STRATEGIC FINANCIAL MANAGEMENT Hurdle Rate: The Basics of Risk II KHURAM RAZA

First Principle and Big Picture

The Basics of Risk  Defining the Risk  Equity Risk and Expected Returns  Measuring Risk  Rewarded and Unrewarded Risk  The Components of Risk  Why Diversification Reduces the Risk  Measuring Market Risk  The Capital Asset Pricing Model  The Arbitrage Pricing Model  Multi-factor Models for risk and return  Proxy Models  The Risk in Borrowing  The Determinants of Default Risk  Default Risk and Interest rates

The Basics of Risk  Defining the Risk  Equity Risk and Expected Returns  Measuring Risk  Rewarded and Unrewarded Risk  The Components of Risk  Why Diversification Reduces the Risk  Measuring Market Risk  The Capital Asset Pricing Model  The Arbitrage Pricing Model  Multi-factor Models for risk and return  Proxy Models  The Risk in Borrowing  The Determinants of Default Risk  Default Risk and Interest rates

Measuring Market Risk

Mean - Variance Optimization AB C Return % Risk 10% 5% To the risk-averse wealth maximizer, the choices are clear, A dominates B, A dominates C. According to Markowitz’s approach, investors should evaluate portfolios based on their return and risk as measured by the standard deviation 20%5% A B C ρ a,b ρ b,c ρ a,c A C B D To analyze 50 stocks, the input list includes: n = 50 estimates of expected returns n = 50 estimates of variances (n 2 - n)/2 = 1,225 estimates of covariance's 1,325 estimates If n = 3,000 (roughly the number of NYSE stocks), we need more than 4.5 million estimates.

Efficient portfolio – a portfolio that has the smallest portfolio risk for a given level of expected return or the largest expected return for a given level of risk Efficient set (frontier) – Portfolio that offers the best risk-expected return combinations available to investors  Minimum Variance Portfolio  It represented by the all the common stocks  High correlation with all portfolios excess return over the risk free rate Capital-Asset Pricing Model

CAPM-Assumptions  Capital Markets are Efficient  Investor are well informed  No transaction cost  No investor is large enough to affect the market price of a stock  Investors are rational mean-variance optimizers  Investors are in general agreement Performance of individual securities Common holding period  Two types of investment opportunities  Risky Assets (portfolios of common stocks)  Risk-free security

CAPM-The Characteristic Line A line that describes the relationship between an individual security’s returns and returns on the market portfolio. The slope of this line is beta.

Beta: An Index of Systematic Risk

Over Priced & under priced stocks

The Arbitrage Pricing Model  Like the capital asset pricing model, the arbitrage pricing model begins by breaking risk down into two components.  The first is firm specific and covers information that affects primarily the firm.  The second is the market risk that affects all investment; this would include unanticipated changes in a number of economic variables, including  Gross national product,  Inflation, and  Interest rates. r i = a i + b i1 F 1 + b i2 F 2 + …+b ik F k

Multi-factor Models for risk and return Multi-factor models generally are not based on extensive economic rationale but are determined by the data. Once the number of factors has been identified in the arbitrage pricing model, the behavior of the factors over time can be extracted from the data. These factor time series can then be compared to the time series of macroeconomic variables to see if any of the variables are correlated, over time, with the identified factors.

 a study from the 1980s suggested that the following macroeconomic variables were highly correlated with the factors that come out of factor analysis:  industrial production,  changes in the premium paid on corporate bonds over the riskless rate,  shifts in the term structure,  unanticipated inflation,  and changes in the real rate of return.  These variables can then be correlated with returns to come up with a model of expected returns, with firm-specific betas calculated relative to each variable. The equation for expected returns will take the following form:  E(R) = Rf + ß GNP (E(R GNP )-Rf ) + ß i (E(Ri)-Rf)...+ ßg (E(Rg)-Rf) Multi-factor Models for risk and return

Proxy Models  The Fama-French Three-Factor Model is an advancement of the Capital Asset Pricing Model (CAPM). Beta is the brainchild of CAPM, which is designed to determine a theoretically appropriate required rate of return of any investment and compare the riskiness of an investment to the risk of the market.  Fama and French found that on average, a portfolio’s beta is the reason for 70% of its actual stock returns. Unsatisfied, they thought, rightly, that there was an even better explanation. They discovered that figure jumps to 95% with the combination of beta, size and value.

Proxy Models They added these two factors to a standard CAPM:  SMB = “small [market capitalization] minus big” "Size" This is the return of small stocks minus that of large stocks. When small stocks do well relative to large stocks this will be positive, and when they do worse than large stocks, this will be negative.  HML = “high [book/price] minus low” "Value" This is the return of value stocks minus growth stocks, which can likewise be positive or negative.

The Risk in Borrowing In contrast to the general risk and return models for equity, which evaluate the effects of market risk on expected returns, models of Borrowing risk measure the consequences of firm-specific risk on promised returns.  Default Risk  Interest Rate Risk Default Risk Function of firm capacity to generate cash flows from operations and its financial obligations, its depends on  generate high cash flows  more stable the cash flows  more liquid a firm’s assets Interest Rate Risk corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility  When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down and and vise versa Bounds Ratings 1.Financial Ratios  Return on assets  Debt ratios  Interest coverage ratio 2.Contract terms  Secured by a mortgage  Subordinated to other debt  Sinking fund provisions  Guarantees by some other party 3.Qualitative Factors  Sensitivity of earnings to the economy  Affected by inflation  Labor problems  Potential environmental problems