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Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Investing
Purchase of assets with the goal of
increasing future income
Focuses on wealth accumulation
Underlying investment decisions: the
tradeoff between expected return and risk
Expected return is not usually the same as
realized return
Risk: the possibility that the realized return
will be different than the expected return
2
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Total return on investment expressed
as a percentage of the amount of
money invested
Investments usually earn higher rates
of return than savings tools
Rate of Return
Total Return
Amount of
Money Invested
Rate of Return
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Risk
Risk- uncertainty regarding the
outcome of a situation or event
Investment Risk- possibility that an
investment will fail to pay the expected
return or fail to pay a return at all
All investment tools carry some level of
risk
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Types of Investment Tools
Stocks Bonds
Mutual Funds
Index Funds
Real Estate
Cash
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Risk Return Tradeoff
Investors manage risk at a cost
- lower expected returns (ER)
Any level of expected return and risk
can be attained
Risk
ER
Risk-free Rate
Bonds
Stocks
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
10.1 A First Look at Risk and Return
We begin our look at risk and return by illustrating how the risk premium affects investor decisions and returns:
Suppose you won $10,000 in a raffle in December 1988 and decided to invest it all in a portfolio of Australian shares, with dividends being reinvested.
By December 2008, 20 years later, your shareportfolio would be worth $55,695 and a comparable portfolio of cash $41,134 as shown in Figure 10.1.
The impact of the stock market decline of 2007 and the global slowdown that occurred from 2008 is evident in the sharp decline of the graph.
7
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Figure 10.1 Value of $10,000 Invested in Cash and Australian Shares over 20 Years from December 1988
8
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Table 10.1 Range of Returns on Australian Investments over 20 Years from December 1988
9
The table above shows returns of four investment classes with different risk profiles over 20 years.
The general principle is that investors do not like risk and demand a premium to bear it.
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Individual investment realised return
The realised return is the total return that occurs
over a particular time period.
The realised return from your investment from t
to t+1 is:
(Eq. 10.1)
10
FORMULA!
10.2 Historical Risks and Returns of Securities
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Example 10.1 Realised Return (p.314)
Problem:
Metropolis Limited paid a one-time special
dividend of $3.08 on 15 November 2010.
Suppose you bought a Metropolis share for
$28.08 on 1 November 2010 and sold it
immediately after the dividend was paid for
$27.39.
What was your realised return from holding the
share?
11
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Solution:
Plan:
We can use Eq. 10.1 to calculate the realised
return.
We need the purchase price ($28.08), the selling
price ($27.39), and the dividend ($3.08) and we
are ready to proceed.
12
Example 10.1 Realised Return (p.314)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute:
Using Eq. 10.1, the return from 1 Nov 2010 until 15 Nov
2010 is equal to:
This 8.51% can be broken down into the dividend yield
and the capital gain yield:
13
Example 10.1 Realised Return (p.314)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Evaluate:
These returns include both the capital gain (or in this case a capital loss) and the return generated from receiving dividends.
Both dividends and capital gains contribute to the total realised return—ignoring either one would give a very misleading impression of Metropolis’ performance.
14
Example 10.1 Realised Return (p.314)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Individual investment realised return
For quarterly returns (or any four compounding
periods that make up an entire year), the annual
realised return, which can be observed over
years, Rannual, is found by compounding:
1+ Rannual =(1+R1) (1+R2) (1+R3) (1+R4)
(Eq. 10.2)
15
10.2 Historical Risks and Returns of Securities
FORMULA!
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Example 10.2 Compounding Realised Returns (pp.315-6)
Problem:
Suppose you purchased Metropolis shares on 1
November 2010 and held them for one year,
selling on 31 October 2011. All dividends you
earned were re-invested in the same Metropolis
shares.
What was your realised return?
16
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Solution:
Plan:
We need to analyse the cash flows from holding
Metropolis shares for each quarter.
In order to get the cash flows, we must look up
Metropolis share price data at the start and end
of the year, as well as at any dividend dates.
From the data we can construct the following
table to fill out our cash flow timeline:
17
Example 10.2 Compounding Realised Returns (pp.315-6)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Plan (cont’d):
Next, calculate the return between each set of dates using Eq. 10.1.
Then, determine each annual return similarly to
Eq. 10.2 by compounding the returns for all of the
periods in that year.18
Example 10.2 Compounding Realised Returns (pp.315-6)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute:
In Example 10.1, we already calculated the
realised return for 1 Nov to 15 Nov 2010 as 8.51%.
We continue this for each period until we have a
series of realised returns.
For example, from 15 Nov 2010 to 15 Feb 2011,
the realised return is:
19
Example 10.2 Compounding Realised Returns (pp.315-6)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute (cont’d):
We then determine the one-year return by
compounding:
20
Example 10.2 Compounding Realised Returns (pp.315-6)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute (cont’d):
The table below includes the realised return at
each period:
21
Example 10.2 Compounding Realised Returns (pp.315-6)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Evaluate:
By repeating these steps, we have successfully calculated the realised annual returns for an investor holding Metropolis shares over this one-year period.
