|
|
- Maximilian Little
- 5 years ago
- Views:
Transcription
1 MWF 3:15-4:30 Gates B01 Final Exam MS&E 247S Fri Aug :15PM-3:15PM Gates B03 (Alternate Time) Or Saturday Aug PM-10PM Terman Auditorium (Official Time) Remote SCPD participants will also take the exam on Friday, 8/15 Please Submit Exam Proctor s Name, Contact info as SCPD requires. C.c. the info to yeetienfu@yahoo.com, preferably a week before the exam. Local SCPD students please come to Stanford to take the exam. Light refreshments will be served. Handout #20 as of 0808, 2008 International Asset Portfolios Equity Portfolios + Foreign Exchange Market Intervention
2 Reading Assignments for this Week Scan Read Levich Chap 15 Pages Equity Portfolios + Chap 17 Foreign Exchange Market Intervention (pp ) Luenberger Chap Pages Solnik Eun 8, 9, 12, 13 Pages , , Alternate Investments, Int l Diversification, Performance Measurement, Global Asset Allocation: Structuring and Quantifying the Process Wooldridge Chap Chap Pages International Financial Management 4E:Chapter 13 International Equity Markets Pages 15-2
3 International Asset Portfolios Equity Portfolios MS&E 247S International Investments Yee-Tien Fu
4 Introduction to Equities While they share a long history, equities and bonds are very different financial instruments. The owner of a bond is entitled to a set amount of at periodic intervals. All bonds (excluding those with equity-like features) are claims on some nominal amount of. In comparison, the owner of an equity share in a British firm may receive dividends denominated in. But what the shareholder truly owns is a claim on the real assets of the firm and all the cash flows that accrue once the firm has paid all of its creditors. 15-4
5 Introduction to Equities Both bonds and shares may be exposed to similar market forces. If a bond was issued in London and trades in London, it will be subject to British exchange control risk, expropriation risks, and withholding taxes when viewed by non-british investors. The fundamental difference is this: The valuation of a bond is based on a stream of nominal cash flows that we can enumerate. The valuation of a British equity is linked to the firm s real assets (regardless of location) and the cash flows (in all currencies) associated with the firm s operations. 15-5
6 Introduction to Equities The performance of equity investments is usually evaluated in 2 dimensions - expected return and risk. These dimensions describe the 2 basic incentives for international investment: to enhance portfolio returns for the same level of risk, or to reduce the riskiness of a portfolio without sacrificing expected return. 15-6
7 Introduction to Equities Expected value gains could occur if foreign equity markets are inefficient, such that foreign equity prices do not reflect all available information, or if foreign equity markets may be segmented from other capital markets, such that investors in the foreign market receive a different compensation for bearing equity risk than in other markets. Diversification gains could occur if the correlation of returns across countries is low. 15-7
8 Introduction to Equities Diversification gains are available even when domestic and foreign capital markets are integrated, so that risk bearing in different markets is rewarded in a similar fashion. When investors are risk averse, international equity investment offers an opportunity for welfare gains through superior sharing of international equity risks. 15-8
9 Introduction to Equities A pioneering study by Herbert Grubel (1968) showed that investors from 11 developed economies could have enjoyed substantially more favorable risk-return opportunities had they diversified their portfolios internationally in the 1960s. However... The analysis overstated the gains. Capital restrictions would have made some markets off-limits to foreign investors.. The efficient frontier could not have been obtained by all investors. 15-9
10 % Rate of Return (% per annum) Figure 15.1 Pg 524 Return and Risk in World Equity Markets and Efficient Frontiers, Efficient frontier labeled AA includes all 11 industrial countries, while BB includes only 8 European and North American countries Japan A A xx x x B x 2 Belgium Risk: Standard Deviation of Returns Australia x x B USA Canada France U.K. S. Africa Italy Germany Netherlands
11 Introduction to Equities The portfolios in segment AA of the efficient frontier call for roughly a 40% weight on Australia. Since Australia represents less than 1% of the world equity market, these portfolios were inconsistent with the overall valuation of equity markets. Despite the shortcomings, Grubel s insight has been verified by many subsequent studies. Yet, despite promotion by investment advisors as a prudent strategy, most investor portfolios reflect a home country bias in equities as well as bonds, as shown in Table
12 Holdings of Foreign Securities by Residence of Investor Residence of investor US$ Value of Holdings (in billions) Equities % of Equity Portfolio Bonds % of Bond Portfolio Canada $ 9 $ 12 $ Germany Japan Netherlands U.K U.S Table
13 Introduction to Equities This investment pattern is a puzzle that has rekindled research into international equity markets. Have home country investors been inexcusably slow to diversify their portfolios internationally? Or have important aspects of the international investment process been left out of the theoretical and empirical analysis thus far? 15-13
14 Size and Institutional Features of Global Equity Markets Market Capitalization Measures From Figure 15.2, we see that U.S. market capitalization, while growing in absolute terms, has fallen in relative size from 54.1% of the world market in 1984 to 38.6% in Higher economic growth rates in smaller economies is the primary contributor to this long-term trend which is most likely to continue. Also note the substantial growth of emerging markets
15 World Market Capitalization US$ Trillions $ % 15.2% 19.4% 7.1% 54.1% $ % 18.2% 40.2% 7.9% 28.7% $ % 21.9% 21.3% 8.2% 37.0% $ % 24.6% 12.6% 8.1% 46.2% Figure 15.2 U.S. U.K. Japan Other Developed Emerging
16 Market Capitalization of Equity Markets in Developed Countries (in Billions of U.S. Dollars) 15-16
17 Market Capitalization of Equity Markets in Selected Developing Countries (in Billions of U.S. Dollars) 15-17
18 Size and Institutional Features of Global Equity Markets The pattern for Japan is unusual on 2 accounts: 1 Japan s share of world stock market capitalization more than doubled between 1984 and 1988, and then dropped by half in This reflects the surge in Japanese equity prices in the late 1980s, which many label a speculative bubble, and the collapse of those prices in The value of Japanese equities surpassed the U.S. in 1987 to become (for 3 years) the world s largest equity market. Note that the GNP of U.S. exceeds that of Japan by about 75%
19 How Large is the Japanese Stock Market? Cross-holding of securities (the practice of firm A owning equity shares in firm B) complicates the calculation of market capitalization values. Cross-holding is common in Japan, Germany, etc. where banks are permitted to hold substantial and sometimes controlling interests in non-banking firms. Cross-holding is fairly rare in the United States. Suppose firm A has $100 of net productive assets and 100 shares outstanding, each valued at $1. Firm B is similar. The market value of these 200 shares of firms A and B is $200. To introduce a cross-holding effect, let A issue 50 new shares at $1 each and use the proceeds to purchase shares in B
20 How Large is the Japanese Stock Market? As conventionally measured (taking the number of shares outstanding and multiplying by the price per share) the market value of firms A and B is now $250. Yet the value of productive physical assets is unchanged at $200, and $200 is sufficient to purchase all of A s and B s stock. It takes $150 to buy all of A s stock, and only $50 to buy the remaining shares of B not already acquired by purchasing A. Hence, to measure market value properly, we must adjust for the cross-holding effect by netting out the value of the cross-held shares. This adjustment reduced the 1988 market capitalization weight for Japan from 44% to 29.5%, a figure very close to Japan s GDP weight in the world portfolio
21 Size and Institutional Features of Global Equity Markets Institutional Aspects of Global Equity Markets Investors are unlikely to invest abroad if restrictions and limitations affect the repatriation of their capital. Number of Firms Listed In 1994, less than 7% of the firms listed on U.S. exchanges are foreign firms. In comparison, foreign firms make up about 18% of the total firms listed in United Kingdom, the center for trading in foreign stocks. The requirements for listing shares are more stringent in the U.S. than elsewhere
22 Size and Institutional Features of Global Equity Markets Market Concentration Market concentration, measured by the percentage of market capitalization within the 10 largest firms, is another statistic with wide variation across countries. In the U.S., Japan, and India, the top 10 firms account for 15-20% of the overall market capitalization. In all other countries, market concentration is higher, averaging close to 30%. In the Netherlands, New Zealand, and some smaller emerging markets, market concentration exceeds 60%
