Professional Documents
Culture Documents
Risks,
Return,
Portfolio Theory
and
Value Creation
Chienny Hocosol
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Click to edit Master title style
• When mutually exclusive projects have unequal useful lives, capital budgeting
decision is made based on annual net present value (also called equivalent
annual annuity) and replacement chain methods.
• Mutually exclusive projects are projects out of which only one project has to be
ultimately selected for investment.
• Unlike independent projects, they are competing projects in that selection of
one excludes the other projects from consideration.
• When they have equal lives, decision is simple: accept the project with highest net present
value and/or highest internal rate of return and/or payback period.
• However, when they have unequal lives, more elaborate analysis is required to arrive at the
right decision.
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Replacement Chain title
(Common
style Life) Approach
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Click to editAnnual
Equivalent MasterAnnuity
title style
(EAA) Method
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Click to edit Risk
Stand-alone Master title style
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Methods of Assessing
Master title
Stand-Alone
style Risk
1. Sensitivity Analysis
This approach focuses on a project’s NPV sensitivity to a single variable. The
approach starts with a base case and calculates the change in NPV in the
event of a change to an input variable in the NPV calculation.
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2. Scenario
to editAnalysis
Master title style
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3. Break-even
to edit Master
Analysis
title style
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4. Monte
to edit
Carlo
Master
Simulation
title style
• This capital project risk analysis will use a computer program to simulate likely
events and generate an internal rate of return (IRR) or NPV for the project in
question.
• The computer will pick a random variable and calculate an IRR and NPV; the
process will be repeated many times, generating new IRRs and NPVs.
• Each of the IRRs and NPVs will be analyzed and a statistical report will be
generated for the number of iterations ran, showing data on the mean, standard
deviation, median, etc.
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Capital edit Master
Theory
title style
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Capital edit Master
Assumptions
title style
• 1. All investors can borrow or lend money at the risk-free rate of return.
• 2. All investors have identical probability distributions for future rates of return; they
have homogeneous expectations with respect to the three inputs of the portfolio
model i.e. expected returns, the variance of returns, and the correlation matrix.
Therefore, given a set of security prices and a risk-free rate, all investors use the
same information to generate an efficient frontier.
• 3. All investors have the same one-period time horizon.
• 4. There are no transaction costs.
• 5. There are no personal income taxes---investors are indifferent between capital gains
and dividends.
• 6. There is no inflation.
• 7. There are many investors, and no single investor can affect the price of a stock
through his or her buying and selling decisions. Investors are price takers and act as if
prices are unaffected by their own trades.
• 8. Capital markets are in equilibrium.
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Role to Capital
edit Master
Market
title
Theory
style
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Capital edit Master
Line title style
• The line formed by the action of all investors mixing the market
portfolio with the risk free asset is known as the capital market line.
• All efficient portfolios of all investors would lie along this CML.
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Decision TreeMaster
Basics title style
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Decision TreeMaster
analysis
title style
• A financial option gives the owner the right to buy (or sell) a financial asset at
a certain price for a certain period of time.
• Example: An option to purchase IBM stock at $100 per share at any time for the next three
months. This (call) option has value even if IBM stock is currently selling for less than $100
per share. Why - because IBM stock might have a price of greater than $100 before the
end of the three-month period.
• A real option gives the owner a similar right to do something (or not do
something). Just like a financial option has value, a real option also has value.
• Example: Project X will use of a pilot program that permits the company to evaluate a
scaled down version of the project before funds are spent on a full-scale project.
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Example of Decision
Master title
Treestyle
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Portfolio RiskMaster title style
• is a chance that the combination of assets or units, within the investments that
you own, fail to meet financial objectives. Each investment within a portfolio
carries its own risk, with higher potential return typically meaning higher risk.
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Click to editCoefficient
Correlation Master title( style
r)
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ClickReduction
Risk to edit Master title style
• Combining stocks that are NOT perfectly correlated will reduce portfolio risk.
• We call this diversification.
• The risk of a portfolio is reduced as the number of stocks in the portfolio
increases.
• The lower the positive correlation of each stock we add to the portfolio, the
lower the risk.
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Firm to edit Master
vs Market
titleRisk
style
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Portfolio Diversification
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Portfolio Diversification
Master title style
• Correlation coefficient - can range from -1.0 (perfect negative correlation), meaning that
two variables move in perfectly opposite directions to +1.0 (perfect positive correlation).
Lower the correlation, greater will be the diversification benefits.
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Diversification
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Modern Portfolio
Master
Theory
title style
(MPT)
• MPT quantifies the idea of diversified investment portfolios through the use of
correlation
• Previously a subjective judgment
• Makes use of the correlations of investment returns for the first time.
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MPT to edit
“Optimal”
Master title
Portfolios
style
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Limits Diversification
Master title style
• Market risk cannot be diversified away.
• MPT distinguishes between risks inherent in the market and risks that can be
diversified.
