Risk and Return in Financial Markets

Risk and Return in Financial Markets

• Understanding risk and return is crucial for financial market decisions

Key Learning Objectives

• Measure and compare risk.
• Calculate expected returns.
• Construct a smart investment portfolio.
• Utilize models like CAPM for informed decisions.

Risk-Return Trade-Off

• Higher potential return is associated with higher risk.
• Low-risk investments yield less; potentially high-reward investments carry a greater risk of loss.
• Investment decisions are influenced by individual risk tolerance, requiring a trade-off understanding.

Types of Risk

• Stand-Alone Risk: The risk associated with holding a single asset; poor performance impacts the entire investment.
• Systematic (Market) Risk: Affects the entire market, unavoidable through diversification, and includes factors like inflation, recessions, and interest rate changes.
• Unsystematic Risk: Company-specific risk, reduced via diversification, arising from events like product recalls or scandals.

Expected Return

• It involves estimating average outcomes based on probabilities due to future uncertainty.
• States of the Economy: Probability of economic state multiplied by expected return.

Assessing Investment Riskiness

• Standard Deviation (σ): Measures how the returns are spread against it's average, and serves as the common method to measure risk.
• Low risk involves returns close to the average, while high risk involves wildly fluctuating returns
• US Water is safer than Martin Products despite both having 10% prospective returns.

Estimating Historical Risk

• Historical returns can provide a foundation for risk measurement.

Steps:

• Calculate average past returns.
• Determine the average from each return and square the variance
• Calculate the average of squared differences and take the square root.
• The final calculation offers insights on the investment's unpredictability

Coefficient of Variation (CV)

• It provides the risk assumed per unit of return.
• A lower CV indicates a more favorable risk-return balance.

Sharpe Ratio

• Indicates excess return earned for each risk unit compared to a risk-free investment.

Portfolio Theory

• Portfolio goal involves mitigating risk through asset diversification.

Expected Portfolio Return

• Involves, asset weight and expected return in portfolio

Portfolio Risk

• The total risk is related to individual risks and their correlation

Correlation (ρ)

• Measures how the movement of two assets relate.
• Assets can move together, move opposite or have no correlation.
• Low/negative correlation enhances diversification benefits.

Types of Risk in Portfolios

• Diversifiable (Unsystematic) Risk: Decreases with more stocks added.
• Systematic (Market) Risk: Persists regardless of stock diversification.
• Total risk equals the sum of diversifiable and systematic risks.

Capital Asset Pricing Model (CAPM)

• Predicts return using a stock's beta (systematic risk).
• Risk-free rate, market return, and asset market movement are factors.

Beta (β)

• Measures the stocks relative movement with the market
• Beta values: (=1) same, (>1) more volatile, (<1) less volatile, (=0) no correlation

Security Market Line (SML)

• Graph showing required return against beta.
• Stocks above the line are undervalued and good buys.
• Stocks below the line are overvalued and bad deals.

Effects of Inflation and Risk Aversion

• Inflation: Inflation rise causing SML to shift upward to target returns for the same risk
• Risk Aversion: Higher risk aversion steepens the SML, requiring more return for higher beta.

Legal Rights of Common Stockholders

• Common stockholders' rights influences company, protects investments and ownership rights
• Ownership: Stockholder owns a share of the company.
• Transfer Ownership: Stockholder can sell shares to others.
• Voting: One vote per share, electing directors vital for executive appointments.
• Inspect Documents: Stockholder has access to records to maintains transparency.
• Right to Sue: Right to legal action if company is in wrong.
• Right to Dividends: Stockholders receive a share of company profits when dividends are issued.

Proxy Voting

• Voting can be done in person or through assigned proxy.
• Large shareholders (mutual funds) often vote by proxy.

Underperforming Company

• Managers replaced via proxy fights led by shareholders.
• CalPERS example: They drive change in underperforming companies.

Preemptive Right

• Allows existing shareholders to buy new shares first to maintain ownership.
• Prevents Dilution: Preserves ownership percentage.
• Keeps Voting Power: Limits external control.
• Protects Value: Prevents devaluing shares through cheap sales.