23 Percentage of Market Capitalization Represented by the 10 Largest Stocks: Emerging Equity Markets in Selected Developing Countries 15-23
24 Size and Institutional Features of Global Equity Markets Trading Volume Market turnover, measured as the annual volume of trading as a percentage of market capitalization, also varies substantially across countries. Statistics suggest that liquidity varies considerably across markets, as high trading volume tends to reduce liquidity risks and trading costs. But liquidity could vary as well within a market, with greater liquidity for a small number of high capitalization stocks, and much lower liquidity otherwise
25 Turnover Ratio of Equity Markets in Developed Countries (Transactions in US $ / Year-End Market Capitalization in US $) 15-25
26 Turnover Ratio of Emerging Equity Markets in Selected Developing Countries (Transactions in US $ / Year-End Market Capitalization in US $) 15-26
27 Size and Institutional Features of Global Equity Markets Transaction Taxes, Transaction Costs, Clearing and Settlement A long settlement period for making payment and obtaining delivery of securities (on the buy side) and delivering securities and obtaining cash settlement (on the sell side) is a deterrent to investment
28 15-28 Trading Practices and Costs of Major Equity Markets
29 Trading Practices and Costs of Major Equity Markets 15-29
30 International Investment Vehicles Direct Purchase of Foreign Shares American Depositary Receipts (ADRs) In order to issue an ADR, a U.S. bank takes custody of foreign shares in its foreign office. Then an ADR can be issued as a claim against these foreign shares. This can be especially valuable when there are doubts about the authenticity of foreign shares. Owners of the ADR have the right to redeem their ADR and obtain the true underlying foreign shares. Arbitrage of this sort ensures that the price of the ADR and the underlying shares will be nearly identical
31 Mechanics of Issuance and Cancellation of ADRs 15-31
32 International Investment Vehicles The issuing bank services the ADR by collecting all dividends, rights offerings, and so forth in foreign currency, and distributing the proceeds in US$ to the ADR owner. Rights offering - When a corporation is about to issue additional stock, it is customary to offer the stock first to its existing shareholders at special rate. U.S. investors can trade ADRs with each other without recourse to the foreign equity market, without using the foreign exchange market, and without relying on foreign clearing and settlement
33 Types of ADRs 15-33
34 International Investment Vehicles In a sponsored ADR, the foreign firm pays a fee to the depositary bank to cover the cost of the ADR program. In an unsponsored ADR, the issuance of the ADR is demand driven in response to a security firm s desire to facilitate trading in a popular foreign issue. Closed-End and Open-End Mutual Funds Mutual funds that invest in foreign stocks can be grouped into several categories - global, international, regional, country, specialty. In addition, foreign stock funds are classified as either open-end or closed-end
35 International Investment Vehicles An open-end fund stands ready to issue and redeem shares at prices reflecting the net-assetvalue of the underlying foreign shares. A closed-end fund issues a fixed number of shares against an initial capital offering. The shares of the fund then trade in a secondary market (usually listed on an exchange) at prices reflecting a premium or discount relative to the net-asset-value of the underlying foreign shares. Closed-end country funds were the fastest growing segment of the public investment funds during the late 1980s. At the end of 1992, there were 42 closed-end country funds listed in the U.S., representing $4.3 billion in equity
36 Global Depository Receipt Tombstone 15-36
37 Example of Dow Jones Country Stock Market Indexes 15-37
38 Major National Stock Market Indexes Major National Stock Market Indexes
39 International Investment Vehicles A 1994 paper by Gikas Hardouvelis, et al. analyzed the behavior of closed-end country fund discounts and premiums. They concluded that: Such discounts varied widely and are a significant factor in the variability of country fund returns. On average, the variance of country fund returns is 3 times larger than the variance on the underlying foreign assets. Discounts tend to be mean reverting, implying that unusually large discounts and premiums tend back toward their average value. Thus, by selecting a closed-end country fund, the investor also takes a position on an additional unobserved factor - the local sentiment about world events and country-specific events
40 Risk and Return in International Equity Markets Calculating the Unhedged Returns on Foreign Equity in US$ Terms Let E t represent the initial purchase price of the equity in foreign currency terms. Let S t represent the spot exchange rate, in $/FC terms, on the purchase date. The product E t S t is the US$ purchase price of the foreign equity. ~ After one period, the value of the equity is E t+1, representing the initial equity price plus the price ~ change over the period (Δ t+1 ) plus dividends D t+1 : ~ E ~ t + 1 Et + Δt D t
41 Risk and Return in International Equity Markets The value of the equity after one period in US$ terms is ~ ~ E t+1 S t+1. The continuous rate of return on the foreign equity measured in US$ and on an unhedged basis is: E S E S R ~ ~ ~ ~ ~ t + 1 t + 1 t + 1 t + ~ ~ $, U = ln = ln + ln 1 = EFC + S E S E S t t t US$,FC (15.1) The equation shows that the unhedged US$ return has 2 components: the return on the equity shares in foreign currency terms plus the return on the foreign currency used to buy the shares. Both terms may be greater than or less than zero. t 15-41
42 Risk and Return in International Equity Markets The variance of the returns reflects the variance of each term and the covariance between the returns on the foreign equity and the returns on spot foreign exchange: 2 ~ 2 ~ 2 ~ ~ ~ σ R = σ E + σ S + 2Cov E ; S ( ) ( ) ( ) ( ) $, U FC US$,FC US$,FC (15.2) The covariance term represents the sensitivity of share returns to exchange rate changes, and can be either positive or negative. A positive covariance implies that the value of foreign equity tends to fall or rise along with the value of foreign currency as shown in cells A and B in Table FC 15-42
43 Currency Market Return and Stock Market Return Combinations Currency Market Return Negative Positive Stock Market Returns Negative Positive Stock Market Prices Spot FX (A) Stock Market Prices Spot FX (D) Stock Market Prices Spot FX (C) Stock Market Prices Spot FX (B) Table
44 Risk and Return in International Equity Markets The Mexican peso devaluation in late 1994 and early 1995 is an example of cell A, where capital flight and a loss in confidence in the Mexican economy brought the Mexican stock market down as well. With the peso overvalued and the country running a large current account deficit, Mexican policy makers allowed the peso to depreciate. Interest rates rose dramatically, as did import prices; the Mexican stock market dropped sharply in anticipation of a fall in Mexican GDP and corporate profits
45 $$ Pricing Determinants The analysis of international equity prices requires us to confront several challenging problems: 1 Are national equity markets integrated or segmented? 2 Are national equity markets efficient or inefficient? 3 Does purchasing power parity hold or not? 4 Do the assumptions of the capital asset pricing model (CAPM) apply or is arbitrage pricing theory (APT) more appropriate? 15-45
46 $$ Pricing Determinants The traditional CAPM hypothesizes that returns for an individual equity (R i ) in excess of the risk-free rate (R F ) are proportional to the systematic risk of the equity (β im ) times the expected market risk premium : R i R F = β im [ E( R ) R ] M F where E(R M ) is the expected return on the market portfolio
47 $$ Pricing Determinants The assumptions of the traditional CAPM are: Investors maximize their utility which depends only on expected return (+) and risk (-). Investors have homogeneous expectations, agreeing about expected return and risk for all assets. Returns are expressed in nominal terms. A risk-free interest rate exists and unlimited borrowing and investing is possible at this rate. No transaction costs or taxes exist
48 $$ Pricing Determinants A security s β is related to its covariance with the return on the market portfolio. regression coefficient σ β σ iw 2 W β tells us how much the security s rate of return tends to change when the return on the market portfolio changes. Thus, for a security with a β of 2, if the market goes up by 10% more than what was expected, the return on the security will tend to go up by 20% more than what was expected
49 $$ Pricing Determinants The CAPM leads to a separation, or mutual fund theorem, which claims that all investors will hold some combination of two assets: The risk-free asset and the market portfolio of all risky assets
50 Is Investment in MNCs a Close Substitute for International Investment? If portfolios exhibit a home country bias, can investors argue that the shares of multinational corporations (MNCs) offer a close substitute for international diversification? The shares of an MNC could reflect real assets and/or cash flows from, say, 20 countries. So, the MNC could offer ready-made diversification and an inexpensive proxy for the purchase of 20 firms, each one based in a different country