• Systematic Risk (market risk) is inherent in every security and cannot be avoided
• Unsystematic Risk (company specific risk) can be reduced through diversification
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Efficient Market
Master
Theory
title(Hypothesis)
style
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Efficient Market
Master
Hypothesis
title style
According to Eugene Fama
• Quoting Eugene Fama “In an efficient market, competition among the many
intelligent participants leads to a situation where, at any point in time, the actual
prices of securities already reflects the effects of information based on events
that have
1. already occurred and on events,
2. as of now, [and events]
3. the market expects to take place in the future”
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Click and
EMH to edit
Random
Master
Walk
title style
• Efficient market theory - Stocks are always correctly priced since everything that
is publicly known about a stock is reflected in its market price.
• Random walk theory - All future price changes are independent from previous
price changes, thus, future stock prices cannot be predicted
• If a market is efficient, price levels are not random; price changes are random (cannot be
predicted).
• Why would price changes be random?
• Prices react to new information
• Information is new only if it is not expected
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Forms EMHMaster title style
1. Weak Form – a market is weak-form efficient if prices fully reflect market data
• Technical Analysis –using patterns in market data to predict price changes.
• If the stock market is weak-form efficient, can technical analysis benefit investors?
2. Semi-strong Form – a market is semi-strong efficient if prices fully reflect all
public information
• Fundamental Analysis –using economic and accounting information to evaluate a security.
• If the stock market is semi strong form efficient, can fundamental analysis benefit investors?
3. Strong Form – A market is strong form efficient if prices fully reflect all
information, public and private. If the stock market is strong form efficient, do
insiders have an advantage over other investors?
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Click to editStrategy
Investment Master title style
In Efficient Market:
• Diversify broadly
• Match portfolio risk to your risk tolerance
• Buy & hold
In Inefficient Market:
• Try to beat the market by identifying undervalued securities or sectors
and overweighting
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Capital edit Master
Pricingtitle
Modelstyle
(CAPM)
• Portfolio theory implied that each investor faced an efficient frontier. But
differences in expectations leads to different frontiers for different investors.
• CAPM provides a framework for assessing whether a security is overpriced,
under priced or correctly priced.
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Capital edit Master
Pricingtitle
Modelstyle
(CAPM) Assumptions:
• All investors employ Markowitz portfolio theory to find portfolios in the efficient
set and then based on their individual risk preferences invest in one of the
portfolios in the efficient set
• All investors have the same planning horizon and identical beliefs about the
distributions of security returns
• No barriers to flow of capital or information. E.g. no transaction costs, no taxes
etc.
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The to edit Master
Markettitle
Linestyle
(SML)
• For well diversified portfolios, non systematic risk tends to go to zero, and the
only relevant risk is systematic risk measured by beta. So a straight line that
shows investors risk and return in terms of expected return and beta is called
the SML. Thus SML provides the relationship between the expected return and
beta of a security or portfolio.
• The straight line relationship between the betas and expected return, and its
slope is often referred to as the reward to risk ratio
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CAPM
• The relationship between risk and return established by the SML is known as
the CAPITAL ASSET PRICING MODEL. It is basically a simple linear
relationship.
• The higher the value of beta, higher would be the risk of the security and
therefore larger would be the return expected by the investors. In other words
all securities are expected to yield return commensurate with the riskiness as
measured by beta. This relationship is valid not only for individual securities, but
is also valid for all portfolios whether efficient or inefficient.
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Arbitrage Pricing
Master
Theory
title style
• is a theory of asset pricing that holds that an asset’s returns can be forecasted
with the linear relationship of an asset’s expected returns and
the macroeconomic factors that affect the asset’s risk.
• offers analysts and investors a multi-factor pricing model for securities based on
the relationship between a financial asset’s expected return and its risks.
• The theory assumes that market action is less than always perfectly efficient,
and therefore occasionally results in assets being mispriced – either overvalued
or undervalued – for a brief period of time
• The APT asserts that asset prices are determined through an arbitrage
relationship. It is based on the premise that two or more securities or portfolios
that provide the same payoffs to their investors are same and must therefore
sell at the same price. This is the ‘Law of One Price’.
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Assumptions in the Arbitrage
title stylePricing Theory
• APT operates with a pricing model that factors in many sources of risk and
uncertainty, unlike CAPM which only takes into account the single factor of the
risk level of the overall market
• The APT model looks at several macroeconomic factors that determine the risk
and return of the specific asset
• These factors provide risk premiums for investors to consider because the
factors carry systematic risk that cannot be eliminated by diversifying.
• APT suggests that investors will diversify their portfolios, but that they will also
choose their own individual profile of risk and returns based on the premiums
and sensitivity of the macroeconomic risk factors.
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Factors
• Factor Characteristics
• Each risk must have a pervasive influence on stock returns
• Risk factors must influence expected return and have nonzero prices
• Risk factors must be unpredictable to the market
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