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Financial Securities in U.S. Market MODULE 1 RISK AND RETURN A portfolio of Treasury bills (US government debt securities maturing...

Financial Securities in U.S. Market MODULE 1 RISK AND RETURN A portfolio of Treasury bills (US government debt securities maturing in less than one year) Risk is measured in different ways A portfolio of U.S government bonds All business assets are expected to A portfolio of U.S. common stocks produce cash flows, the riskiness of an asset is based on ⧪Treasury bills = pautang sa banko the riskiness of its cash flows. ⧪ Government issue bonds kasi kailangan rin The riskier the cash flows, the riskier nila ng pera the asset. ⧪ Treasury bills = less than 1 year Assets can be categorized as ⧪ Government bonds = long term: 1 year or financial assets, especially stocks more and bonds, and as real assets, such ⧪ Common stocks = capital market as trucks, machines, and whole ⧪ majority of bond holders, hold it not to sell it businesses. ⧪ coupon payments = are fixed income and fixed time on when u are going to have it ⧪ stocks and bonds are financial securities ⧪ house is not an asset because hindi tayo ⧪Common stock ang pinaka riskiest, if you kumikita don purchase a common stock, you become a ⧪ not all assets/ things in the market move in stockholder and you earn by dividends if may the same direction at the same time, some go profit and usually walang dividends so you earn up and some go down at the same time by capital gains Financial Securities ⧪ Capital gains = when the stock price goes also referred to as financial up, you earn capital gains instruments or financial assets, is a generic term used to describe ⧪ But what if hindi tumaas yung stock price? stocks, bonds, money market So risky sya securities (e.g., treasury bills), ⧪Pinaka stable is government bonds kasi yung An instruments representing the coupon payments it is less riskier right to receive future benefits under ⧪ if you are a stockholder then it is riskier a set of stated conditions ⧪ Treasury bills are considered risk free ⧪ key word = negotiable instrument bcuz it is a ⧪ it is very rare for government to get bankrupt contract that is why it is risk free ⧪ Bond is a debt instrument ⧪ T-bill rate = risk free rate In issuing a bond they have to go in an investment banker (financial intermediary) ⧪ Default = if you don’t get to pay the bonds on ⧪ When interest rate goes down, the bond time or really wala ng pambayad it means price is higher and favorable yun sa bond default holder ⧪ bond payment = coupon payment ⧪ main point = assets and financial securities Figure 7.1 How an Investment of $1 at have different risk the End of 1899 Would Have Grown by NOTE: These investments offer different the End of 2017 degrees of risk. Treasury bills Issued by the government Less than year maturity No risk default Prices of Treasury bills are stable. Can achieve a perfectly certain payoff with 3 months maturity The investor cannot lock in a real rate of return: some uncertainty about inflation ⧪ The more earlier you invest, the better, ⧪ real rate is different from stated rate you are utilizing the power of time to earn ⧪Real rate is uncertain pa bcuz of inflation ⧪ equities = where u can earn the highest/biggest Long-term government bonds (T-bonds): Issued by the government ⧪ Not all of financial asset will have the Price fluctuates as interest rates same level or risk and same level of vary (bond prices falls when interest rewards rates rise and rise when interest rates fall) ⧪ Inflation is a big factor maturities greater than 20 years risk-free -they are backed by the Figure 7.1 government's ability to tax its Shows how $1 would have grown if citizens. invested at the end of 1899 and reinvested all dividend or interest Common stocks income in each of the three represents a share of ownership in a portfolios. corporation. more shares a person owns, the Treasury Bills A dollar invested in larger the stake they own in the the safest company as well. investment, the right to vote regarding company Treasury bills, policies would have grown to $74 there are risks involved –if the company does poorly or goes Long term An investment in bankrupt. treasury bills long term Treasury Receive dividends when net income bonds would have is positive produced $293  makuha ex. 1.5 yung hindi mo makuha out of Invested in Stocks An investor who placed a dollar in 5.3 the stocks of large U.S. firms would ⧪ Solution: treasury bills nominal rate - have received government bonds nominal rate $47,661. Solution on how nakuha yung 1.5 ⧪ 5.3 - 3.8 = 1.5 ⧪ Risk premium : If you are taking more Why 3.8 sinubtract? Kasi 3.8 is sure na yan