INTRODUCTION PART
Q. What is meant by a perfect capital market?
Ans. Perfect Capital Market:
A perfect capital market exists if the following conditions hold:
- 1. There are no transaction (brokerage) costs.
- 2. There are no taxes.
- 3. There are large numbers of buyers and sellers, so the actions of no one buyer or seller affect the price of the traded security.
- 4. Both individuals and firms have equal access to the market.
- 5. There is no cost to obtain information, so everyone has the same information.
- 6. Everyone has the same (homogeneous) expectations.
- 7. There are no costs associated with financial distress.
Q. What role does the perfect capital market assumption play in financial theory?
Ans. Role of perfect capital market assumption:
Clearly most of these assumptions do not hold in the real world-taxes and brokerage costs exist, individuals often do not have the same access to markets as corporations, managers often have more information about their firms’ prospects than do outside investors and so on. Still, a theory should not be judged on the reality of its assumption, but rather on how consistent its predictions are with actual behavior. If a theory seems reasonable and is consistent with behavior, then the theory will generally be accepted, regardless of the realism of its assumption. Often the assumptions do not limit the ability of the theory to explain real world phenomena.
For example, although taxes certainly exist, there may be enough tax exempt institutions with sufficient capital to produce the results predicted by a theory that assumes zero taxes.
Q. what are the four essential steps in discounted cash flow analysis?
Ans. John Burr Williams originally developed the concept of DCF analysis, but Myron J. Gordon first applied it to corporate financial decisions and popularized its use in cost of capital studies. Discounted cash flow analysis can be broken down into four steps-
1. Estimate the future cash flows:
Estimating future cash flows for some assets, such as bond, is relatively easy- since the cash flows are fixed by contract, the promised flows will be realized unless the issuer defaults. On the other hand, existing cash flows for others assets can be extremely difficult. For example, when Boeing made the decision to develop its new 777aircraft, it had to estimate R&D costs, number of aircraft that would be sold, sales price and production costs, all over a 30-year production life.
2. Assess the riskiness of the flows:
When cash flows are being estimated, single estimate are usually not sufficient. Rather, the potential uncertainty inherent in the cash flows must also be assessed.
3. Incorporate the risk assessment into the analysis:
Risk can be handled in two ways: (1) by the certainty equivalent approach or (2) by the risk adjusted discount rate approach. In the CE approach, the expected cash flows are reduced to account for risk- the higher the risk, the lower risk adjusted, or certainty equivalent cash flow. In the RADR approach, the discount rate rather than the cash flow is adjusted for risk- the higher the risk, the higher the discount rate.
4. Find present value of the cash flows:
The final step is to find the present value of the cash flows.
Q. How does the opportunity cost principle apply to discounted cash flow analysis?
Ans.The opportunity cost concept plays an important role in DCF analysis. To illustrate, let us suppose a firm unexpectedly wins a lawsuit, is awarded $100000, and now is evaluating several investment alternatives. Should a cost be assigned to this $100000 or should it be considered as free capital? At first blush, it might appear that the funds have a zero cost-after all; the $100000 was an unexpected windfall. However the opportunity cost must be assigned to each alternative. By investing the $100000 in one alternative, the firm forgoes the opportunity to invest the funds in any other alternative.
Q. How would you estimate the opportunity cost of an investment in a high-risk limited partnership which invests in speculative research and development projects?
Ans.The discount rate applied in DCF investment analysis must reflect foregone opportunities, but which one should be considered? The discount rate should reflect the return that could be earned by investing the funds in the best alternative investment opportunity of similar risk. It may be difficult to estimate the return available on alternative real assets investments. When Boeing was setting the opportunity cost rate for its 777 investment, the most logical choice was the return expected on other new aircraft investments. However such information is rarely available, so the expected rate of return on financial assets are usually used to set the opportunity cost rate for all investment decisions. To illustrate, when the cash flows of an average-risk project are discounted at the firm’s weighted average cost of capital to find the projects NPV, the opportunity cost principle is being applied- in lieu of investing in the project, the firm could invest the funds in securities having the same risk characteristics as the project and earn a return equal to the firm’s weighted average cost of capital.