51 Is Investment in MNCs a Close Substitute for International Investment? While this strategy sounds reasonable, the data reject the hypothesis that MNCs are a proxy for foreign markets or international diversification. A study by Jacquillat and Solnik (1978) examined the returns of MNCs from 9 countries by regressing their returns against all 9 market indexes. In each case, the returns on MNCs were most closely connected with the domestic market index. In the case of U.S. and U.K. MNCs, the addition of foreign markets offered virtually no improved explanation of MNC share returns
52 Policy Matters - Private Enterprises After 15 years, Let s ask the same question: Can investors create homemade international diversification? Using data from 1973 to 1993 for seven developed and nine emerging markets, a study found that a set of domestically traded assets, including market indices, industry portfolios, 30 MNCs, closed-end country funds and ADRs, was successful at mimicking the gains from international portfolio diversification
53 Total, Domestic, and Foreign Company Listings on Major National Stock Exchanges for
54 Assignments from Chapter 15 Exercises 3, 4, 5. (no need to hand in) 15-54
55 Chap 17 Foreign Exchange Market Intervention (pp ) Overview Foreign Exchange Market Intervention Intervention as a Policy Instrument The Objectives of Central Bank Intervention The Mechanics of Intervention Empirical Evidence on Intervention The Effectiveness of Central Bank Intervention Security Transaction Taxes: Should We Throw Sand in the Gears of Financial Markets? 15-55
56 Foreign Exchange Market Intervention Many government actions (such as monetary policy, interest rate policy, fiscal spending, and taxation policies) can have an impact on the foreign exchange rate. The central bank may also intervene officially by directly purchasing or selling currency. Intervention is an essential part of a pegged exchange rate system
57 Foreign Exchange Market Intervention The modern experience of floating exchange rates is better described as a period of managed floating exchange rates. Note that acknowledging the importance of exchange rates and the potentially adverse effects of exchange rate misalignments or volatility does not automatically establish a valid case for central bank intervention
58 Foreign Exchange Market Intervention Under floating exchange rates, an active intervention policy presumes that: markets are at times inefficient, thus permitting misaligned or excessively volatile rates, policymakers can identify such market inefficiencies, intervention techniques can correct the misalignments and excess volatility, and the benefits from the correction exceed the costs of conducting the intervention
59 The Objectives of Central Bank Intervention Shortly after the breakdown of the Bretton Woods Agreement in 1973, the International Monetary Fund (IMF) enacted a set of guidelines designed to limit the use of intervention and the potential for conflicts among nations
60 The Objectives of Central Bank Intervention The guidelines, which are still in effect, specify that member nations of the IMF: Have an obligation to intervene to prevent disorderly conditions in the foreign exchange market. Should avoid manipulating exchange rates to prevent balance of payments adjustment or gain an unfair competitive advantage in trade. Should take into account the interests and policies of other members when setting their own intervention policies
61 Eun: International Financial Management Chapter 4: The Market for Foreign Exchange
62 Eun: International Financial Management Chapter 4: The Market for Foreign Exchange
63 Stephen G. Cecchetti on Central Banks, Monetary Policy, and Financial Stability (great optional reading) Chapter 15 Central Banks in the World Today 2_ch15.pdf 15-63
64 Stephen G. Cecchetti on Central Banks, Monetary Policy, and Financial Stability (great optional reading) Chapter 16 The Structure of Central Banks: The Federal Reserve and the European Central Bank 2_ch16.pdf 15-64
65 The Mechanics of Intervention Central bank interventions typically occur in the spot foreign exchange market. If the domestic currency is stronger than desired, the central bank sells domestic currency, and vice versa. Central bank interventions may generate direct effects associated with the changed quantities of money and/or bonds. The magnitude of the effects depends on whether the intervention was sterilized or unsterilized
66 The Mechanics of Intervention An unsterilized intervention is simply a foreign exchange market sale or purchase. The money supplies in both countries are affected. A sterilized intervention includes an offsetting transaction in the domestic money market (such as the purchase or sale of government securities) that reverses, or sterilizes, the impact of the initial intervention transaction. The money supplies remain unchanged, but the bond supplies are affected
67 The Mechanics of Intervention According to the monetary approach, sterilized interventions have no direct impact on the exchange rate. However, according to the portfolio balance approach, the relative supply of government bonds helps to determine the exchange rate
68 The Mechanics of Intervention Central bank interventions may also generate indirect effects: They may signal the market about future monetary and fiscal policies. They may interrupt short-term patterns in rates and reduce the profitability and incidence of noise trading
69 Empirical Evidence on Intervention From 1982 to 1991, the U.S. Federal Reserve sold $35.8 billions and purchased $15.8 billions. Note that the interventions were small compared with the daily foreign exchange trading volume. There was also evidence of coordinated interventions with other central banks, such as the German Bundesbank and the Swiss National Bank
70 The Effectiveness of Central Bank Intervention Does intervention have any effect - beneficial or detrimental - on the course of exchange rates and the ability of policymakers to achieve their larger macroeconomic goals? The debate hinges on whether a market failure has occurred and whether official intervention can correct this failure
71 The Effectiveness of Central Bank Intervention Private Speculation Official Intervention A C Stabilizing Efficient markets view Official intervention smoothes the market Credible signals of future policy remove uncertainty Encourages stabilizing private speculators B D Destabilizing Inefficient markets: Stabilization policy gamed bandwagons, bubbles, by market and becomes noise traders destabilizing Intervention is inconsistent with underlying economic policies 15-71
72 The Effectiveness of Central Bank Intervention Evidence suggests that intervention may stabilize exchange rates by lowering the daily volatility, as well as cause the rates to move in the intended direction. It seems that interventions send the strongest signals and have the highest chance of success when the conditions of surprise, publicity, and coordination with other central banks, are met
73 Excel Finance Gallery Available at Companion Website for Oxford Handbook of Financial Modeling by Ho and Lee Oup.org (Oxford University Press Website) 94 downloadable Excel Templates for Finance Modelers
74 Ross / Corporate Finance 7E / CAPM Capital Asset Pricing Model 10.3 The Return and Risk for Portfolios Stock fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% 3.24% 17% 1.00% Normal 12% 0.01% 7% 0.00% Boom 28% 2.89% -3% 1.00% Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks
75 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio: r = w r + w P B 5 % = 50% ( 7%) + 50% (17%) B S r S 15-75
76 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio: r = w r + w P B 12.5% = 50% (28%) + 50% ( 3%) B S r S 15-76
77 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio. E ( r ) = P wb E( rb ) + ws E( rs 9 % = 50% (11%) + 50% (7%) ) 15-77
78 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The variance of the rate of return on the two risky assets portfolio is σ = P (wbσ B ) (wsσ S ) 2(wBσ B )(wsσ S )ρ BS where ρ BS is the correlation coefficient between the returns on the stock and bond funds
79 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation
80 10.4 The Efficient Set for Two Assets % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50.00% 3.08% 9.00% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% P o rtfo lio R e turn 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) We can consider other portfolio weights besides 50% in stocks and 50% in bonds 100% stocks 15-80
81 10.4 The Efficient Set for Two Assets % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50% 3.1% 9.0% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% P o rtfo lio R e turn 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) We can consider other portfolio weights besides 50% in stocks and 50% in bonds 100% stocks 15-81
82 10.4 The Efficient Set for Two Assets % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50% 3.1% 9.0% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% P ortfolio R eturn 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) 100% stocks Note that some portfolios are better than others. They have higher returns for the same level of risk or less. These compromise the efficient frontier