risk, you are required to have risk premium makukuha mo eh Figure 7.2 How an Investment of $1 at the ⧪11.5 - 3.8 = 7.7 End of 1899 Would Have Grown in Real ⧪ again 3.8 kasi yun yung sure na makukuha Terms by the End of 2017 mo Table 7.1 Average rates of return on U.S. Treasury bills, Govt. bonds and common stocks Over the period, Treasury bills have provided the lowest average return-3.8% per year in nominal terms and.9% in real terms, the inflation over this period was about 3% per year. Stocks of major corporations provided an average nominal return Table 7.1 Average rates of return in the U.S. of 11.5%. By taking on the risk of Treasury Bills, government bonds, and common stocks, investors earned a stocks, 1900-2017 figures in % per year) risk premium of 11.5-3.8=7.7% over the return on Treasury bills. Estimate of Return Example: Suppose that the current interest on Treasury bills is 3.8%. Adding on the risk premium of 7.7%. Market return formula ⧪3.8 ay sure makukuha mo kasi 0 yung risk premium since it is t-bills and it is risk free ⧪ nominal = is what you will get ⧪ risk premium = hindi pa sure if makukuha mo yun like yun yung % na baka yun yung hindi mo 𝑟𝑚 = 3.8% + 7.7% = 11.5% Arithmetic Averages and Geometric (Compound Annual Returns) ⧪ “Risk free rate” = Treasury bills Arithmetic average, or arithmetic mean, or just mean, is the very basic Risk statistical measure. Risk is defined in financial terms provides quick and easy information as the chance that an outcome or about the general level of values in a investment's actual gains will differ data set – it is one of the measures from an expected outcome or of central tendency Arithmetic return. average of the returns correctly Risk includes the possibility of measures the opportunity cost of losing some or all of an original capital for investments of similar risk investment. to Big Oil stock. Risk can be quantified by considering historical behaviors ⧪ Cost of capital = cost of money to raise and outcomes. your capital In finance, standard deviation is a ⧪ Opportunity Cost of capital = expected common metric associated with return from the investment risk. Arithmetic Averages and Compound ⧪ we use standard deviation to measure the Annual Returns risk Suppose that the price of Big Oil’s common stock is $100. There is an Relationship of Risk and Return equal change that at the end of the Standard deviation provides a year the stock will be worth $90, measure of the volatility of asset $110, or $130. Therefore, the return prices in comparison to their could be historical averages in a given time frame. Solution: A fundamental idea in finance is the - $90 - $100 = – 10% relationship between risk and return. - $110 - $100 = 10% The greater the amount of risk an - $130 - $100 = 30% investor is willing to take, the greater —------------------------------------- the potential return. Total = +10% expected return Individuals, financial advisors, and companies can all develop risk The arithmetic average of the returns management strategies to help correctly measures the cost of capital for manage risks associated with their investment of similar risk of Big Oil stock. investments and business activities. ⧪ All the results you, get the average by dividing it on how many yung results, in this case it is divided by 3 Geometric Mean ⧪ Portfolio = represents all of your assets The geometric mean is the average Example: common portfolio: of a set of products 10% stocks the calculation of which is commonly 90% cash used to determine the performance results of an investment or portfolio. Better portfolio: 10% cash 20% stocks 30% bonds And etc The average compound annual return is ⧪ prices of stocks and bonds are volatile Solution: ⧪ we do portfolio risk = to spread assets and to $90 / $100 = –.90 lower the risk or spread the risk $110 / $100 = 1.10 ⧪ if konti lang yung asset mo sa portfolio then if $130 / $100 = 1.30 2 lang yun then both bumaba sa market = risk ⧪ pero if 10 yung portfolio mo, it is unlikely na 2nd solution: lahat yun baba, yung iba tataas kaya mas less (.90, 1.10, 1.30)^⅓ - 1 = 0.088 or 8.8% riskier ⧪ No na ito kasi 10% yung capital so dapat ⧪ having a lot of stocks na owned by 1 atleast or equal to 10% yung geometric rate corporate is not diversification para mag invest ako Diversification and Portfolio Risk Diversification and Portfolio Risk Expected return Variance Standard Deviation Expected The square squared root of the deviation from variance the expected A measure of Variance return volatility A measure of volatility ⧪ it is the measure of risk ⧪ if 25% yung standard deviation = Standard Deviation 25% yung risk ⧪ Mas riskier ang prices ng stocks compared to bonds ⧪ prices of