Q. what three factors must be considered when choosing a discount rate to apply to a cash flow stream?
Ans. In any DCF analysis it is necessary to assign an opportunity cost discount rate. In general that rate must reflect three factors-
1. The riskiness of the flow:
Risk inherent in the cash flows- the higher the risk, the higher the discount rate. For example the discount rate used to evaluate corporate bonds will be higher than that of treasury bonds had the rate applied to cash flows fro a firm common stock will be higher than that applied to its bond.
2. The prevailing level of rates of return:
The discount rate must reflect the prevailing level of the return in the economy. thus in may 2005 the discount rate applied to cash flows having the same levels of risk as a 3-months treasury bill was 5.8 percent, but in may 2002 the rate was only 3.5 percent. Because of changes in expected inflation, in risk aversion, and in supply and demand conditions, the prevailing return on short-term treasury securities rose by 230 basis points in three years.
3. The timing of the cash flows:
The final consideration is the timing of the flows; that is, do the flows occur annually, quarterly or over some other period? In general, we think in terms of annual discount rate and in many situations the cash flow do occur annually. Under these circumstances, no adjustment is required. However, if the cash flows occur over some non-annual period, say, semi-annually, then the discount rate must reflect this fact.
Q. What are the three forms of market efficiency?
Ans. Efficient Markets Hypothesis (EMH) is one of the most important financial theories. Here “efficient market” means one that is informationally efficient, which implies that prices reflect all known information.
There are primary conditions are necessary for a market to be informationally efficient:
Ø Information must be costless, and it must be available to all market participants at the same time.
Ø There can be no transaction costs, taxes, or other barriers to trading.
Ø Prices cannot be affected by the trading of a single person or institution.
The EMH is divided in three forms:
1. Weak-form efficiency
2. Semistrong-form efficiency
3. Strong-form efficiency
1. Weak-form efficiency:
It holds that all information contained in past price movements is fully reflected in current market prices.
It is applied to the stock market, empirical tests fall into two broad categories.
a. Tests which amine the correlation between price changes over time:
The EMH holds that prices change in response to new information, and since new information can have either a positive or negative impact on stock prices.
b. Tests which examine the profitability of various technical trading rules:
It means applying technical trading rules to historical market data to determine whether following a given trading rule have produced excess returns.
1. Semi strong-form efficiency:
It embraces the weak form and then goes on to hypothesize that current market prices reflect both past price movements and all other publicly available information.
In this efficiency two major types of empirical test have been used to test.
a. Examining how prices adjust to new information:
In perfectly efficient markets, prices would adjust instantaneously to new information
b. Assessing professional managers’ performance relative to the market:
It sees whether professional analyst and portfolio managers can outperform the market: if markets are Semistrong-form efficient, then no one having only public information should be able to consistently “beat the market.” Most evidence supports the concept of Semistrong-form efficiency.
1. Strong-form efficiency:
It holds that current market prices reflected all information, whether publicly available or privately held.
Q. What is meant by “risk / return trade-off”?
Ans.The concept of market efficiency leads directly to the risk/return trade off concept. In semi strong form efficient markets, where prices reflect all public information and hence securities are fairly valued, investments that offer higher returns must also carry higher risk. Therefore, differences in expected rates of return are due primarily to differences in risk.
Ans.The concept of market efficiency leads directly to the risk/return trade off concept. In semi strong form efficient markets, where prices reflect all public information and hence securities are fairly valued, investments that offer higher returns must also carry higher risk. Therefore, differences in expected rates of return are due primarily to differences in risk.
To illustrate, suppose AT&T’s stock had an expected rate of return of 14 percent, while its bond yielded only 9 percent. The higher expected return on the stock merely reflects its higher risk. Investors who are not able or willing to assume much risk will choose AT&T’s bonds, while those who are less risk averse will buy AT&T’s stock. From the company perspective, financing with stock is less risky than financing with debt, so AT&T’s managers are willing to pay the higher equity cost in order to limit the firm’s exposure to risk.
Transactions in financial markets generally do not provide excess returns. However, product or real goods, markets are not generally efficient, at least in the short run, and excess return can be made by selling real assets such as machine tools or toothpaste or shopping centers. For example, in the early days of personal computers, IBM and Apple had a near monopoly on the market, and high profit margins and good volume combined to produce high returns for the two companies. But these high rates of returns attracted entry by dozen of competitors, and that entry lowered prices to consumers and margins to manufacturers to normal levels. Thus, product market may be inefficient in the short run, but they tend to be efficient in the long run.