83 Definition of Risk When Investors Hold the Market Portfolio Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (β)of the security. Beta measures the responsiveness of a security to movements in the market portfolio. β = i Cov( R σ 2 i, ( R R M M ) ) 15-83
84 Estimating β with regression Characteristic Characteristic Line Line Slope = β i Security Returns Security Returns Return on market % R i = α i + β i R m + e i
85 Estimates of β for Selected Stocks Stock Bank of America Borland International Travelers, Inc. Du Pont Kimberly-Clark Corp. Microsoft Green Mountain Power Beta Homestake Mining Oracle, Inc
86 The Formula for Beta β = i Cov( R σ 2 i, ( R R M M ) ) Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio
87 10.9 Relationship between Risk and Expected Return (CAPM) Expected Return on the Market: R M = R F + Market Risk Premium Expected return on an individual security: R i = R F + β i ( R M R F ) Market Risk Premium This applies to individual securities held within welldiversified portfolios
88 Expected Return on an Individual Security This formula is called the Capital Asset Pricing Model (CAPM) R i = R F + β i ( R M R F ) Expected return on a security = Riskfree rate + Beta of the security Market risk premium Assume β i = 0, then the expected return is R F. Assume β i = 1, then R i = RM 15-88
89 Relationship Between Risk & Expected Return Expected return R M R i = R F + β i ( R M R F ) R F 1.0 β 15-89
90 Relationship Between Risk & Expected Return Expected return 13.5% 3% β =1.5 =3% 1.5 β i R F RM =10% Ri = 3 % (10% 3%) = 13.5% 15-90
91 10.10 Summary and Conclusions This chapter sets forth the principles of modern portfolio theory. The expected return and variance on a portfolio of two securities A and B are given by E ( r ) = P wa E( ra ) + wb E( rb ) σ = P (waσ A ) + (wbσ B ) + 2(wσ B B )(wσ A A )ρ AB By varying w A, one can trace out the efficient set of portfolios. We graphed the efficient set for the two-asset case as a curve, pointing out that the degree of curvature reflects the diversification effect: the lower the correlation between the two securities, the greater the diversification. The same general shape holds in a world of many assets
92 10.10 Summary and Conclusions The efficient set of risky assets can be combined with riskless borrowing and lending. In this case, a rational investor will always choose to hold the portfolio of risky securities represented by the market portfolio. Then with borrowing or lending, the investor selects a point along the CML. return M CML efficient frontier r f σ P 15-92
93 10.10 Summary and Conclusions The contribution of a security to the risk of a well-diversified portfolio is proportional to the covariance of the security's return with the market s return. This contribution is called the beta. Cov( Ri, RM β = i 2 σ ( R ) The CAPM states that the expected return on a security is positively related to the security s beta: M ) R i = R F + β i ( R M R F ) 15-93
94 Ross / Corporate Finance 7E / CAPM 12.1 The Cost of Equity Capital Firm with excess cash Pay cash dividend A firm with excess cash can either pay a dividend or make a capital investment Shareholder invests in financial asset Invest in project Shareholder s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk
95 The Cost of Equity From the firm s perspective, the expected return is the Cost of Equity Capital: R i = R F + β R i ( M RF ) To estimate a firm s cost of equity capital, we need to know three things: 1. The risk-free rate, R F 2. The market risk premium, 3. The company beta, RM R F Cov( Ri, RM ) σ β = = i Var( R ) σ M i, M 2 M 15-95
96 Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for an expansion of this firm? R = R R F + β i ( R M R ) F = 5 % % R =30% 15-96
97 Example (continued) Suppose Stansfield Enterprises is evaluating the following nonmutually exclusive projects. Each costs $100 and lasts one year. Project Project β Project s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B 2.5 $130 30% $0 C 2.5 $110 10% -$
98 Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects Project IRR Good project A SML 30% B 5% C 2.5 Bad project Firm s risk (beta) An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital
99 12.2 Estimation of Beta: Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock s return to the return on the market portfolio
100 12.2 Estimation of Beta Theoretically, the calculation of beta is straightforward: Cov( Ri, RM ) β = = Var( R ) M M Problems 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk. Solutions Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for changes in business and financial risk. Look at average beta estimates of comparable firms in the industry. σ σ i, M
101 Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry. That s not to say that a firm s beta can t change. Changes in product line Changes in technology Deregulation Changes in financial leverage
102 Using an Industry Beta It is frequently argued that one can better estimate a firm s beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firm s beta. Don t forget about adjustments for financial leverage
103 Modern Financial Markets: Prices, Yields, and Risk Analysis Blackwell, Griffiths and Winters Chapter 15 Stock Portfolio Formation and Risk Management
104 Learning Objectives 1. Portfolio formation and correlation 2. Measuring portfolio risk 3. Incremental value-at-risk 4. Portfolio risk management strategies using derivative securities
105 The Basics of Portfolio Formation A portfolio is a group of assets. The relative importance (weight) of an asset in a portfolio is based on the asset s contribution to the value of the portfolio. We will focus on forming a stock portfolio
106 The Basics of Portfolio Formation (cont.) Example Let s assume we have 15,000 invested in our portfolio and the investment is divided among three stocks: FLYBY 5,000 33% UO 6,000 40% GDAY 4,000 27%
107 The Basics of Portfolio Formation (cont.) Example (cont.) Investment Expected Return (Annual) Standard Deviation (Monthly) Beta FLYBY 11% 10% 1.05 UO 9% 5% 0.95 GDAY 12% 7% 1.11 Correlation Coefficients FLYBY UO GDAY FLYBY UO GDAY
108 The Basics of Portfolio Formation (cont.) Example (cont.) So, what is the likely return on the portfolio? The answer is the weighted average of the individual returns. E[R] = w1*r1 + w2 * r2 + w3*r3 = 0.33(11%) (9%) (12%) = 10.47% Also, what is the Beta (β) of the portfolio? The answer is the weighted average of the individual Betas. E[β] = w1*β1 + w2 *β2 + w3*β3 = 0.33(1.05) (0.95) (1.11) =
109 The Basics of Portfolio Formation (cont.) Example (cont.) The third calculation we would like to do for our portfolio is its standard deviation. However, the standard deviation of the portfolio is not the weighted average of the individual standard deviations because of the difference between diversifiable and non-diversifiable risk
110 The Basics of Portfolio Formation (cont.) Correlation The degree of correlation is a measure of the extent to which returns on two assets move together. If both move up and down together, they are positively correlated and ρ ij >
111 Return Return The Basics of Portfolio Formation (cont.) Correlation (cont.) Perfect Positive Correlation Stock A Less Than Perfect Positive Correlation Time Stock B Time Stock A Stock B
112 Return Return The Basics of Portfolio Formation (cont.) Correlation (cont.) If one moves up when the other moves down, they are negatively correlated and ρ ij < 0. Perfect Negative Correlation Stock B Less Than Perfect Negative Correlation Stock B Stock A Stock A Time Time
113 Return The Basics of Portfolio Formation (cont.) Correlation (cont.) If the two assets are completely independent, then they are uncorrelated and ρ ij = 0. Zero Correlation Stock B Time Stock A
114 Measuring Portfolio Risk We now want to measure portfolio risk and since a portfolio has more than one asset we have to consider the correlation of the assets in the portfolio. The standard deviation of a portfolio includes the correlation between the assets in the portfolio and thus provides a measure of portfolio risk
115 Measuring Portfolio Risk (cont.) The formula for portfolio standard deviation is: σ p [ ( )] 2 2 w σ + 2 w w ρ σ σ 0. 5 = i i i j ij i j
116 Measuring Portfolio Risk (cont.) Now, let s return to our portfolio and calculate its standard deviation. INVESTMENT FLYBY UO GDAY FLYBY UO GDAY The shaded area (on the diagonal) represent the weighted total risk of the of the individual securities in the portfolio, which in the formula is Σw i2 σ 2 i
117 Measuring Portfolio Risk (cont.) The off-diagonal items represent the correlations between the different assets in the portfolio and the formula is: 2(ΣΣw i w j ρ ij σ i σ j ) The formula starts by multiplying by 2 because the items above the diagonal are the same as the items below the diagonal
118 Measuring Portfolio Risk (cont.) Using our portfolio, the cells of the figure are as follows: INVESTMENT FLYBY UO GDAY FLYBY (0.33) 2 (.1) 2 (.33)(.4)(.8)(.1)(.05) (.33)(.27)(.5)(.1)(.07) UO (0.4) 2 (0.05) 2 (.4)(.27)(.2)(.05)(.07) GDAY (0.27) 2 (.07)
119 Measuring Portfolio Risk (cont.) σ σ Now, the calculation for the portfolio standard deviation is: p p 2 2 = [ wi σ i + 2( wi w jρijσ iσ j )] = [(.33) 2 (.1) 2 + (.4) 2 (.05) 2 + (.27) (.07) 2((.33)(.4)(.8)(.1)(.05) + (.33)(.27)(.5)(.1)(.07) + (.4)(.27)(.2)(.05)(.07))] = [ ( )] 0.5 = [ ] 0.5 =.0606 or 6.06%