From this exercise, we can see that returns are risky.
Metropolis fluctuated up and down over the year and ended up only slightly up (2.75%) at the end.
22
Example 10.2 Compounding Realised Returns (pp.315-6)
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9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Average annual returns
The average annual return of an investment during some historical period is simply the average of the realised returns for each year.
That is, if Rt is the realised return of a security in each year t, then the average annual return for years one through T is:
23
10.2 Historical Risks and Returns of Securities
(Eq. 10.3)
FORMULA!
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The average return provides a estimate of the return we should expect in any given year.
24
Table 10.2 Annual Returns on the Australian All Ordinaries Index 2004-08
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
The variance and volatility of returns
To determine the variability, we calculate the standard deviation of the distribution of realised returns, which is the square root of the variance of the distribution of realised returns.
Variance measures the variability in returns by taking the differences of the returns from the average return and squaring those differences.
25
10.2 Historical Risks and Returns of Securities
FORMULA! (Eq. 10.4)
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9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
(Eq. 10.5)
26
Variance estimate using realised returns
We have to square the difference of each return
from the average, because the unsquared
differences from an average must be zero.
Because we square the returns, the variance is in
units of ‘%2’ or per cent-squared, which is not
useful.
So we take the square root, to get the standard
deviation in units of ‘%’.
10.2 Historical Risks and Returns of Securities
FORMULA!
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9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Example 10.3 Calculating Historical Volatility (pp.318-9)
Problem:
Using the data from Table 10.2, what is the
standard deviation of the return on the All
Ordinaries Index for the years 2004–08?
27
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Solution:
Plan:
First, calculate the average return using Eq. 10.3
because it is an input to the variance equation.
Next, calculate the variance using Eq. 10.4 and
then take its square root to determine the standard
deviation.
28
Example 10.3 Calculating Historical Volatility (pp.318-9)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute:
In the previous section we already calculated the
average annual return of the All Ordinaries
during this period as 9.74%, so we have all of the
necessary inputs for the variance calculation.
From Eq. 10.4, we have:
29
Example 10.3 Calculating Historical Volatility (pp.318-9)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute (cont'd):
Alternatively, we can break the calculation of this
equation out as follows:
Summing the squared differences in the last row, we get 0.3531.
30
Example 10.3 Calculating Historical Volatility (pp.318-9)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute (cont'd):
Finally, dividing by
(5 – 1= 4) gives us 0.3531/4 =0.0883.
The standard deviation is therefore:
Evaluate:
Our best estimate of the expected return for the All
Ordinaries Index is its average return, 9.74%, but it
is risky, with a standard deviation of 29.71%.
31
Example 10.3 Calculating Historical Volatility (pp.318-9)
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The normal distribution
Standard deviations are useful for more than just
ranking the investments from riskiest to least risky.
It also describes a normal distribution, shown in
Figure 10.2:
About two-thirds of all possible outcomes fall within
one standard deviation above or below the average.
About 95% of all possible outcomes fall within two
standard deviations above and below the average.
Figure 10.2 shows these outcomes for the shares of a
hypothetical company.
32
10.2 Historical Risks and Returns of Securities
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Figure 10.2 Normal Distribution
33
Because we are about 95% confident that next year’s
returns will be within two standard deviations of the
average:
(Eq. 10.6)
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Table 10.3 Summary of Tools for Working with Historical Returns
34
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The returns of large portfolios
Figure 10.3 plots the average returns versus the
volatility of US large company shares, US small
shares, US corporate bonds, US Treasury bills
and a world portfolio.
Note that investments with higher volatility,
measured by standard deviation, have rewarded
investors with higher average returns.
This is consistent with the view that investors are
risk averse—risky investments must offer higher
average returns to compensate for the risk.
35
10.3 The Historical Trade-off Between Risk and Return
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Figure 10.3 The Historical Trade-off Between Risk and Return in Large Portfolios, 1926–2006
36
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Returns of individual securities
The following observations are noteworthy
1. There is a relationship between size and risk—larger shares have lower volatility than smaller ones.
2. Even the largest shares are typically more volatile than a portfolio of large shares, such as the S&P 500.
3. All individual shares have lower returns and/or higher risk than the portfolios in Figure 10.3—the individual shares all lie below the line in the figure.
37
10.3 The Historical Trade-off Between Risk and Return
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Individual securities
While volatility (standard deviation) seems to be
a reasonable measure of risk when evaluating a
large portfolio, the volatility of an individual
security doesn’t explain the size of its average
return.
38
10.3 The Historical Trade-off Between Risk and Return
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10.4 Common versus Independent Risk
Example: Theft vs earthquake insurance
Consider two types of home insurance: theft
insurance and earthquake insurance.
