Lecture 17

Risk and Return, and Capital Markets

Fina 110 Spring 2009 Dr. Samuel Xin Liang

1
How would market react to corporate
events and new information?
April 1 (Bloomberg) -- President Barack Obama believes a quick, negotiated
bankruptcy is the most likely way for General Motors Corp. to restructure and
become a competitive automaker, people familiar with the matter said.

Obama also is prepared to let Chrysler LLC go bankrupt and be sold off
piecemeal if the third-largest U.S. automaker can’t form an alliance with Fiat
SpA, said members of Congress who were briefed on the GM and Chrysler
situation before the president said two days ago that the automakers’ viability
plans were insufficient.

What are GM and Chrysler one day return after the new information?
When did investors expect GM’s bankruptcy?
Why is not GM’s common share trading zero now?

Note: We will study risks and returns together with market efficiency in coming
lectures!
Dr. Samuel Xin Liang
2
Risk, Return, and Financial Markets
„ We learn from the history that there are risks associated with expected returns and
realized returns in the financial markets.

„ Our understanding and study on financial assets will help us determine the
appropriate returns on non-financial assets.

„ Lessons from capital market history

… There is a reward for bearing risk.
… The greater the risk, the greater the potential reward.
… This is called the risk-return trade-off.

3
3
The connectivity of materials taught

Capital Markets Corporations

Market Efficiency and Capital Financing Capital Budgeting

Systematic Risk

Debt and Equity Financial

Issuances PV&FV Analysis
Risk and
Returns
Cost of
Investments Financing Capital Investment
Securities
Valuations Decisions
Required Rate of Returns Raised Capital

Dr. Samuel Xin Liang

4
Recall Previous Bond and Stock Examples
1) Bond Example: We assume that Dr. Liang bought a AA corporate bond is
selling at $102 with face value 100 and 6% annual coupon rate in December
2007. For simplicity, we can assume that the Yield to Maturity (YTM) at the
time he bought bond is 5.5%. Dr. Liang received two coupon payment since he
bought the bond. We suppose that the bond is trading at $120 in the market at
the end of March. He decides to sell the bond to realize its capital gain on his
investment.

2) Stock Example: We assume that Dr. Liang bought shares of Bank of America
at price of $4.88 in February 2009. The implied market required return for Bank
of America is 40% since it was very risky to invest in banking stocks at that time.
Dr. Liang received $0.04 after he bought the stock. Bank of American is trading
at $7.22 on March 25 in the market. He decides to sell the bond to realize its
capital gain on his investment.

What are the dollar and percentage returns on Dr. Liang’s investments?
What types of sources were the contributors of these returns?

Dr. Samuel Xin Liang

5
Dollar Returns
„ Total dollar return = income from investment + capital gain (loss) due to
change in price

„ Bond Example:
… Income = $6 + $6 = $12
… Capital Gain = $120-$102 = $18
… Total dollar return = $12 + $18 = $30
… What if Dr. Liang decided to hold the bond until maturity?

„ Stock Example:
… Income = $0.04
… Capital gain = $7.22 – $4.88 = $2.34
… Total dollar return = $0.04 + $2.34 = $2.38
… What if Dr. Liang decided to hold the stock until today (trading at $6.38)?
… Which investment is better? Bond or Stock?

6
6
Percentage Returns
„ It is generally more intuitive to think in terms of percentages than dollar returns

„ Bond Returns
… Current yield = coupon/beginning price
… Capital gains yield = (ending price – beginning price) / beginning price
… Total percentage return = current yield + capital gains yield

„ Stock Returns
… Dividend yield = income / beginning price
… Capital gains yield = (ending price – beginning price) / beginning price
… Total percentage return = dividend yield + capital gains yield

„ Holding Period: The length between buying and selling the securities

7
7
Comparable Returns without Risks
„ Bond Example:
… Current Yield = $12/$102 =
… Capital Gain Yield = $18 / $102 =
… Total percentage return = $30/$102 = 29.4% for holding 1.25 years!
… The annualized returns = 29.4 % / 1.25 = 23.5%

„ Stock Example:
… Dividend Yield = $0.04/$4.88
… Capital gain yield= $2.34/$4.88 =
… Total percentage return = $2.38/$4.88 = 48.78% for holding 1 month!
… The annualized returns = 48.78*12 = 585.4%

… We need to standardized the length of the return even without considering

the risks and other factors associated with the investments!