Q. What are the implications of the efficient markets hypothesis for investors and also for managers?
Ans. One of the most important financial theories is the Efficient Markets Hypothesis (EMH). The term “efficient market” means one that is informationally efficient, which implies that prices reflect all known information.
The EMH & the resulting risk/return trade-off concept have more important implication for both investors and managers.
Implications of Efficient Markets Hypothesis for Investors
For investors, the EMH suggests that an optimal strategy involves:
1) Selecting a suitable risk level
2) Creating a well-diversified portfolio which has that risk level.
3) Minimizing transactions costs with a buy and hold strategy.
Implications of Efficient Markets Hypothesis for managers:
For managers, the EMH suggests that
1) A firm’s value cannot be increased by financial market transactions. If the NPVs of such transactions are zero, then a firm’s value can be increased only by product market transactions. Intel became a world leader in microchips because it was good at designing, manufacturing, & marketing products, not because of superior financial decisions.
2) Financial assets, by and large, are fairly valued, and decisions based on the assumption that a security is undervalued or overvalued must be viewed with caution.
3) Innovations in securities markets lead to abnormal returns, because new securities, which offer a risk/return combination that cannot be obtained with existing securities, can initially be priced above their true value. This was the case when Wall Street firms stripped Treasury bonds to create zero coupon Treasury securities in the early 1980s.
4) However, new securities cannot be patented, so any pent-up demand that supports the overpricing of a new security will quickly be removed from the market.
Q. What is an agency conflict?
Ans. An agency relationship arises whenever one or more individuals, called principals, hire other individuals, called agents, to perform some service and also delegate decision making authority to the agents.
A potential agency conflict exists whenever a manager owns less than 100 percent of the firm’s common stock. If the firm is a proprietorship manager by the owner, the owner-manager will take actions to maximize his or her own welfare, or utility. The owner-manager will probably measure utility primarily by personal wealth, but other factors, such as leisure time and perquisites, will be considered. However, if the owner-manager sells some of the firm’s stock to outside investors, a potential conflict of interest, called an agency conflict, arises. For example, the owner-manager may now decide to lead a more relaxed life and not work as strenuously to maximize shareholder wealth because less of this wealth will accrue to him or her. Also, the owner-manager may decide to take more “business trips” to fun locations because some of the cost will now be borne by the outside shareholders.
In most large corporations, potential agency conflicts are quite important, because managers generally own only a small percentage of the firm’s stock. In this situation, shareholder wealth maximization could take a back seat to any number of possible managerial goals.
Q. What are agency costs? Who must bear these costs?
Ans. Managers can be encouraged to act in the stockholders’ best interests through incentives, constraints, and punishments. But these tools are effective only if shareholders can observe all of the actions taken by managers. A moral hazard problem, defined here as a situation in which agents take unobserved actions in their own interests, arises because it is virtually impossible for shareholders to monitor all managerial actions. To reduce agency conflicts and the moral hazard problem, stockholders must incur agency costs, which include all costs designed to encourage managers to maximize shareholder wealth rather than act in their own self-interests. There are three major categories of agency costs:
- Expenditures to monitor managerial actions, such as audit cost,
- Expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors, and
- Opportunity costs which are incurred when restrictions, such as requirements for stockholders to vote on certain issues, limit the ability of managers to take timely actions that would contribute to shareholder wealth.
Agency costs must bear by shareholders. In the absence of any effort whatever to affect managerial behavior, and hence with zero agency costs, there will almost certainly be some loss of shareholder wealth due to improper managerial actions. Conversely, agency costs would be very high if shareholders attempted to ensure that every single managerial action coincided exactly with shareholder interests. Thus, the optimal amount of agency costs to be borne by shareholders should be viewed like any other investment decision.
Q. What mechanisms exist that encourage managers to act in the best interests of shareholders?
Ans. Most firms today use a package of economic incentives, along with some monitoring, to influence managers’ performance and thus reduce the agency problem. The following incentives, or factors that motivate managers, are used today:
1. Performance-based compensation plans:
Firms are increasingly tying managers’ compensation to the company’s performance by instituting performance-based compensation plans. Managers obviously must be compensated and the structure of the compensation package can and should be designed to meet two primary objectives:
- To attract and then retain able managers and
- To align the managers’ actions as closely as possible with the interests of the firms’ stockholders, this is primarily stock price maximization.