bonds are not that volatile How Diversification Reduces Risk Figure 7.11 Diversification Eliminates Specific Risk Diversification Strategy designed to reduce risk by spreading the portfolio across many investments. ⧪ you are spreading your assets/investment to avoid many risk, ⧪ with this, we can lower down risk Firm-specific Risk factors affecting only Risk that firm. Also called “diversifiable risk.” Or unique risk Risk that diversification cannot eliminate is ⧪ lahat ng companies market risk have unique risk ⧪ iba iba risk per company Risk are divided into 2 parts Market Risk Economy wide sources of Specific risk if you only have a risk that affect the overall single stock. The risk stock market. Also called that potentially can “systematic risk.” be eliminated by diversification ⧪ systematic risk = Market risk risk that you can’t damay tayo lahat, if avoid, regardless of bagsak yung market then how much you morelikly down rin tayo diversify ⧪ we cannot control this since systematic risk tayo ⧪ we cannot lower down Calculating the Portfolio the risk Example 1: Suppose you invest 60% of your portfolio in Southwest Airlines and the remainder in ⧪ positive correlation = same direction with the Amazon. The expected dollar return on your market, if market goes up , i go up Southwest investment is 15.0% and on Amazon is ⧪ negative correlation = same direction with the 10.0%. The expected return on your portfolio is: market, if market goes down, i go down Expected return = (.60*15)+(.40*10) =13% Example 2: Suppose you invest 60% of your portfolio in Southwest Airlines and the remainder in Amazon. The expected dollar return on your Southwest investment is 15.0% and on Amazon is 10.0%. The standard deviation of returns was 26.6% for Amazon and 27.9% for Southwest Airlines. Assume a correlation coefficient of 1.0 and ⧪ if mababa standard deviation = mababa rin calculate the portfolio variance ang risk ⧪ impossible mag karoon ng correlation coefficient of –1 pero we aim to be close sa –1 Market Risk Is Measured by Beta Market Portfolio Portfolio of all assets in the economy. In Example Suppose you invest 60% of your portfolio practice, a broad stock market index, in Southwest Airlines and the remainder in such as the S&P Composite, is used to Amazon. The expected dollar return on your represent the market. Southwest investment is 15.0% and on Amazon is 10.0%. The standard deviation of returns was ⧪ ex: PSEi 26.6% for Amazon and 27.9% for Southwest ⧪ it is composed top 30 companies/stocks that Airlines. Assume a correlation coefficient of.26 and malaking pera na raise nila, they represent the calculate the portfolio variance philippine market ⧪ if philippine market is down then PSEi is down Beta Sensitivity of a stock’s return to the return on the market portfolio. ⧪ pag 1 ang beta then gumagalaw sya with Another Example Suppose you invest 60% of your the market portfolio in Southwest Airlines and the remainder in ⧪ ex. Beta ni fruitas ay 1 and pag umakyat Amazon. The expected dollar return on your then aakyat ang market Southwest investment is 15.0% and on Amazon is ⧪ the lower the beta = the lower the risk kasi 10.0%. The standard deviation of returns was hindi ka sumusunod sa market 26.6% for Amazon and 27.9% for Southwest ⧪ if the beta is 1.5 then u move greater with Airlines. Assume a correlation coefficient of –1 and the market which is mas higher risk calculate the portfolio variance. ⧪ if you’re a company who likes to take risk then go for a beta na 1 and higher ⧪ if you’re a conservative type then go with beta na lower ⧪ in the real life, we don’t solve for the beta manually Figure 7.15 Portfolio Risk, Beta The green line shows that a well-diversified portfolio of randomly selected stocks ends up with β = 1 and a standard deviation equal to the market’s—in this case 20%. The upper red line shows that a well-diversified portfolio with β = 1.5 has a standard deviation of about 30%—1.5 times that of the market. The lower blue line shows that a well-diversified portfolio with β =.5 has a standard deviation of about 10%—half that of the market. Figure 7.15 Portfolio Risk, Beta - Stocks with betas greater than 1.0 tend to amplify the overall movement of the market. - Stock with betas between 0 and 1.0 tend to move in the same direction as the market. - The market is the portfolio of all stocks, which is the “average” stock has a beta of 1.0 ⧪ you have to compare your personal portfolio to the market, and see how are they are doing ⧪ your personal portfolio should also the same kung gaano ka same yung na ea-earn ng PSEi or market portfolio ⧪ ex. 5% na ea earn ng market portfolio in the year 2024 then sayo 3% so hindi maganda yun ⧪ benchmark is PSEi