8
8
Bank of America Returns
Dividends: $0.04
Dividend Yield =
Total Return: $2.38
48.78%
Capital Gain: $2.34
Capital Gain Yield =

Time
$7.22 Ending market price
0 1

-$4.88 Beginning market price

Dr. Samuel Xin Liang

9
The differences
Required Return Expected Return Realized Return

Mode “Before you buy” “If you buy” “After you buy”

What investors What investors expect What investors

require from investing to get from actually gain after
the assets or can earn investing/buying the buying and selling the
from identical/similar assets eg. Discount rate assets.
risky assets. It to discount all future
Meaning measures the cash flows. In most of
demanded time, investors demand
compensation for or set Required Return
investing the risky = Expected Return
assets or bearing the
risks

Dr. Samuel Xin Liang

10
The Importance of Financial Markets
„ Financial markets allow companies, governments, and individuals to increase
their utility
… Savers have the ability to invest in financial assets so they can defer
consumption and potentially earn a return to compensate them for doing so.
… Borrowers have better access to the capital that is available, allowing them to
invest in productive assets.

„ Financial markets also provide us with information about the returns that are
required for various levels of risk.

„ Financial markets also help improve economic development and productivity.

11
11
12
12
Average Returns

Investment Average Return

Large Stocks 12.3%

Small Stocks 17.4%

Long-term Corporate Bonds 6.2%

Long-term Government Bonds 5.8%

U.S. Treasury Bills 3.8%

Inflation 3.1%

13
13
Year-to-Year Total Returns

Large-Company Stock Returns

Large Companies

Long-Term Government Bond Returns

Long-Term Government Bonds

U.S. Treasury Bill Returns

U.S. Treasury Bills

14
14
Risk Premiums
„ Stocks are risky and have higher returns than government bonds

„ The “extra” return earned for taking on risk

„ Treasury bills are considered to be risk-free

„ The risk premium is the return over and above the risk-free rate (treasury bill).

risk premium = R − R f

15
15
Historical Risk Premiums

„ Large Stocks: 12.3 – 3.8 = 8.5%

„ Small Stocks: 17.4 – 3.8 = 13.6%

„ Long-term Corporate Bonds: 6.2 – 3.8 = 2.4%

„ Long-term Government Bonds: 6.2 – 3.8 = 2.4%

„ U.S. Treasury Bills: 3.8 – 3.8 = 0 (by definition!)

16
16
What is the risk premium in our previous
examples?

1) Bond Example:
The expected risk premium = 5.5% - 0.4% = 5.1%
The realized risk premium = 23.5% - 0.4% = 23.1%

2) Stock Example:
The expected risk premium = 40% - 0.4% = 39.6%
The realized risk premium = 585.4% - 0.25% = 585.15%

One year risk free rate is 0.4%

One month T-bill is 0.25%

Dr. Samuel Xin Liang

17
 Frequency Distribution of Returns

18
18
What is traditional risk measure?
„ We use variance and standard deviation to measure the volatility of asset
returns

„ The greater the volatility, the greater the uncertainty

… In other word, greater risk

„ Historical variance
= sum of squared deviations from the mean / (number of observations – 1)

„ Standard deviation = square root of the variance

„ We sometime call the standard deviation the total risk for stocks, but not all
risks eg. Bankcruptcy

19
19
Variance and Standard Deviation
„ The history of capital market returns can be summarized by the mean and standard
deviation.