2. Direct intervention by shareholders:
Although a great deal of stock is owned by individuals, an increasing percentage is owned by institutional investors. Institutional investors can influence a firm’s managers’ in two ways:
- They can talk with a firm’s management and make suggestions regarding how the business should be run.
- Any shareholder who has owned at least $1,000 of a company’s stock for one year can sponsor a proposal which must be voted on at the annual stockholders’ meeting, even if the proposal is opposed by management.
3. The threat of firing: Until recently, the probability of a large firm’s management being ousted by its stockholders was so remote that it posed little threat. This situation existed because the ownership of most firms was so widely distributed, and management’s control over the proxy mechanism so strong, that it was almost impossible for dissident stockholders to get the votes needed to overthrow the managers. However, that situation has changed dramatically, and now the threat of firing is real.
4. The threat of takeover: Hostile takeovers (where management does not want the firm to be taken over) are most likely to occur when a firm’s stock is undervalued relative to its potential. In a hostile takeover, the managers of the acquired firm are generally fired, and any who are able to stay on lose the autonomy they had prior to the acquisition. Thus, managers have a strong incentive to take actions which maximize stock price.
Q. Discuss the agency conflict between shareholders and creditors.
Ans. In addition to the agency conflict between stockholders and managers, a second agency conflict also merits discussion that between creditors and stockholders. Creditors have a claim on part of the firm’s earnings stream as well as a claim on the firm’s assets in the event of bankruptcy. However, the stockholders have control through the firm’s managers of the decision that affect the profitability and risk of the firm. Creditors lend funds at rates that are based, among other factors:
- On the riskiness of the firm’s existing assets,
- On expectations concerning the riskiness of future asset additions,
- On the firm’s existing capital structure (that is, the amount of debt financing used), and
- On expectations concerning future capital structure decision.
These are the primary determinants of the riskiness of a firm’s cash flows and hence its debt, so creditors base their required rates of return on these factors.
Now suppose the stockholders, acting through management, have the firm takes on a large new project that has a greater risk than was anticipated by creditors. This increased risk will cause the required rate of return on the firm’s debt to increase, which in turn will cause the value of the outstanding debt to fall. If the risky capital investment is successful, all of the benefits will go to the firm’s stockholders, because creditors’ returns are fixed at the old, low-risk rate. However, if the project is unsuccessful, the bondholders will have to share in the losses.
Q. What is Market Value Added (MVA)?
Ans.The primary goal of any firm should be shareholder wealth maximization. This goal obviously benefits shareholders & it also ensures that scarce resources are allocated as efficiently as possible. Although this fundamental concept is widely accepted, it is easy to mistake maximizing the firm’s total market value for shareholder wealth maximization. A firm’s total market value can be maximized by rising & investing as much capital as possible, but this is rarely in the best interest of shareholders. Shareholder wealth is maximized by maximizing the difference between the market value of equity & the amount of capital that investors have supplied to the firm. This difference is called Market Value Added (MVA).
MVA=Market value of equity- Equity capital supplied.
MVA can also be defined in terms of total capital supplied, including both debt & equity. However, the definition presented here focuses solely on equity capital, is easier to use & is generally consistent with the broader definition.
For example: Consider Coca-cola in 1994, its total market value was $61 billion, While its investors had supplied only $8 billion. Thus Coca-cola’s MVA was $61-$8= $53 billion. This $53 billion represents the difference between the cash that its investors have put into the corporation since it’s founding- including retained earnings & the value of the cash they could get by selling the business. By maximizing this spread, management maximizes the wealth of its shareholders.
Q. What id Economic Value Added (EVA)?
Ans. Whereas MVA measures the effect of managerial actions to enhance shareholders wealth since the inception of the company, Economic Value Added (EVA) focuses on managerial effectiveness in a given year. The basic formula for Eva is this:
EVA= Operating profit- Cost of capital
= (sales revenues-operating costs- taxes) - (total capital supplied* cost of capital)
Here operating profit ids defined as sales revenue minus operating cost & taxes, while the cost of capital used is total capital times the weighted average cost of that capital.