120 Measuring Portfolio Risk (cont.) The financial definition of risk is uncertainty and standard deviation provides a measure of uncertainty. However, individuals often think of risk in terms of losses and focus on the absolute dollar value of their losses. The focus on dollar losses as a concept of risk has led to the development of an alternative measure of risk called Value-at- Risk
121 Value-at-Risk To measure value-at-risk, we change our focus from portfolio percentages to dollar value invested. With this change we can measure portfolio standard deviation in terms of dollar value invested. That is, we replace the portfolio percentage weights with the dollar values invested. The calculation for our portfolio is as follows:
122 Value-at-Risk (cont.) σ σ p p Continuing with our portfolio, the portfolio standard deviation based on value invested is. 2 2 = [ wi σ i + 2( wi w jρijσ iσ j )] = [(5000) 2 (.1) 2 + (6000) 2 (.05) (4000) 2 (.07) 2((5000)(6000)(.8)(.1)(.05) + (5000)(4000)(.5)(.1)(.07) + (6000)(4000)(.2)(.05)(.07))] = [250, , , (120, , ,800)] 0.5 = [832,000] 0.5 =
123 Value-at-Risk (cont.) Having calculated the portfolio standard deviation in terms of value invested, we have completed the first step in determining Valueat-Risk. Value-at-Risk provides the expected maximum loss over a target horizon with a given level of confidence
124 Value-at-Risk (cont.) To calculate Value-at-Risk, we need two more pieces of information: 1. Length of holding period, which is chosen to match the amount of time required to liquidate the portfolio in an orderly manner. 2. Confidence interval, which is a function of the amount of risk aversion of the investor. Higher confidence intervals imply higher value-at-risk figures
125 Value-at-Risk (cont.) Both measures are somewhat arbitrary and are chosen to fit the situation and the investors. For a stock portfolio, a common horizon is one month and we will choose a confidence level of 5% for our calculation of value-at-risk
126 Value-at-Risk (cont.) Recall from statistics that the point estimate from a confidence level is as follows: Point estimate = +/- (confidence level critical value) * (standard deviation) Since we are looking at value losses, we focus only on the left tail of the distribution
127 Value-at-Risk (cont.) Assuming that the changes in the value of our portfolio are normally distributed then the critical value for the confidence interval can been seen from Figure N(d) c = 5% confidence level 1.65 σ d = Standard Normal Variable
128 Value-at-Risk (cont.) Value-at-Risk calculation: Portfolio standard deviation in value is and critical value for 5% lower tail confidence interval is So, the value-at-risk is 1, = ( *1.65). This means that we are 95% confident that our maximum monthly loss is 1,
129 Incremental Value-at-Risk Value-at-Risk provides a calculation of portfolio risk. However, we may want to know which security provides the most risk (or threat to maintaining value) in our portfolio. We can address this question by calculating incremental value-at-risk
130 Incremental Value-at-Risk (cont.) Incremental value-at-risk is a two step calculation with the steps as follows: 1. Calculate the individual stock value variance in the portfolio followed by 2. Calculating the individual stock contribution to the value-at-risk for the portfolio
131 Incremental Value-at-Risk (cont.) Step 1 of incremental value-at-risk Stock Positio n Variance + Position Covariance + Position Covariance FLYBY 5, , , = UO 6, , , = GDAY 4, , , = Recall that covariance = ρ ij σ i σ j so the covariance between GDAY and FLYBY is (0.5)(.1)(.07) =
132 Incremental Value-at-Risk (cont.) Step 2 of incremental value-at-risk Stock Stock (Variance/ Covariance) Portfolio Variance * Portfolio Value-at- Risk * Stock Wealth Position FLYBY * * 5,000 = UO * * 6,000 = GDAY * * 4,000 = Total (rounded)
133 Incremental Value-at-Risk (cont.) Points from incremental value-at-risk. 1. FLYBY puts the most value-at-risk even though at is not the largest investment in the portfolio. 2. UO has the lowest value variance (from Step 1) but is not the least risky portion of our portfolio because of the large value investment in UO
134 Three Important Points about Value-at-Risk 1. The value-at-risk calculation is only an estimate. It is not a guarantee. 2. The value-at-risk calculation assumes that stock returns follow a certain distribution (e.g., normal). 3. To this point we have not borrowed to buy stock. Borrowing to buy stocks is referred to as trading on margin
135 Value-at-Risk with Margin Our calculations assumed that we owned the stocks in our portfolio. If an investors uses margin to buy stock, then the investor does not own the entire investment because a portion of the cash flows are obligated to the lender. Buying on margin is a classic example of leverage; we know that leverage increases risk
136 Value-at-Risk with Margin (cont.) Let s assume that we borrow 15,000 at a rate of 7% to increase the positions in each of the three stock in our portfolio by 5,000. Security Original position Margin Position Market Falls 20% Market Rises 20% FLYBY 5,000 10,000 8,000 12,000 UO 6,000 11,000 8,800 13,200 GDAY 4,000 9,000 7,200 10,800 Margin Loan 0 15,000 15,000 15,000 Total Equity Value 15,000 30,000 24,000 36,000 Net Equity Value 15,000 15,000 9,000 21,
137 Value-at-Risk with Margin (cont.) The impact of margin on portfolio return is the following Ending Portfolio Value Repayment of Principal and Interest Net Gain (Loss) Investor Return Market Rises by 20% 36,000 16,050 19,950 (19,950-15,000)/15,000 = 33% Market Unchanged 30,000 16,050 13,950 (13,950-15,000)/15,000 = -7% Market falls by 20% 24,000 16,050 7,950 (7,950-15,000)/15,000 = -47%
138 Value-at-Risk with Margin (cont.) Points about investor returns with margin. 1. When there is no change in the market, the investor loses because of the interest owed on the borrowing. 2. Leverage magnifies both gains and losses
139 Value-at-Risk with Margin (cont.) Now, let s take the leverage effect of margin and apply it to our value-at-risk calculation for the portfolio. Re-calculating the money standard deviation with margin, the standard deviation becomes 3,351, which means at a confidence interval of 95% the value-at-risk of our portfolio with 15,000 of margin borrowing is 5,529.15, which is a 3.67 time increase over the original value-at-risk amount
140 Global Portfolios and Value-at-Risk Let s use market indices from 13 stock markets around the world and look at value-at-risk for an equal weighted portfolio invested in the 13 market indices. Returns, standard deviations and correlations for the indices using data from January 1998 through December 1999 are:
August 8, 2008 MS&E247s International Investments Handout #20 Page 1 of 72
August 8, 2008 MS&E247s International Investments Handout #20 Page 1 of 72 Reading Assignments for this Week MWF 3:15-4:30 Gates B01 Final Exam MS&E 247S Fri Aug 15 2008 12:15PM-3:15PM Gates B03 (Alternate
More informationTTh 3:15-4:30 Gates B01 Final Exam MS&E 247S Fri Aug 14 2009 7PM-10PM Gates B01 (Official Time) Or Saturday Aug 15 2009 7PM-10PM Gates B03 (Alternate Time) Remote SCPD participants will also take the exam
More informationChapter 11. Return and Risk: The Capital Asset Pricing Model (CAPM) Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 11 Return and Risk: The Capital Asset Pricing Model (CAPM) McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 11-0 Know how to calculate expected returns Know
More informationMWF 3:15-4:30 Gates B01. Handout #13 as of International Asset Portfolios Bond Portfolios
MWF 3:15-4:30 Gates B01 Final Exam MS&E 247S Fri Aug 15 2008 12:15PM-3:15PM Gates B01 Or Saturday Aug 16 2008 12:15PM-3:15PM Gates B01 Remote SCPD participants will also take the exam on Friday, 8/15.
More informationLecture 5. Return and Risk: The Capital Asset Pricing Model
Lecture 5 Return and Risk: The Capital Asset Pricing Model Outline 1 Individual Securities 2 Expected Return, Variance, and Covariance 3 The Return and Risk for Portfolios 4 The Efficient Set for Two Assets
More informationReturn and Risk: The Capital-Asset Pricing Model (CAPM)
Return and Risk: The Capital-Asset Pricing Model (CAPM) Expected Returns (Single assets & Portfolios), Variance, Diversification, Efficient Set, Market Portfolio, and CAPM Expected Returns and Variances
More informationChapter 13. Risk, Cost of Capital, and Valuation 13-0
Chapter 13 Risk, Cost of Capital, and Valuation 13-0 Key Concepts and Skills Know how to determine a firm s cost of equity capital Understand the impact of beta in determining the firm s cost of equity
More informationCurrency and Interest Rate Futures
MWF 3:15-4:30 Gates B01 Handout #14 as of 0722 2008 Derivative Security Markets Currency and Interest Rate Futures Course web page: http://stanford2008.pageout.net Reading Assignments for this Week Scan
More informationRETURN AND RISK: The Capital Asset Pricing Model
RETURN AND RISK: The Capital Asset Pricing Model (BASED ON RWJJ CHAPTER 11) Return and Risk: The Capital Asset Pricing Model (CAPM) Know how to calculate expected returns Understand covariance, correlation,
More informationQR43, Introduction to Investments Class Notes, Fall 2003 IV. Portfolio Choice
QR43, Introduction to Investments Class Notes, Fall 2003 IV. Portfolio Choice A. Mean-Variance Analysis 1. Thevarianceofaportfolio. Consider the choice between two risky assets with returns R 1 and R 2.