( R1 + L + R T ) 1 T
… Average return : R =
T
=
T
∑
t =1
Rt

… Return Variability :

( R1 − R ) 2 + ( R 2 − R ) 2 + L ( R T − R ) 2
SD = Variance =
T −1
1
1 T
=[ ∑
T − 1 t =1
( Rt − R ) ]
2 2

Dr. Samuel Xin Liang

20
An Example
Year Actual Average Deviation from the Squared
Return Return Mean Deviation
1 .15 .105 .045 .002025
2 .09 .105 -.015 .000225
3 .06 .105 -.045 .002025
4 .12 .105 .015 .000225
Totals .42 .00 .0045

Average return = .42 / 4 = .105

Variance = .0045 / (4-1) = .0015
Standard Deviation = 3.87%

21
21
Volatility of financial assets

22
22
Return Distribution: Normal

23
23
Arithmetic vs. Geometric Mean
„ Arithmetic average – return earned in an average period over multiple periods

„ Geometric average – average compound return per period over multiple periods

„ The geometric average will be less than the arithmetic average unless all the
returns are equal

„ Which is better?
… The arithmetic average is overly optimistic for long horizons
… The geometric average is overly pessimistic for short horizons
… So the answer depends on the planning period under consideration
„ 15 – 20 years or less: use arithmetic
„ 20 – 40 years or so: split the difference between them
„ 40 + years: use the geometric

24
24
Computing Returns
„ What are the arithmetic and geometric averages for the following returns?
… Year 1 5%
… Year 2 -3%
… Year 3 12%

… Arithmetic average = (5 + (–3) + 12)/3 = 4.67%

… Geometric average = [(1+.05)*(1-.03)*(1+.12)]1/3 – 1 = .0449 = 4.49%

25
25
When did investors expect GM’s
bankruptcy? Getting funding from Bloomberg (April 1): Obama
Said to Find Bankruptcy
US government
Likely for GM, Chrysler

26
26
Efficient Capital Markets
„ Stock prices are in equilibrium - they are “fairly” priced

„ If this is true, then you should not be able to earn “abnormal” or “excess” returns

„ Efficient markets DO NOT imply that investors cannot earn a positive return in the
stock market

27
27
Market Reaction

28
28
What Makes Markets Efficient?

„ There are many investors out there doing research

… As new information comes to market, this information is analyzed and trades
are made based on this information
… Therefore, prices should reflect all available public information

„ If investors stop researching stocks, then the market will not be efficient

„ It is the perfect assumption and condition for many theories in model finance.

„ It is also call frictionless.

„ It is also based on that all investors are rational!

29
29
Common Misconceptions about EMH
„ Efficient markets do not mean that you can’t make money

„ They do mean that, on average, you will earn a return that is appropriate for the
risk undertaken, and there is not a bias in prices that can be exploited to earn excess
returns

„ Market efficiency will not protect you from wrong choices if you do not diversify –
you still don’t want to put all your eggs in one basket

30
30
When did market react to GM’s new
information? Was it overpriced?
Should the price move below $1.27?

Bloomberg (April 1): Obama Said to

Find Bankruptcy Likely for GM,
Chrysler

Historical low: $1.27

price dropped 15%, but closed at $1.93 Was it oversold or underpriced?
31
31
Market Reaction
Overpriced!

Underpriced!

32
32
Strong Form Efficiency

„ Prices reflect all information, including public and private

„ If the market is strong form efficient, then investors could not earn abnormal
returns regardless of the information they possessed

„ Empirical evidence indicates that markets are NOT strong form efficient, and
that insiders can earn abnormal returns (may be illegal)

33
33
Semistrong Form Efficiency

„ Prices reflect all publicly available information including trading

information, annual reports, press releases, etc.

„ If the market is semistrong form efficient, then investors cannot earn

abnormal returns by trading on public information.

„ Implies that fundamental analysis will not lead to abnormal returns.

34
34
Weak Form Efficiency
„ Prices reflect all past market information such as price and volume

„ If the market is weak form efficient, then investors cannot earn abnormal
returns by trading on market information

„ Implies that technical analysis will not lead to abnormal returns

„ There are strong debate on whether capital markets are in either strong or weak
form efficient.

„ Market efficiency implies that markets correct themselves!

„ Discussion:
Does the global financial crisis suggests market efficiency? A research debate!

35
35