For example, suppose a firm in 1995 had $100 million of sales, $80 million of operating costs & $10 million of taxes, so its operating profits as defined were $10 million. Suppose further that the firm has $ 50 million of investor- supplied debt & equity capital & the weighted average cost of capital was 10 percent. The firm’s 1995 EVA would be $5 million:
EVA= $10-$5(0.10)=$10 -$5 =$5million.
EVA= $10-$5(0.10)=$10 -$5 =$5million.
EVA is an estimate of a business’s economic profit for that year & it differs substantially from accounting profitability measures. EVA represents the residual income that remains after the opportunity cost of the employed capital has been deducted. EVA depends on both operating efficiency & balance sheet management. EVA can be applied to divisions as well as to the entire company & the charge for capital should reflect the risk of the business unit, be it the whole company or an operating division.
Q. Why is EVA a better measure of managerial performance than accounting measures such as earning per share?
Ans. In past few years many highly successful firms have adopted incentive compensation system based on EVA. The primary rationale s that EVA is linked both theoretically & empirically to shareholder wealth. For example, AT&T found an almost perfect positive correlation between its EVA & its stock price, whereas the correlation between accounting profits & stock prices was much lower. Moreover, what holds for AT&T holds for stocks in general – security analysts have found that stock prices track EVA far more closely than other measures such as earning per share, operating margin or return on equity. Had analysts & investors used EVA as an evaluation tool in 1980s, they would have seen that Gm’s EVA was negative during most of the decade, a clear signal that stock price was headed for a fall. Thus they could have avoided large losses.
When executive compensation is tied to EVA, managers are given the proper incentive to take the set of actions that contribute the most to shareholder’s wealth. The advantages of using EVA as a centerpiece of a completely integrated framework for financial management & incentive compensation were stated this way by George McFadden chief financial officer of Palwaukee Industries:
“We have not had a single capital budgeting project turned down since we adopted EVA. With EVA (NPV) as the basis of capital budgeting decisions, performance evaluations & bonus determinations, our managers are spending money as it is their own & that is paying big dividends for them & for our shareholders.”
Q. In financial market what is meant by asymmetric information?
Ans.Asymmetric information:
When a manager knows more about his or her firm’s future than do the analysts and investors who follow the company then a situation of asymmetric information exists. In this situation a firm’s managers may correctly conclude that its securities are undervalued or overvalued depending on whether the inside information is favorable or unfavorable. Of course there are degrees of asymmetry management is almost always better informed about a firm’s prospects than are outsiders but in some situations this informational difference is too small to influence managerial actions. In other circumstances such as prior to a merger announcement or when a drug company has made a major research breakthrough managers may have information that will significantly alter the prices of the firm’s securities when it becomes public. In most situations the degree of information asymmetry lies between the two extremes.
The potential impact of asymmetric information on markets was analyzed by George Ackerlof in a paper titled “The market for Lemons”
The only convincing way for a seller to convey potential buyers that the product is good to take some action that buyer can unambiguously interpret as a sign that the product is not defective. Such actions are called signals and the act of providing signals is called signaling.
Since manager’s primary goal is to maximize shareholders wealth managers are generally motivated to convey favorable inside information to the public as rapidly as possible. The easiest way would be to issue a press release announcing the favorable development. However outsider would have no way of knowing whether the announcement was true or how important it really was. Therefore such announcements have limited value. But if managers could signal information concerning favorable prospects in some truly credible way then the information would be taken seriously by investors and reflected in security prices.
Example: Dividend announcements are the classic example of managers providing information through signaling. If a firm announces a significant increase in cash dividend this is its managers signal that the firm has good future earnings and cash flow prospects. If dividend increase is widely anticipated but then is not forthcoming this is negative signal.
The presence of effective management signals plays an important role in financial management.
Q. What are some ways that managers can signal to outsiders their forecasts for a bright earnings future?
Ans. The only convincing way for a seller to convey potential buyers that the product is good to take some action that buyer can unambiguously interpret as a sign that the product is not defective. Such actions are called signals and the act of providing signals is called signaling.
