Академический Документы
Профессиональный Документы
Культура Документы
FINC361 Fall2016
Professor Mahdi Mohseni
Cost of equity
GOAL:
Determine the cost of equity
APPROACH:
In two steps:
1. Quantifying the risk-return trade-off in Finance
2. CAPM model
Expected return
Measure of central tendency of distribution
Definition: Weighted average of each outcome
weights = probabilities of each outcome
Expected Return
=
E
=
[ R]
PR R
E ( R E [ R ]) =
PR
(R
E [ R ])
Var ( R)
Finance language:
Volatility = Standard deviation
Example
If we take again our example of BFI:
Var [ RBFI =
]
=
SD( R)
=
Var ( R)
=
0.045
21.2%
STOCKS: RISKIER (MORE VOLATILE) BUT ALSO HIGHER RETURN IN THE LONG-RUN
1
R
=
( R1 + R2 + + RT =
)
T
Where, for each time period:
Pt + Dt Pt 1
Rt =
,
Pt 1
where Pt 1 = Price at beginning of period
where Pt = Price at end of period
1 T
Rt
T t =1
1
T 1
(R
t =1
R)
Why (T-1)?
Estimate of the standard deviation (volatility)
is just the square root of that number
Simple Example
Compute the standard deviation of the numbers 1, 2, 3, 4 and 5.
Step 1: Compute the average (here equal to 3)
Step 2: Compute the deviation and squared deviation from the
average:
Value
1
2
3
4
5
Deviation
(1 3)
(2 3)
(3 3)
(4 3)
(5 3)
Squared Deviation
4
1
0
1
4
1. Firm-specific risk
2. Systematic risk
By forming a portfolio:
Types of risk
Diversifiable
risk
Systematic
risk
For a portfolio:
Volatility = Systematic risk
Goal:
Example
If a stock has =2, it means that when market portfolio has
an excess return of 1%, the stock will have an excess return
of 2%
Returns
Market
Time
Market
Time
Beta () of a stock
A securitys beta is related to how
sensitive its underlying revenues and
cash flows are to general economic
conditions (business cycle) as
measured by broad market
movements
Stocks in cyclical industries (e.g.
semi-conductors), are likely more
exposed to systematic risk and tend
to have high betas
Stocks in consumer staple goods
(e.g. Coca-Cola) are likely less
exposed to systematic risk and tend
to have low betas
Beta can be estimated using
regression analysis
E (ri ) =
rf
+ i (E (rMkt ) rf )
E [ RMkt ] rf
Cost of equity:
Implementing the CAPM formula
Formula:
E (ri ) = rf + i (E (rMkt ) rf )
Hence, we need:
1. Risk-free rate
YTM (annual rate) on US Treasury bonds with longterm maturity to reflect long term use of firm assets
2. Estimates for:
Beta
Measures the co-movement of a security with the market
Mathematically:
Volatility of i that is common with the market
Mkt
i
Cov(Ri ,RMkt )
Var (RMkt )
A simple example
Assume:
Risk-free return is 5%
Expected return on market portfolio of 12% and a
standard deviation of 44%
AXP Oil and Gas has a standard deviation of 68%
and a correlation with the market of 0.91
Solution
Simply use the previous formula:
SD(Ri ) Corr (Ri ,RMkt ) (.68)(.91)
=
= = 1.41
i
.44
SD(RMkt )
Beta in practice:
Estimating beta from historical returns
Definition of beta:
Expected % change in the excess return of the
security for a 1% change in the excess return of the
market portfolio
We use the past (statistics) to make inferences about
the future (probabilities)
1. Frequency:
2. Window:
Slope
X-axis
Statistics
Beta = Slope of the best-fitting line of the cloud of points representing
Ciscos excess returns versus the market excess return
Excess return: Frequency is monthly/weekly/daily.
i = Intercept
i = error term
PuttingItAllTogether:TheCapitalAssetPricingModel
Investorsrequireariskpremiumproportional
totheamountofsystematic risktheyare
bearing
Wecanmeasuresystematicriskusingbeta()
Themostcommonwaytoestimatebetaisto
uselinearregression theslopeofthelineis
thestocksbeta
PuttingItAllTogether:TheCapitalAssetPricingModel
TheCAPMsayswecancomputetheexpected
(required)returnonstockofanyfirmusing
thefollowingequation:
E (ri ) = rf + i (E (rMkt ) rf )
which,whengraphed, iscalledthesecurity
marketline.