More informationModels of Asset Pricing
appendix1 to chapter 5 Models of Asset Pricing In Chapter 4, we saw that the return on an asset (such as a bond) measures how much we gain from holding that asset. When we make a decision to buy an asset,
More informationArchana Khetan 05/09/ MAFA (CA Final) - Portfolio Management
Archana Khetan 05/09/2010 +91-9930812722 Archana090@hotmail.com MAFA (CA Final) - Portfolio Management 1 Portfolio Management Portfolio is a collection of assets. By investing in a portfolio or combination
More informationAnswers to Concepts in Review
Answers to Concepts in Review 1. A portfolio is simply a collection of investment vehicles assembled to meet a common investment goal. An efficient portfolio is a portfolio offering the highest expected
More informationFIN 6160 Investment Theory. Lecture 7-10
FIN 6160 Investment Theory Lecture 7-10 Optimal Asset Allocation Minimum Variance Portfolio is the portfolio with lowest possible variance. To find the optimal asset allocation for the efficient frontier
More informationRisk and Return and Portfolio Theory
Risk and Return and Portfolio Theory Intro: Last week we learned how to calculate cash flows, now we want to learn how to discount these cash flows. This will take the next several weeks. We know discount
More informationPrinciples of Finance Risk and Return. Instructor: Xiaomeng Lu
Principles of Finance Risk and Return Instructor: Xiaomeng Lu 1 Course Outline Course Introduction Time Value of Money DCF Valuation Security Analysis: Bond, Stock Capital Budgeting (Fundamentals) Portfolio
More informationCHAPTER 9: THE CAPITAL ASSET PRICING MODEL
CHAPTER 9: THE CAPITAL ASSET PRICING MODEL 1. E(r P ) = r f + β P [E(r M ) r f ] 18 = 6 + β P(14 6) β P = 12/8 = 1.5 2. If the security s correlation coefficient with the market portfolio doubles (with
More informationOPTIMAL RISKY PORTFOLIOS- ASSET ALLOCATIONS. BKM Ch 7
OPTIMAL RISKY PORTFOLIOS- ASSET ALLOCATIONS BKM Ch 7 ASSET ALLOCATION Idea from bank account to diversified portfolio Discussion principles are the same for any number of stocks A. bonds and stocks B.
More informationPortfolio Management
Portfolio Management Risk & Return Return Income received on an investment (Dividend) plus any change in market price( Capital gain), usually expressed as a percent of the beginning market price of the
More informationChapter 5: Answers to Concepts in Review
Chapter 5: Answers to Concepts in Review 1. A portfolio is simply a collection of investment vehicles assembled to meet a common investment goal. An efficient portfolio is a portfolio offering the highest
More informationCopyright 2009 Pearson Education Canada
Operating Cash Flows: Sales $682,500 $771,750 $868,219 $972,405 $957,211 less expenses $477,750 $540,225 $607,753 $680,684 $670,048 Difference $204,750 $231,525 $260,466 $291,722 $287,163 After-tax (1
More informationCHAPTER 5: ANSWERS TO CONCEPTS IN REVIEW
CHAPTER 5: ANSWERS TO CONCEPTS IN REVIEW 5.1 A portfolio is simply a collection of investment vehicles assembled to meet a common investment goal. An efficient portfolio is a portfolio offering the highest
More informationGeneral Notation. Return and Risk: The Capital Asset Pricing Model
Return and Risk: The Capital Asset Pricing Model (Text reference: Chapter 10) Topics general notation single security statistics covariance and correlation return and risk for a portfolio diversification
More informationCost of Capital (represents risk)
Cost of Capital (represents risk) Cost of Equity Capital - From the shareholders perspective, the expected return is the cost of equity capital E(R i ) is the return needed to make the investment = the
More informationUniversity 18 Lessons Financial Management. Unit 12: Return, Risk and Shareholder Value
University 18 Lessons Financial Management Unit 12: Return, Risk and Shareholder Value Risk and Return Risk and Return Security analysis is built around the idea that investors are concerned with two principal
More informationLecture 10-12: CAPM.
Lecture 10-12: CAPM. I. Reading II. Market Portfolio. III. CAPM World: Assumptions. IV. Portfolio Choice in a CAPM World. V. Minimum Variance Mathematics. VI. Individual Assets in a CAPM World. VII. Intuition
More informationRisk and Return: From Securities to Portfolios
FIN 614 Risk and Return 2: Portfolios Professor Robert B.H. Hauswald Kogod School of Business, AU Risk and Return: From Securities to Portfolios From securities individual risk and return characteristics
More informationCHAPTER III RISK MANAGEMENT
CHAPTER III RISK MANAGEMENT Concept of Risk Risk is the quantified amount which arises due to the likelihood of the occurrence of a future outcome which one does not expect to happen. If one is participating
More informationInternational Portfolio Investments
International Portfolio Investments Chapter Objectives: Chapter Eleven 11 INTERNATIONAL FINANCIAL MANAGEMENT 1. Why investors diversify their portfolios internationally. 2. How much investors can gain
More informationPowerPoint. to accompany. Chapter 11. Systematic Risk and the Equity Risk Premium
PowerPoint to accompany Chapter 11 Systematic Risk and the Equity Risk Premium 11.1 The Expected Return of a Portfolio While for large portfolios investors should expect to experience higher returns for
More informationFinancial Mathematics III Theory summary
Financial Mathematics III Theory summary Table of Contents Lecture 1... 7 1. State the objective of modern portfolio theory... 7 2. Define the return of an asset... 7 3. How is expected return defined?...
More informationLECTURE NOTES 3 ARIEL M. VIALE
LECTURE NOTES 3 ARIEL M VIALE I Markowitz-Tobin Mean-Variance Portfolio Analysis Assumption Mean-Variance preferences Markowitz 95 Quadratic utility function E [ w b w ] { = E [ w] b V ar w + E [ w] }
More informationCHAPTER 2 RISK AND RETURN: Part I
CHAPTER 2 RISK AND RETURN: Part I (Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard) Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject
More informationFinancial Market Analysis (FMAx) Module 6
Financial Market Analysis (FMAx) Module 6 Asset Allocation and iversification This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF Institute for
More informationAnalysis INTRODUCTION OBJECTIVES
Chapter5 Risk Analysis OBJECTIVES At the end of this chapter, you should be able to: 1. determine the meaning of risk and return; 2. explain the term and usage of statistics in determining risk and return;
More informationMicroéconomie de la finance
Microéconomie de la finance 7 e édition Christophe Boucher christophe.boucher@univ-lorraine.fr 1 Chapitre 6 7 e édition Les modèles d évaluation d actifs 2 Introduction The Single-Index Model - Simplifying
More informationCOMM 324 INVESTMENTS AND PORTFOLIO MANAGEMENT ASSIGNMENT 2 Due: October 20
COMM 34 INVESTMENTS ND PORTFOLIO MNGEMENT SSIGNMENT Due: October 0 1. In 1998 the rate of return on short term government securities (perceived to be risk-free) was about 4.5%. Suppose the expected rate
More informationEfficient Frontier and Asset Allocation
Topic 4 Efficient Frontier and Asset Allocation LEARNING OUTCOMES By the end of this topic, you should be able to: 1. Explain the concept of efficient frontier and Markowitz portfolio theory; 2. Discuss
More informationHomework #4 Suggested Solutions
JEM034 Corporate Finance Winter Semester 2017/2018 Instructor: Olga Bychkova Homework #4 Suggested Solutions Problem 1. (7.2) The following table shows the nominal returns on the U.S. stocks and the rate
More informationCHAPTER 2 RISK AND RETURN: PART I
1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. False Difficulty: Easy LEARNING OBJECTIVES:
More informationFNCE 5205, Global Financial Management H Guy Williams, 2008
CHAPTER 7. ENTERPRISE COST OF CAPITAL The cost of capital is a concept that is central to valuation, investment (and divestment) decisions, measures of economic profit, and performance appraisal. Perhaps
More informationQuestion # 1 of 15 ( Start time: 01:53:35 PM ) Total Marks: 1
MGT 201 - Financial Management (Quiz # 5) 380+ Quizzes solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Date Monday 31st January and Tuesday 1st February 2011 Question # 1 of 15 ( Start time: 01:53:35 PM
More informationModule 6 Portfolio risk and return
Module 6 Portfolio risk and return Prepared by Pamela Peterson Drake, Ph.D., CFA 1. Overview Security analysts and portfolio managers are concerned about an investment s return, its risk, and whether it
More informationCHAPTER 14 BOND PORTFOLIOS
CHAPTER 14 BOND PORTFOLIOS Chapter Overview This chapter describes the international bond market and examines the return and risk properties of international bond portfolios from an investor s perspective.