Dilution Example

• Owning 10,000 of 1,000,000 shares (1%) leads to diluted share if company releases 500,000 shares unless stockholder by 1% (5,000) of the new shares.

Types of Stocks

• Class A: Common with one vote per share aimed for public investors.
• Class B: Increased vote powers (e.g. 10 votes/share), often provided for executives and founders.
• For instance Google's founders hold Class B shares (10 votes/share), while public investors possess Class A(1 vote/share).

Stock Markets

Primary Market

• Stocks are created and sold via IPOs, with investors investing into the company for capital.

Secondary Market

• Secondary stocks are traded between investors on exchanges like the NYSE and NASDAQ.
• In the secondary market the company does not receive money.
• Example: Buying/selling stock on Robinhood.

Stock Price

• The current market price is related to supply and demand

Intrinsic Value

• Represents value through earning, risk and dividends

Market Dynamics

• Market Price can be different from it's Intrinsic Value due to risks, hype and behavior.
• Market Equilibrium is when they are of equal value.

2008 Crisis

• Banks holding risky mortgage securities, had prices drop fast revealing risks involved.

Stock Strategies

• Buy stocks that are undervalued (Market price < intrinsic value)
• Sell short, overvalued stocks (Market price > intrinsic value)

Short Selling

• Borrowing stock to be sold, then repurchasing at a lower price to return for a profit.

Corporate Actions

• Issuing stock when overvalued.
• Repurchasing stock when undervalued.

Discounted Dividend Model (DDM)

• A stock's value is based on future dividends reduced to todays value.
• The formula for the discounted dividend model is: (\hat{P}0 = \sum{t=1}^{\infty} \frac{D_t}{(1 + r_s)^t})
• D_t represents expected dividend at time t
• r_s represents required return for the risks

Key terms in DDM

• D_0 refers to recent Dividends
• D_1 equals next year's dividend [D_0(1 + g)]
• g equals the rate of dividend growth.

Constant Growth Stocks

• The Gordon Growth Model is used when dividends increase at the same rate forever.
• A model to find the growth rate equals (\hat{P}_0 = \frac{D_1}{r_s - g} \quad\text{or}\quad \hat{P}_0 = \frac{D_0(1 +g)}{r_s - g}), which only valid if (r_s > g)
• A model to determine Expected Return equals (\hat{r}_s = \frac{D_1}{P_0} + g), which refers to (Dividend yield + growth rate)

Dividends vs Growth

• Companies need to determine dividend payout against reinvestment.
• The formula for Growth Rate equals (g = (1 - \text{Payout Ratio}) \times ROE)
• Example: ROE equals 10%, Payout equals 60% and the the Growth Rate equals 4%.

Non-Constant Growth Stocks

• Companies increase at high rates, then decline
• A formula for 2-Stage Valuation equals (\hat{P}0 = \sum{t=1}^{N} \frac{D_t}{(1 + r_s)^t} + \frac{\hat{P}_N}{(1 + r_s)^N})
• \( \hat{P}_N = \frac{D{N+1}}{r_s - g} ) measures terminal Value

Enterprise Valuation

• For companies with no dividends, the Free Cash Flow Model comes into utilization.
• With the formula (MV_{ops} = \sum_{t=1}^{\infty} \frac{FCF_t}{(1 + WACC)^t})

Formula explanation

• FCF_t represents free cash flow for year t
• WACC equals the average cost of capital

Stock Valuation

• Total stocks Formula Equals: (MV_{firm} = MV_{ops} + MV_{non\text{-}operating\ assets}) If FCF increases at a constant rated after N years, then: \( MV_0 = \sum_{t=1}^{N} \frac{FCF_t}{(1 + r_s)^t} + \frac{FCF_{N+1}}{(r_s - g)(1 + r_s)^N} )

Preferred Stock Valuation

• Preferred stock provides dividend similarly to Bonds, but company will not bankrupt from missing payments.

The preferred stock formula

• The fixed stock formula Equals: ( V_p = \frac{D_p}{r_p} ) were:
  • D_p represents annual preferred dividend
  • r_p equals needed return
  • An example can highlight that if \( {D_p} ) equals 10 and rr equals 0.103, Then the preferred stock will equal 97.09