk, we can reasonably expect equity beta to
be higher than asset beta
Measure remainder
(systematic) risk: Beta measures the correlation between a company’s returns and the market
Introducing Beta returns

Company’s return on stock (%)

Average monthly
returns

Market
index
return
(%)

Characteristic line
Beta = slope of The slope is going to capture
characteristic line what a beta is : Literally how
slope a company co-moves with
the market
Measure remainder
(systematic) risk:
Introducing Beta
Interpreting Beta
• Let’s take two well-known companies – the insurance company AIG and food retailer Yum! Brands
Inc.
• Given AIG equity beta is around 1.65, while Yum!’s is around 0.67, why are the two betas so
different?
• It helps to remember what beta is measuring – correlation with the overall market

Yum! Brand
Yum! Restaurants – KFC and Taco Bell – sell relatively inexpensive food. Even in the worst recession,
people will likely still eat there, but they may be more cost-conscious and frugal. When things get
better and people have more money, they may order more there, but they may also upgrade from
fast food to casual dining. So Yum! Is fairly insulated from the variability from the economy
Measure remainder
(systematic) risk: Interpreting Beta (con’t)
Introducing Beta

• AIG, provides insurance to companies to help them manage their financial risks. When times
are bad, if often has many claims it needs to pay out, reducing its profits. In good times, it
receives premiums paired with fewer claims and does better. As result, AIG is more tightly
bound to market performance.
 Introducing Beta A measure of Systematic Risk: Estimating Beta

Beta is the percentage change in the stock return given a 1% change in the market portfolio

Suppose the market portfolio tends to increase by 47% when the economy is strong and decline by 25% when the
economy is weak. What is the beta of Type S firm whose return is 40% on average when the economy is strong
and -20% when the economy is weak? What is the beta of a Type I firm that bears only idiosyncratic firm-specific
risk?

Type S firm (Systematic risk) Type I firm (only firm specific)

Changes of return in the market portfolio Only has firm-specific risk  No systematic risk
= 47% - (-25%) =72% (not affecting by strength of economy)

Changes in return in Firm S = 40% - (-20%) = 60% Therefore, it will have the same expected return,
Therefore, regardless economy is strong or weak

This means each 1% change in the return of market portfolio

leads to 0.833% change in the Type S return on average
Measure remainder
(systematic) risk:
Introducing Beta
What about negative betas?
• Negative beta means beta moves against the market
• E.g., Asset will perform poorly when the market goes up. When the market does poorly, this
asset will perform well.
• Stocks with negative beta may be caused by poor business performance during a rising market, or
a counter-cyclical stock that moves against the market (i.e., Discount retailers such as Kmart,
Walmart)

• Another example of negative beta is Gold: This asset is special because when the world falls apart,
they are there for you.
• Reason : Gold is seen as secure store of value than currency, and a market crash prompt
investors to sell their stocks and buy gold (for negative beta).
• Investors may consider negative beta stocks as part of portfolio as a way to hedge their
investments
• The implication for negative beta for the firm is that the cost of equity are going to be low.
 Summary: Beta classification
Value of Beta Interpretation
Asset moves in the opposite direction compared to
the market index
Movement of assets is uncorrelated (independent)
with the movement of the benchmark
Movement of the asset in the same direction and by
the same amount as the movement of the benchmark
Movement of the asset is generally in the same
direction, but volatile than the market
Example
Gold, discount retailers
Fixed-yield assets; Growth is not related to
the stock market movement. E.g., Treasury
bill
Index funds which tracks the movements
of a market index
Tech companies; Stocks which are highly
influenced by day-to-day market news. Oil
& gas; Sensitivity with demand & Supply of
underlying commodities.
Putting it together: The
CAPM Model Capital Asset Pricing Model

𝑬 ( 𝑹𝒊 ) = 𝑹 𝒇 + 𝜷 𝒊 ( 𝑬 ( 𝑹𝒎 ) − 𝒓 𝒇 )

Risk premium

= the required return on the security i

risk-free rate
= the beta for security i
= the return on the market index

Investors’ perspective Required rate of return from an investment (return on equity) The return to
the investor is
Firm’s perspective Cost of capital (Cost of equity) for a particular project the cost to the
firm
Put together: Capital
Asset Pricing Model Capital Asset Pricing Model

The CAPM shows that the expected return for a particular asset depends on three things

1. Pure time value of money: As measured by risk-free rate, - this is the reward for
merely waiting for your money, without taking any risk
2. The amount of systematic risk: As measured by , this is the amount of systematic risk
present in a particular asset or portfolio, relative to that in an average asset
3. The reward for bearing systematic risk: As measured by the market risk premium ,
this component is the reward the market offers for bearing an average amount of
systematic risk
Put together: Capital
Asset Pricing Model Example: CAPM application

According to CAPM, what is the required rate of return for a stock with a beta of
0.7, when the risk-free rate is 7%, and the expected market return of is 14%?