More informationAsset Allocation. Cash Flow Matching and Immunization CF matching involves bonds to match future liabilities Immunization involves duration matching
Asset Allocation Strategic Asset Allocation Combines investor s objectives, risk tolerance and constraints with long run capital market expectations to establish asset allocations Create the policy portfolio
More informationRisk, return, and diversification
Risk, return, and diversification A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Diversification and risk 3. Modern portfolio theory 4. Asset pricing models 5. Summary 1.
More information80 Solved MCQs of MGT201 Financial Management By
80 Solved MCQs of MGT201 Financial Management By http://vustudents.ning.com Question No: 1 ( Marks: 1 ) - Please choose one What is the long-run objective of financial management? Maximize earnings per
More informationFor each of the questions 1-6, check one of the response alternatives A, B, C, D, E with a cross in the table below:
November 2016 Page 1 of (6) Multiple Choice Questions (3 points per question) For each of the questions 1-6, check one of the response alternatives A, B, C, D, E with a cross in the table below: Question
More informationBehavioral Finance 1-1. Chapter 2 Asset Pricing, Market Efficiency and Agency Relationships
Behavioral Finance 1-1 Chapter 2 Asset Pricing, Market Efficiency and Agency Relationships 1 The Pricing of Risk 1-2 The expected utility theory : maximizing the expected utility across possible states
More informationFinal Exam Suggested Solutions
University of Washington Fall 003 Department of Economics Eric Zivot Economics 483 Final Exam Suggested Solutions This is a closed book and closed note exam. However, you are allowed one page of handwritten
More informationSDMR Finance (2) Olivier Brandouy. University of Paris 1, Panthéon-Sorbonne, IAE (Sorbonne Graduate Business School)
SDMR Finance (2) Olivier Brandouy University of Paris 1, Panthéon-Sorbonne, IAE (Sorbonne Graduate Business School) Outline 1 Formal Approach to QAM : concepts and notations 2 3 Portfolio risk and return
More informationFinancial Economics: Capital Asset Pricing Model
Financial Economics: Capital Asset Pricing Model Shuoxun Hellen Zhang WISE & SOE XIAMEN UNIVERSITY April, 2015 1 / 66 Outline Outline MPT and the CAPM Deriving the CAPM Application of CAPM Strengths and
More informationQuestion # 4 of 15 ( Start time: 07:07:31 PM )
MGT 201 - Financial Management (Quiz # 5) 400+ Quizzes solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Date Monday 31st January and Tuesday 1st February 2011 Question # 1 of 15 ( Start time: 07:04:34 PM
More informationCHAPTER 8 Risk and Rates of Return
CHAPTER 8 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM The basic goal of the firm is to: maximize shareholder wealth! 1 Investment returns The rate of return on an investment
More informationThe Capital Assets Pricing Model & Arbitrage Pricing Theory: Properties and Applications in Jordan
Modern Applied Science; Vol. 12, No. 11; 2018 ISSN 1913-1844E-ISSN 1913-1852 Published by Canadian Center of Science and Education The Capital Assets Pricing Model & Arbitrage Pricing Theory: Properties
More informationDefine risk, risk aversion, and riskreturn
Risk and 1 Learning Objectives Define risk, risk aversion, and riskreturn tradeoff. Measure risk. Identify different types of risk. Explain methods of risk reduction. Describe how firms compensate for
More informationAdjusting discount rate for Uncertainty
Page 1 Adjusting discount rate for Uncertainty The Issue A simple approach: WACC Weighted average Cost of Capital A better approach: CAPM Capital Asset Pricing Model Massachusetts Institute of Technology
More informationCorporate Finance Finance Ch t ap er 1: I t nves t men D i ec sions Albert Banal-Estanol
Corporate Finance Chapter : Investment tdecisions i Albert Banal-Estanol In this chapter Part (a): Compute projects cash flows : Computing earnings, and free cash flows Necessary inputs? Part (b): Evaluate
More informationRisk and Return. CA Final Paper 2 Strategic Financial Management Chapter 7. Dr. Amit Bagga Phd.,FCA,AICWA,Mcom.
Risk and Return CA Final Paper 2 Strategic Financial Management Chapter 7 Dr. Amit Bagga Phd.,FCA,AICWA,Mcom. Learning Objectives Discuss the objectives of portfolio Management -Risk and Return Phases
More informationAccountant s Guide to Financial Management - Final Exam 100 Questions 1. Objectives of managerial finance do not include:
Accountant s Guide to Financial Management - Final Exam 100 Questions 1. Objectives of managerial finance do not include: Employee profits B. Stockholders wealth maximization Profit maximization Social
More informationGuide to Financial Management Course Number: 6431
Guide to Financial Management Course Number: 6431 Test Questions: 1. Objectives of managerial finance do not include: A. Employee profits. B. Stockholders wealth maximization. C. Profit maximization. D.
More informationChapter 10. Chapter 10 Topics. What is Risk? The big picture. Introduction to Risk, Return, and the Opportunity Cost of Capital
1 Chapter 10 Introduction to Risk, Return, and the Opportunity Cost of Capital Chapter 10 Topics Risk: The Big Picture Rates of Return Risk Premiums Expected Return Stand Alone Risk Portfolio Return and
More informationCh. 8 Risk and Rates of Return. Return, Risk and Capital Market. Investment returns
Ch. 8 Risk and Rates of Return Topics Measuring Return Measuring Risk Risk & Diversification CAPM Return, Risk and Capital Market Managers must estimate current and future opportunity rates of return for
More informationJ B GUPTA CLASSES , Copyright: Dr JB Gupta. Chapter 4 RISK AND RETURN.