Managers can signal to outsiders their forecasts for a bright earning future by the following ways:
- Press release
- Dividend announcements
Press release:
Since manager’s primary goal is to maximize shareholders wealth managers are generally motivated to convey favorable inside information to the public as rapidly as possible. The easiest way would be to issue a press release announcing the favorable development. However outsider would have no way of knowing whether the announcement was true or how important it really was. Therefore such announcements have limited value. But if managers could signal information concerning favorable prospects in some truly credible way then the information would be taken seriously by investors and reflected in security prices.
Dividend announcement:
Dividend announcements are the classic example of managers providing information through signaling. If a firm announces a significant increase in cash dividend this is its managers signal that the firm has good future earnings and cash flow prospects
RISK and RETURN
Q. What are the differences between risk and uncertainty?
Differences between risk and uncertainty
Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus risk refers to the chance that some unfavorable event will occur. Risk relates to the probability of earning a return less than the expected return.
Uncertainty is defined as a risk which cannot be insured against and is incalculable.
| Subject | Risk | Uncertainty |
| Risk can be measurable statistically or mathematically. | Uncertainty cannot be measured. |
| Risk can be avoided by taking some techniques. | Uncertainty cannot be avoided. |
| Risk is highly relates with the income or, expected rate of return. | Uncertainty is not related with income. |
| Risk can be controlled in a scientific way. | Uncertainty cannot be controlled. |
| Risk can be insured by taking different policies. | Uncertainty cannot be insured. |
| Risk is connected with the possible losses of an organization. | Uncertainty is connected with the imagination of a person. |
| Measuring & analyzing of risk depends on mathematical information. | Uncertainty is connected with the imagination of a person. |
Q. What are the differences between diversifiable risk and non-diversifiable risk?
Differences between diversifiable risk and non-diversifiable risk
| Subject | Diversifiable risk | Non-diversifiable risk |
| 1. Definition | Diversifiable risk is that type of risk that arises from the uncertainties and which are unique to individual securities. | Non-diversifiable risk is that type of risk that arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with change in the market. |
| 2. Elimination | Portion of an asset’s risk that can be eliminated through diversification, also called diversifiable risk. | Portion of an asset’s risk that cannot be eliminated through diversification, also called non-diversifiable risk. |
| 3. Risk reduction | This part of the risk can be totally reduced. | This part of the risk can’t be totally reduced. |
| 4. Sources | Occurrences of random event like labor strike, lawsuits, or lose of accounts are the sources of this risk. | Interest rates, recession and wars all represent the sources of this risk. |
| 5. Affect | They don’t affect the entire market. | They affect the entire market. |
| 6. Mitigation | Diversifiable risk is the risk which can be mitigated by investing in different companies, different sectors, different assets and also different regions. | Non-Diversifiable risk cannot be mitigated at all. |
| 7. Means | It is unsystematic risk. | It is systematic risk. |
| 8. Type | It is also called unique risk. | It is also called market risk. |
| 9. Nature | It is the traditional form of risk, which is a diversifiable risk, where you can eliminate a risk by owning many securities. | A non-diversifiable risk is actually the risks we want to take, since we can't eliminate those risks. |
| 10. unique | This type of risk is unique to a given asset. | This type of risk is non-unique to a given asset. |
| 11. Scope | This risk affects a very specific group of securities or an individual security. | This risk affects an individual security. |
Q. Why standard deviation is considered as a better measurement for risk?
In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a measure for the amount of expected volatility. Basically standard deviation is used to see whether the project has less or high risk.
A measure of the variation in a distribution, equal to the square root of the arithmetic mean of the squares of the deviations from the arithmetic mean, the square root of the variance.
The reasons behind standard deviation as a better measurement for risk are given below:
The most commonly used measure of risk for assets or securities is a measure known as the standard deviation. The larger the standard deviation the greater the dispersion and hence the greater the distribution’s stand alone risk. On the other hand the lower the standard deviation the lower the risky-ness of the project.
If we want to know how `risky' a fund/ a project is, there are other ways of assessing it. For instance, we can compare the annual returns of a fund over the past several years. we can analyze how the fund has done in bull markets and in bear markets. Or we can compare compound returns for several time periods. Using compound returns has one problem though. Compound returns can be affected by one year's exceptional performance. To correct for this, Fund Counsel suggests dropping the exceptional year and re-computing the compound rate of return.