𝐸 ( 𝑟 ) =0.07 +0.7 ( 0.14 − 0.07 )= 0.119 11.9 %

Application: CAPM
and NPV
The relationship between CAPM and NPV

• Previously we calculated Net Present Value given a discount rate , without discussing where it
came from.
• Finance managers are interested in CAPM theories to estimate required rate of return by
investors to discount future cash flows. Consider the following example
Example:
Divine Omega is evaluating the expansion of its business. The cash flow forecasts for the projects
are as follow:

0 1 2 3

-$ 8,000 $4,000 $4,000 $7,000

The firm’s existing assets have a beta of 1.3. The risk-free rate is 4% and the expected
return on the market’s portfolio is 11%. What is the project’s NPV?
Application: CAPM
and NPV The relationship between CAPM and NPV

The firm’s existing assets have a beta of 1.3. The risk-free rate is 4% and the expected return on the
market’s portfolio is 11%. What is the project’s NPV?

1. Calculate using CAPM

𝐸 ( 𝑟 ) =0.04 +1.3 ( 0.11 − 0.04 )=13.1 % Investors will require a minimum
13.1% return

2. Calculate project’ NPV

$ 4,000 $ 4,000 $ 7 , 000
𝑁𝑃𝑉 =− $ 8,000+ 1
+ 2
+ 3
=$ 3,502.24
( 1.131 ) ( 1.131 ) (1.131 )

If the NPV is greater than zero, accepting the project will increase the value of the firm. We
discount cash flows to consider the timing and risk of the cash flow. Based on CAPM, is used as a
measure of risk.
Application: CAPM
and NPV Closer look: The impact of Beta on NPV

• Other risk considerations – the industry in which the company operates.

• Some industries hold more systematic risk than others. For example, Consumer durables
(e.g., electronic appliances) and apparel have higher beta () compared to Utilities ()
• Because of this undiversifiable risk, investors charges firm a higher cost of equity
• This results in investors’ required rate of return higher for consumer durables and
apparels compared to investments in utilities.

• What this means for the firm:

•This higher reflects that entering the consumer durables and apparels, the firm is taking on a
riskier project and thus, the cash flow will be be discounted at a higher rate.

This means, higher discount rates translates to lower present value of cash flows  Lower NPV
Application: CAPM
and NPV Closer look: The impact of Beta on NPV (Con’t)

Example
For simplicity's sake, let’s re-calculate CAPM from slide 34. Now we assume a higher is now
15.9%
With a higher of 1.7, investors will
𝐸 ( 𝑟 ) =0.04 +1.7 ( 0.11 − 0.04 )=15.9 % now demand a minimum 15.9%

$ 4,000 $ 4,000 $ 7 , 000

𝑁𝑃𝑉 =− $ 8,000+ 1
+ 2
+ 3
=$ 2,925.26
( 1.159 ) ( 1. 159 ) (1.1 59 )

Observe how a higher discount rate of 15.9% has reduced the NPV to $2,925.26
compared to a 13.1% discount rate which provided an NPV of $3,502.23
Application: CAPM
and NPV Variable discount rates
• When the risk associated with an investment is expected to change significantly over time, variable
discount rates are used.
• Variable discount rate approach is relevant in capturing changes in systematic risk
• For example, if an investment is expected to have high systematic risk in early years but this risk is
expected to decrease over time, then a higher discount rate may be used for the early years’ cash
flows and a lower rate for the later year

•Often used in industries where risk levels change significantly over time.
•Technology and start-ups, mining and natural resource, construction
0 1 2 3

-$ 8,000 $4,000 $4,000 $7,000

𝛽=1.8 𝛽=1.1
Application: CAPM
and NPV Variable discount rates
• For example, in a manufacturing setting, its possible that risks may vary over time. For example, in the initial
years of a new production line setup, there might be higher risks due to uncertainties related to the installation
of new machinery, employee training, or market acceptance of he new products. As production line stabilizes
and new products gain market acceptance, these risk might decrease.

• Therefore, using a higher discount rate for the initial years and a lower one for later years could provide a more
accurate estimate of the project’s net present value.
 Recap learning objectives

1. Understand the concept of risk and return

2. Be able to describe and understand risk premium
3. Be able to compare and contrast between unsystematic risk and systematic risk
4. Discuss how Beta can be used to measure the systematic risk of a security
5. Use the Capital Asset Pricing Model to calculate the expected return for a risky
security
6. Understand the relationship between CAPM and NPV