J B GUPTA CLASSES 98184931932, drjaibhagwan@gmail.com, www.jbguptaclasses.com Copyright: Dr JB Gupta Chapter 4 RISK AND RETURN Chapter Index Systematic and Unsystematic Risk Capital Asset Pricing Model
More informationSuggested Solutions to Problem Set 6
Department of Economics University of California, Berkeley Spring 2006 Economics 182 Suggested Solutions to Problem Set 6 Problem 1: International diversification Because raspberries are nontradable, asset
More informationEcon 422 Eric Zivot Fall 2005 Final Exam
Econ 422 Eric Zivot Fall 2005 Final Exam This is a closed book exam. However, you are allowed one page of notes (double-sided). Answer all questions. For the numerical problems, if you make a computational
More informationUniversity of Siegen
University of Siegen Faculty of Economic Disciplines, Department of economics Univ. Prof. Dr. Jan Franke-Viebach Seminar Risk and Finance Summer Semester 2008 Topic 4: Hedging with currency futures Name
More informationInternational Financial Markets Prices and Policies. Second Edition Richard M. Levich. Overview. ❿ Measuring Economic Exposure to FX Risk
International Financial Markets Prices and Policies Second Edition 2001 Richard M. Levich 16C Measuring and Managing the Risk in International Financial Positions Chap 16C, p. 1 Overview ❿ Measuring Economic
More informationGovernments and Exchange Rates
Governments and Exchange Rates Exchange Rate Behavior Existing spot exchange rate covered interest arbitrage locational arbitrage triangular arbitrage Existing spot exchange rates at other locations Existing
More informationFinancial Markets. Laurent Calvet. John Lewis Topic 13: Capital Asset Pricing Model (CAPM)
Financial Markets Laurent Calvet calvet@hec.fr John Lewis john.lewis04@imperial.ac.uk Topic 13: Capital Asset Pricing Model (CAPM) HEC MBA Financial Markets Risk-Adjusted Discount Rate Method We need a
More informationECON FINANCIAL ECONOMICS
ECON 337901 FINANCIAL ECONOMICS Peter Ireland Boston College Fall 2017 These lecture notes by Peter Ireland are licensed under a Creative Commons Attribution-NonCommerical-ShareAlike 4.0 International
More informationECON FINANCIAL ECONOMICS
ECON 337901 FINANCIAL ECONOMICS Peter Ireland Boston College Spring 2018 These lecture notes by Peter Ireland are licensed under a Creative Commons Attribution-NonCommerical-ShareAlike 4.0 International
More informationRisk and Return. Nicole Höhling, Introduction. Definitions. Types of risk and beta
Risk and Return Nicole Höhling, 2009-09-07 Introduction Every decision regarding investments is based on the relationship between risk and return. Generally the return on an investment should be as high
More informationMGT Financial Management Mega Quiz file solved by Muhammad Afaaq
MGT 201 - Financial Management Mega Quiz file solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Afaaqtariq233@gmail.com Asslam O Alikum MGT 201 Mega Quiz file solved by Muhammad Afaaq Remember Me in Your
More informationRisk and Return. Return. Risk. M. En C. Eduardo Bustos Farías
Risk and Return Return M. En C. Eduardo Bustos Farías Risk 1 Inflation, Rates of Return, and the Fisher Effect Interest Rates Conceptually: Interest Rates Nominal risk-free Interest Rate krf = Real risk-free
More informationInvestment In Bursa Malaysia Between Returns And Risks
Investment In Bursa Malaysia Between Returns And Risks AHMED KADHUM JAWAD AL-SULTANI, MUSTAQIM MUHAMMAD BIN MOHD TARMIZI University kebangsaan Malaysia,UKM, School of Business and Economics, 43600, Pangi
More informationReturn, Risk, and the Security Market Line
Chapter 13 Key Concepts and Skills Return, Risk, and the Security Market Line Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand
More informationPreview PP542. International Capital Markets. Gains from Trade. International Capital Markets. The Three Types of International Transaction Trade
Preview PP542 International Capital Markets Gains from trade Portfolio diversification Players in the international capital markets Attainable policies with international capital markets Offshore banking
More informationFoundations of Finance
Lecture 5: CAPM. I. Reading II. Market Portfolio. III. CAPM World: Assumptions. IV. Portfolio Choice in a CAPM World. V. Individual Assets in a CAPM World. VI. Intuition for the SML (E[R p ] depending
More information600 Solved MCQs of MGT201 BY
600 Solved MCQs of MGT201 BY http://vustudents.ning.com Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because
More informationMGT201 Financial Management All Subjective and Objective Solved Midterm Papers for preparation of Midterm Exam2012 Question No: 1 ( Marks: 1 ) - Please choose one companies invest in projects with negative
More informationWhen we model expected returns, we implicitly model expected prices
Week 1: Risk and Return Securities: why do we buy them? To take advantage of future cash flows (in the form of dividends or selling a security for a higher price). How much should we pay for this, considering
More informationStock Price Sensitivity
CHAPTER 3 Stock Price Sensitivity 3.1 Introduction Estimating the expected return on investments to be made in the stock market is a challenging job before an ordinary investor. Different market models
More informationCHAPTER 9: THE CAPITAL ASSET PRICING MODEL
CHAPTER 9: THE CAPITAL ASSET PRICING MODEL 1. E(r P ) = r f + β P [E(r M ) r f ] 18 = 6 + β P(14 6) β P = 12/8 = 1.5 2. If the security s correlation coefficient with the market portfolio doubles (with
More informationAll In One MGT201 Mid Term Papers More Than (10) BY
All In One MGT201 Mid Term Papers More Than (10) BY http://www.vustudents.net MIDTERM EXAMINATION MGT201- Financial Management (Session - 2) Question No: 1 ( Marks: 1 ) - Please choose one Why companies
More informationMean-Variance Analysis
Mean-Variance Analysis If the investor s objective is to Maximize the Expected Rate of Return for a given level of Risk (or, Minimize Risk for a given level of Expected Rate of Return), and If the investor
More informationChapter 7. Speculation and Risk in the Foreign Exchange Market Cambridge University Press 7-1
Chapter 7 Speculation and Risk in the Foreign Exchange Market 2018 Cambridge University Press 7-1 7.1 Speculating in the Foreign Exchange Market Uncovered foreign money market investments Kevin Anthony,
More informationPortfolio Management
Portfolio Management 010-011 1. Consider the following prices (calculated under the assumption of absence of arbitrage) corresponding to three sets of options on the Dow Jones index. Each point of the
More informationConsumption- Savings, Portfolio Choice, and Asset Pricing
Finance 400 A. Penati - G. Pennacchi Consumption- Savings, Portfolio Choice, and Asset Pricing I. The Consumption - Portfolio Choice Problem We have studied the portfolio choice problem of an individual
More informationChapter 9. Forecasting Exchange Rates. Lecture Outline. Why Firms Forecast Exchange Rates
Chapter 9 Forecasting Exchange Rates Lecture Outline Why Firms Forecast Exchange Rates Forecasting Techniques Technical Forecasting Fundamental Forecasting Market-Based Forecasting Mixed Forecasting Guidelines
More informationThe International Monetary System
INTERNATIONAL FINANCIAL MANAGEMENT Fourth Edition EUN / RESNICK The International Monetary System 2 Chapter Two INTERNATIONAL Chapter Objective: FINANCIAL MANAGEMENT This chapter serves to introduce the
More informationDoes an Optimal Static Policy Foreign Currency Hedge Ratio Exist?
May 2015 Does an Optimal Static Policy Foreign Currency Hedge Ratio Exist? FQ Perspective DORI LEVANONI Partner, Investments Investing in foreign assets comes with the additional question of what to do
More informationIncome smoothing and foreign asset holdings
J Econ Finan (2010) 34:23 29 DOI 10.1007/s12197-008-9070-2 Income smoothing and foreign asset holdings Faruk Balli Rosmy J. Louis Mohammad Osman Published online: 24 December 2008 Springer Science + Business
More informationChapter 5. Asset Allocation - 1. Modern Portfolio Concepts
Asset Allocation - 1 Asset Allocation: Portfolio choice among broad investment classes. Chapter 5 Modern Portfolio Concepts Asset Allocation between risky and risk-free assets Asset Allocation with Two
More informationBOND ANALYTICS. Aditya Vyas IDFC Ltd.
BOND ANALYTICS Aditya Vyas IDFC Ltd. Bond Valuation-Basics The basic components of valuing any asset are: An estimate of the future cash flow stream from owning the asset The required rate of return for
More informationTHEORY & PRACTICE FOR FUND MANAGERS. SPRING 2011 Volume 20 Number 1 RISK. special section PARITY. The Voices of Influence iijournals.
T H E J O U R N A L O F THEORY & PRACTICE FOR FUND MANAGERS SPRING 0 Volume 0 Number RISK special section PARITY The Voices of Influence iijournals.com Risk Parity and Diversification EDWARD QIAN EDWARD
More informationFINALTERM EXAMINATION Spring 2009 MGT201- Financial Management (Session - 2) Question No: 1 ( Marks: 1 ) - Please choose one What is the long-run objective of financial management? Maximize earnings per
More informationEmpirical Evidence. r Mt r ft e i. now do second-pass regression (cross-sectional with N 100): r i r f γ 0 γ 1 b i u i
Empirical Evidence (Text reference: Chapter 10) Tests of single factor CAPM/APT Roll s critique Tests of multifactor CAPM/APT The debate over anomalies Time varying volatility The equity premium puzzle
More informationMTP_Paper 14_ Syllabus 2012_December 2017_Set2. Paper 14 - Advanced Financial Management
Paper 14 - Advanced Financial Management Page 1 Paper 14 - Advanced Financial Management Full Marks: 100 Time allowed: 3 Hours Answer Question No. 1 which is compulsory and carries 20 marks and any five
More informationIn the sections dealing with global investments, we address the questions including:
June 25, 2008 MS&E 247s International Investments Handout # 1 Page 1 of 6 STANFORD UNIVERSITY MWF 3:15-4:30 pm (Live broadcast on SITN channel E2) Yee-Tien (Ted) Fu Gates B01 Summer 2008 (3 units) COURSE
More information