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Finance Batch ± VESIMSR

2009--11
2009

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§ Return
§ Risk , Uncertainty
§ Types of Risk
§ Systematic and Unsystematic Risk
§ Introduction to Beta, Risk Premium and
Risk free rate
§ Capital Asset Pricing Model (CAPM)
§ Assumptions, Usage, Limitations
§ Problem Solving

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§ Periodic Cash Receipts
§ Price Change over period

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±
± Average-
Average- does
not take into effect the realized
change in wealth over multiple
period.
§ ^

-
- GM ± Reflects
the compounding/ cumulative return
over time. It is given by :
[(1+R1)(1+R2)+««(1+Rn)]^(1/n) -1
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§ 

This

This is ex ±post (
after the fact) return, or return that
was or could have been earned.
§ á

:
: This is the return
from an asset that investors
anticipate or expect to earn over
some future period. This is subject to
uncertainty, or risk, and may or may
not occur
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Õ1) If a share of ACC is purchased for
Rs 0,580 on Feb 8 of last year, and
sold for Rs 0,800 on Feb 9 of this
year and the company paid a
dividend of Rs. 05 for the year, what
is the rate of return?

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Return (k) = [Div + (Period t ± Period
t-1) ]/ Period tt--1
= [05+(0800 ± 0580)]/ 0580
= 7.12%

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§ åow does probability affect the rate of return?

In a world of uncertainty, the expected return

may or may not materialize In such a situation,
the expected rate of return for any asset is the
weighted average rate of return using the
probability of each rate of return as the weight.
The expected rate of return ³k´ is calculated by
summing the products of the rates of return and
their respective probabilities.

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Õ2) The probability distributions and
corresponding rates of return for
Alpha Company are shown below.
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1 .10 50
2 .20 00
0 .40 10
4 .20 -10
5 .10 -00

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A = (0.10)(0.50) +
(0.20)(0.00)+(0.40)(0.10)+(0.20)(-
(0.20)(0.00)+(0.40)(0.10)+(0.20)(-
.010)+(0.10)(--0.00)
.010)+(0.10)(
= 0.05 +0.06 + 0.04 -0.02 -0.00
= .1
or 10%

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§ ½hat is Risk?
§ Is it same as uncertainty?
§ If no, then what is the difference
between them? Is it same as
Uncertainty?

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§ Risk ± Decision makers already
knows the possible µ consequences¶
of a decision and their relative
likelihood at the time he is making a
decision.
§ Uncertainty ± likelihood of the
possible outcomes is not known

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The possibility (likelihood) that
realized returns will be less than the
returns that were expected.

This means that, the more variable the

possible outcomes that can occur (i.e
(i.e
the broader the range of possible
outcomes.), the greater the risk.
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The width of a probability distribution
of rates of return is a measure of
risk. The wider the probability
distribution, the greater is the risk or
greater the variability of return the
greater is the ë 
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§ Ë

 

 
±
Ë

± is that part of
total risk that is related to the general
economy or the stock market as a whole
and hence cannot be eliminated by
diversification. It is also referred to as
market risk or p p

p

§ ‰
 

 
±

± is that part of total
risk that is specific to the company or
industry and hence can be eliminated by
diversification. It is also called as
a p p

p p p 15
 


 


§ Systematic Risk
§ Unsystematic Risk
‡ Types of Systematic Risk
Market risk
Interest Rate Risk
Purchasing Power Risk
‡ Types of Un Systematic Risk
Business Risk
Financial Risk
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§ Ë
‰
 

 
Ë
 § ‰
 

 


 § Company strike
§ Major change in tax § Bankruptcy of a major
rates supplier
§ ½ar & other calamities § Death of a key
§ Increase/ Decrease in company officer
inflation rates § Unexpected entry of
§ Change in economic new competitor into
policy the market etc.
§ Industrial recession

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§ Investor Panic
§ Cost of Living
§ Labour Strike
§ Increased Debt to Equity Ratio
§ Product Obsolescence

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§ Variability of Return around the
expected Average return ± Risk
§ Recall: Calculation of variability
§ Concepts of Variance / standard
Deviation

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§ BETA ±statistical measure of systematic
risk.
ß ± It measures the relative risk associated with
any individual portfolio as measured in relation to
the risk of the market portfolio. The market
portfolio represents the most diversified portfolio
of risk assets an investor could buy since it
includes all risk assets.
 
 

 

 




  
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Thus , the beta co-
co-efficient is a measure of the non
±diversifiable or systematic risk of an asset
relative to that of the market portfolio. A beta of
1.0 indicates an asset of average risk. A beta
coefficient greater than 1.0 indicates above
average risk-
risk- stocks whose returns tend to be
more risky than the market. Stocks with beta
coefficient less than 1.0 are of below average risk
i.e less riskier than the market portfolio.

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Õ) ½hat kind of ß will Indian stocks
have >1, <1 and =1?
=1?
Õ) Can Beta be negative?
Õ) Now , that you know the Beta of a
stock, how will you find the beta of a
portfolio?

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ß = Cov ( stock with market) / Variance of
Market.

½e know Total Risk = Variance of the

market

Systematic Risk = ß ^2 * Variance

Õ) ½hat do you think then Unsystematic
Risk will be?
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 m ! 

 

 
Now this systematic relationship between
the return on the security or a portfolio
and the return on the market can be
described using a simple linear regression
, identifying the return on a security or
portfolio as the dependent variable Rr and
the return on market portfolio as the
independent variable Rm,
Rm, in the single
index model or market model developed
by ½illiam Sharpe.
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§ Developed by ½illiam Sharpe
§ Mathematical equation to show the risk and
Return tradeoff
§ Risk Free Rate (Rf
(Rf))
§ Market Return (Rm
(Rm))
§ Beta (
()
§ Required rate (Rr
(Rr))
Required Rate = Risk free rate + risk premium
§ Rr = Rf + 
((Rm ± Rf)
Rf)

§ Depicts Compensation that investors should

receive for taking the non diversifiable risk
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Õ0) Assuming Savings bank rate as
the risk free rate, find the required
rate of return of Stock ?. ½hen Nifty
goes up by 100%, Stock X goes up
by 127%. åistorical point to point
return of nifty for past 0 months is
14% c.a.g.r

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! R!
§ Graphical
representation of
the CAPM
§ ½hich will be the
SML below?




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!
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      !

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§ Its simplicity and assumptions
§ Decisions only on risk and return
assessments
§ Perfect competition
§ No transaction cost
§ No taxes
§ Borrow and lend any amount at risk less
rate
§ Uniform planning horizons
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Find out about the following variants of
CAPM
. Non Standard forms of CAPM
. Zero Beta CAPM
. Tax adjusted CAPM

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Õ) Eva turns to determining a beta for use
in evaluating the offer of an equity stake in
a private insurer and rounds her beta
estimate of Alleghany, the public
comparable , to 0.5. As of the valuation
date. Alleghany Corporation has no debt in
its capital structure. The private insurer is
20 percent insurer is 20 percent funded by
debt.
If a beta of 0.50 is assumed for the
comparable, what is the estimated beta of
the private insurer?
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