Assume that the risk of each of these two hazards
is similar for a given home in Sydney. Each year
there is about a 1% chance the home will be
robbed, and also a 1% chance the home will be
damaged by an earthquake.
Suppose an insurance company writes 100,000
policies of each type of insurance for homeowners
in Sydney. Are the risks of the two portfolios of
policies similar?
39
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
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10.4 Common versus Independent Risk
Example: Theft vs earthquake insurance
Why are the portfolios of insurance policies so
different when the individual policies themselves
are quite similar?
Intuitively, the key difference between them is that an
earthquake affects all houses simultaneously, so the
risk is linked across homes—common risk.
The risk of theft is not linked across homes, some
homeowners are unlucky, others lucky—independent
risk.
Diversification: the averaging out of independent
risk in a large portfolio.
40
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Table 10.4 Summary of Types of Risk
41
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Example 10.5 Diversification (p.325)
Problem:
You are playing a very simple gambling game
with your friend: a $1 bet based on a coin flip.
That is, you each bet $1 and flip a coin: heads
you win your friend’s dollar, tails you lose and
your friend takes your dollar.
How is your risk different if you play this game
100 times in a row versus just betting $100
(instead of $1) on a single coin flip?
42
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Solution:
Plan:
The risk of losing one coin flip is independent of the risk of losing the next one—each time you have a 50% chance of losing, and one coin flip does not affect any other coin flip.
We can calculate the expected outcome of any flip as a weighted average by weighting your possible winnings (+$1) by 50% and your possible losses (–$1) by 50%.
We can then calculate the probability of losing all $100 under either scenario.
43
Example 10.5 Diversification (p.325)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition
Execute:
If you play the game 100 times, you should lose
about 50% of the time and win 50% of the time,
so your expected outcome is:
50 (+$1) + 50 (–$1) = $0
You should break even.
However the probability of losing $100 is
= 0.5 x 0.5 x 0.5 ………..
= 0.5100
= 0.000000000000000000000000000078%
If it happens, you should take a very careful look
at the coin! 44
Example 10.5 Diversification (p.325)
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –
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Execute (cont’d):
If, instead, you make a single $100 bet on the
outcome of one coin flip, you have a 50% chance
of winning $100 and a 50% chance of losing
$100, so your expected outcome will be the
same—break even.
However, there is a 50% chance you will lose
$100, so your risk is far greater than it would be
for 100 one dollar bets.
45
Example 10.5 Diversification (p.325)
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Evaluate:
In each case, you put $100 at risk, but by
spreading out that risk across 100 different bets,
you have diversified much of your risk away
compared to placing a single $100 bet.
46
Example 10.5 Diversification (p.325)
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10.5 Diversification in Share Portfolios
As the insurance example indicates, the risk of a
portfolio depends upon whether the individual
risks within it are common or independent.
Independent risks are diversified in a large
portfolio, whereas common risks are not.
Our goal is to understand the relation between
risk and return in the capital markets, so let’s
consider the implication of this distinction for the
risk of stock portfolios.
47
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Unsystematic vs systematic risk Share prices and dividends fluctuate due to two
types of news:
Company- or industry-specific news: good or bad news about a company (or industry) itself. For example, a firm might announce that it has been successful in gaining market share within its industry.
Market-wide news: news that affects the economy as a whole and therefore affects all shares. For example, the Reserve Bank might announce that it will lower interest rates to boost the economy.
48
10.5 Diversification in Share Portfolios
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Unsystematic vs systematic risk
Fluctuations of a share’s return that are due to company- or industry-specific news are independent risks.
Like theft across homes, these risks are unrelated across shares and are also referred to as unsystematic risk.
On the other hand, fluctuations of a share’s return that are due to market-wide news represent common risk, which affect all shares simultaneously.
This type of risk is also called systematic risk.
49
10.5 Diversification in Share Portfolios
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Figure 10.4 Volatility of Portfolios of Type S and U Shares
50
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Unsystematic vs systematic risk
When firms carry both types of risk, only the
unsystematic risk will be diversified away when
we combine many firms into a portfolio.
The volatility will therefore decline until only the
systematic risk, which affects all firms, remains.
51
10.5 Diversification in Share Portfolios
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Figure 10.5 The Effect of Diversification on Portfolio Volatility
52
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Diversifiable risk and the risk premium
Competition among investors ensures that no
additional return can be earned for diversifiable
risk.
The risk premium of a share is not affected by
its diversifiable, unsystematic risk.
The risk premium for diversifiable risk is zero.
Thus, investors are not compensated for
holding unsystematic risk.
53
10.5 Diversification in Share Portfolios
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Table 10.5 The Expected Return of Type S and Type U Firms, Assuming the Risk-Free Rate is 5%
54
The risk premium of a security is determined by its
systematic risk and does not depend on its
diversifiable risk.
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Table 10.6 Systematic Risk versus Unsystematic Risk
Thus, there is no relationship between volatility and
average returns for individual securities.
55