FIN719 – Applied Corporate Finance

BCom Hons in Finance

Lecture 3: The Basics of Risk

“You cannot swing upon a rope that is attached only to your own belt.”

Dr. Chipo Mlambo

Department of Finance
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First Principles
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The notion of a benchmark

Since financial resources are finite, there is a hurdle that projects
have to cross before being deemed acceptable. This hurdle should be
higher for riskier projects than for safer projects.
A simple representation of the hurdle rate is as follows:
Hurdle rate = Riskless Rate + Risk Premium
The two basic questions that every risk and return model in finance
tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?
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What is Risk?

Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary,

for instance, defines risk as “exposing to danger or hazard”. The Chinese
symbols for risk, reproduced below, give a much better description of risk
危机
The first symbol is the symbol for “danger”, while the second is the
symbol for “opportunity”, making risk a mix of danger and opportunity.
You cannot have one, without the other.
Risk is therefore neither good nor bad. It is just a fact of life. The question
that businesses have to address is therefore not whether to avoid risk but
how best to incorporate it into their decision making.
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A good risk and return model should…

1. It should come up with a measure of risk that applies to all assets and not
be asset-specific.
2. It should clearly delineate what types of risk are rewarded and what are
not, and provide a rationale for the delineation.
3. It should come up with standardized risk measures, i.e., an investor
presented with a risk measure for an individual asset should be able to
draw conclusions about whether the asset is above-average or below-
average risk.
4. It should translate the measure of risk into a rate of return that the investor
should demand as compensation for bearing the risk.
5. It should work well not only at explaining past returns, but also in
predicting future expected returns.
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The Capital Asset Pricing Model

1. Uses variance of actual returns around an expected return as a
measure of risk.
2. Specifies that a portion of variance can be diversified away, and that it
is only the non-diversifiable portion that is rewarded.
3. Measures the non-diversifiable risk with beta, which is standardized
around one.
4. Translates beta into expected return -
Expected Return = Riskfree rate + Beta * Risk Premium
5. Works as well as the next best alternative in most cases.
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1. The Mean-Variance Framework

The variance on any investment measures the disparity between actual and
expected returns.
Low Variance Investment

High Variance Investment

Expected Return
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How risky is Disney? A look at the past…

Returns on Disney - 2008-2013
25,00%
Average monthly return = 1.65%
Average monthly standard deviation = 7.64%
20,00%
Average annual return = 21.70%
Average annual standard deviation = 26.47%
15,00%

10,00%

5,00%

0,00%

-5,00%

-10,00%

-15,00%

-20,00%

-25,00%
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Oct-09
Dec-09
Feb-10
Apr-10
Jun-10
Aug-10
Oct-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
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Do you live in a mean-variance world?

Assume that you had to pick between two investments. They have the same
expected return of 15% and the same standard deviation of 25%; however,
investment A offers a very small possibility that you could quadruple your
money, while investment B’s highest possible payoff is a 60% return. Would
you
a. be indifferent between the two investments, since they have the same expected
return and standard deviation?
b. prefer investment A, because of the possibility of a high payoff?
b. prefer investment B, because it is safer?
Would your answer change if you were not told that there is a small
possibility that you could lose 100% of your money on investment A but that
your worst case scenario with investment B is -50%?
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The Importance of Diversification: Risk Types

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Why diversification reduces/eliminates firm

specific risk
Firm-specific risk can be reduced, if not eliminated, by increasing the
number of investments in your portfolio (i.e., by being diversified).
Market-wide risk cannot. This can be justified on either economic or
statistical grounds.
On economic grounds, diversifying and holding a larger portfolio
eliminates firm-specific risk for two reasons-
a. Each investment is a much smaller percentage of the portfolio, muting
the effect (positive or negative) on the overall portfolio.
b. Firm-specific actions can be either positive or negative. In a large
portfolio, it is argued, these effects will average out to zero. (For every
firm, where something bad happens, there will be some other firm,
where something good happens.)
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The Role of the Marginal Investor

The marginal investor in a firm is the investor who is most likely to

be the buyer or seller on the next trade and to influence the stock
price.
Generally speaking, the marginal investor in a stock has to own a
lot of stock and also trade that stock on a regular basis.
Since trading is required, the largest investor may not be the
marginal investor, especially if he or she is a founder/manager of
the firm (Larry Ellison at Oracle, Mark Zuckerberg at Facebook)
In all risk and return models in finance, we assume that the
marginal investor is well diversified.
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Identifying the Marginal Investor in your

firm…
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Gauging the marginal investor: Disney in 2013

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Extending the assessment of the investor base

In all five of the publicly traded companies that we are looking at,
institutions are big holders of the company’s stock.
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The Limiting Case: The Market Portfolio

The big assumptions & the follow up: Assuming diversification costs nothing
(in terms of transactions costs), and that all assets can be traded, the limit of
diversification is to hold a portfolio of every single asset in the economy (in
proportion to market value). This portfolio is called the market portfolio.
The consequence: Individual investors will adjust for risk, by adjusting their
allocations to this market portfolio and a riskless asset (such as a T-Bill):
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio
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The Risk of an Individual Asset

The essence: The risk of any asset is the risk that it adds to the market
portfolio. Statistically, this risk can be measured by how much an asset
moves with the market (called the covariance)
The measure: Beta is a standardized measure of this covariance, obtained
by dividing the covariance of any asset with the market by the variance of
the market. It is a measure of the non-diversifiable risk for any asset – can
be measured by the covariance of its returns with returns on a market
index, which is defined to be the asset's beta.
The result: The required return on an investment will be a linear function of
its beta:
Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market
Portfolio - Riskfree Rate)
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Limitations of the CAPM

1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated precisely
The market index used can be wrong.
The firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be:
 A linear relationship between returns and betas
 The only variable that should explain returns is betas
- The reality is that
 The relationship between betas and returns is weak
 Other variables (size, price/book value) seem to explain differences in returns better.
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Alternatives to the CAPM

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Why the CAPM persists…

The CAPM, notwithstanding its many critics and limitations, has survived as
the default model for risk in equity valuation and corporate finance. The
alternative models that have been presented as better models (APM,
Multifactor model..) have made inroads in performance evaluation but not
in prospective analysis because:
The alternative models (which are richer) do a much better job than the CAPM in
explaining past return, but their effectiveness drops off when it comes to
estimating expected future returns (because the models tend to shift and
change).
The alternative models are more complicated and require more information than
the CAPM.
For most companies, the expected returns you get with the alternative models
are not different enough to be worth the extra trouble of estimating four
additional betas.
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Application Test: Who is the marginal

investor in your firm?

You can get information on insider and institutional holdings in your

firm from:
–[Link]
–Enter your company’s symbol and choose profile.
Looking at the breakdown of stockholders in your firm, consider
whether the marginal investor is
–An institutional investor
–An individual investor
–An insider