1、The Investment Principle: Risk and Return Models,“You cannot swing upon a rope that is attached only to your own belt.”,First Principles,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 will be h

2、igher 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 me

3、asure into a risk premium?,What is Risk?,Risk, in traditional terms, is viewed as a negative. Websters 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 The first symbol is the symbol for “

4、danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity. You cannot have one, without the other.,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 d

5、elineate 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-av

6、erage 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.,The Capital Asset Pricing Mo

7、del,Uses variance of actual returns around an expected return as a measure of risk. Specifies that a portion of variance can be diversified away, and that is only the non-diversifiable portion that is rewarded. Measures the non-diversifiable risk with beta, which is standardized around one. Translat

8、es beta into expected return - Expected Return = Riskfree rate + Beta * Risk Premium Works as well as the next best alternative in most cases.,The Mean-Variance Framework,The variance on any investment measures the disparity between actual and expected returns.,Expected Return,Low Variance Investmen

9、t,High Variance Investment,How risky is Disney? A look at the past,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 y

10、ou could quadruple your money, while investment Bs 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? prefer investment B

11、, 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%?,The Importance of Diversification: Risk Types,The Effects of Diversification,Firm

12、-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 elimina

13、tes 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 o

14、ut to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens.),A Statistical Proof that Diversification works An example with two stocks.,The variance of a portfolio,A caveat on diversification: The lessons of 2008,Diversification reduces expo

15、sure to risks that are uncorrelated. It cannot eliminate your exposure to correlated risks. Two phenomena are undercutting the effectiveness of diversification: Globalization: As companies and investors globalize, the correlation across global economies and markets is increasing. The benefits to div

16、ersification are therefore dropping. Securitization: As more and more asset classes become securitized (accounts receivable, mortgages, commodities), the correlation across asset classes is increasing. When there is a crisis of confidence and investors become more risk averse, the correlation across

17、 all risky assets increases, thus undercutting the benefits of diversification when you need it the most.,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 speak

18、ing, the marginal investor in a stock has to own a lot of stock and also trade a lot. 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 (Michael Dell at Dell Computers or Bill Gates at Microsoft) In all risk and

19、 return models in finance, we assume that the marginal investor is well diversified.,Identifying the Marginal Investor in your firm,Analyzing the investor bases,Looking at Disneys top stockholders in 2009 (again),And the top investors in Deutsche and Aracruz,Taking a closer look at Tata Chemicals,Ta

20、ta companies and trusts: 31.6% Institutions 50% in Market Portfolio; A little more risk25% in T-Bills; 75% in Market Portfolio Even more risk100% in Market Portfolio A risk hog.Borrow money; Invest in market portfolio Every investor holds some combination of the risk free asset and the market portfo

21、lio.,The Risk of an Individual Asset,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) Beta is a standardized measure of this covariance, obtained by dividing the covarian

22、ce 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 assets beta. The required return on an investment will be a linear fu

23、nction of its beta: Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio - Riskfree Rate),Limitations of the CAPM,1. The model makes unrealistic assumptions 2. The parameters of the model cannot be estimated precisely - Definition of a market index - Firm may have changed

24、 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

25、, price/book value) seem to explain differences in returns better.,Alternatives to the CAPM,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 becau