But from above mentioned measures standard deviation is consider as a better measurement of risk because by using standard deviation we can easily identify whether the project is risky or not. If the rate of standard deviation is high then the project is risky and if the rate of standard deviation is low then the project is less risky.
Q. SHORT NOTES
(1)Risk; probability distribution
Risk relates to the probability of earning a return less than the expected return and probability distributions provide the foundation for risk measurement.
A probability distribution is defined as a set of possible outcomes with a probability of occurrence attached to each outcome. Probability distribution mat be either discrete or continuous. A discrete probability distribution has finite number of outcomes. A continuous probability distribution has infinite number of outcomes.
(2)Expected rate of return, k^
If we multiply each possible outcome for a single investment by its probability of occurrence and then sum these products, we will have a weighted average which is defined as the expected value. Since the outcomes are rate of returns, the expected values are the expected rate of returns. The expected rate of return, k^, called “k hat” is expressed in the equation as follows:
Expected rate of return = k^ =∑kiPi
Here, ki is the ith possible outcome, Pi is the probability that the ith outcome will occur and n is the number of possible outcomes.
(3)Standard deviation
Since it is difficult to attach meaning to squared percentage, standard deviation often used as the measure of stand alone risk. Standard deviation is found by taking the square root of the variance. It is shown in the following equation:
Standard deviation = SD = δ =√δ2 = √∑ (ki-k^)2Pi
Using the standard as the measure of dispersion enables us to draw some conclusions about the distribution of outcomes. First, the larger the standard deviation, the greater the dispersion and hence the greater the distribution’s stand alone risk.
(4)Variance
Variance is a measure of dispersion of possible outcomes around the expected value. The larger the variance, the greater the dispersion. To calculate the variance of a discrete distribution, we use the following formula:
Variance =δ2 =∑(ki -k^)2Pi
Thus, variance is the sum of the squared deviation weighted by each deviation’s probability of occurrence.
(5)Coefficient of variation
As a general rule, the higher the expected return the larger the standard deviation. To illustrate, suppose project has a 30% expected rate of return & a 10% standard deviation, while project Y has a 10% expected rate of return & a 5% of standard deviation. However if the projects returns are approximately normal, then the project X would have a small probability of a negative return in spite of its 10% standard deviation, while project Y, even with a standard deviation only half as large, would have a much higher probability of a loss. To deal with the situation in which expected returns offer, one should standardize the standard deviation and calculate the risk per unit of return. This is accomplished by using the coefficient of variation (CV), which is defined by standard deviation divided by the expected value:
Coefficient of variation (CV) = δ/K
(6)Stand alone risk & market risk
Risk can be defined & measured in many ways. There are two types of risk- (1) stand alone risk, which is the riskiness of an asset held in isolation & (2) market risk, which is an asset’s relevant or effective risk, if it is held as one of the large number of assets in a well diversified portfolio. To illustrate stand alone risk, suppose an investor holds a single risky asset, say, a stock. In this case, the stock’s risk is measured by the dispersion of returns about its expected return. The greater this dispersion, the higher the probability that the return will fall far below the expected return, hence the greater the risk of the stock. However, if an investor holds a large number of stocks in a portfolio, say, 40 or more, the important issue becomes the overall or aggregate risk of the portfolio because the losses on one stock may be offset by gains on another. In this situation, the relevant risk of each stock is its market risk, which measures the stock’s contribution to the overall riskiness of the portfolio.
(7)Expected return on a portfolio,kp
The expected rate of return on a portfolio is simply the weighted average of the expected returns of the individual securities in the portfolio:
Expected return on a portfolio =Kp = ∑XiKpi
Here kp is the expected rate of return on the portfolio, Xi is the fraction of the portfolio invested in the ith asset, ki is the expected rate of return on the ith asset and n is the number of assets in the portfolio. For example, suppose stock A has an expected return of KA = 10%, stock B has KB = 15% and you plan to invest your money into these stocks. If you put all your money in A your one- stock portfolio would have an expected return of Kp =KA = 10%. If you invest only in B, your expected return would be Kp = KB = 15%. If you put half your money in each stock, then your expected portfolio return would be KP= 0.5(10%)+0.5(15%) = 12.5% a weighted average of the two stocks returns.
(8)Correlation coefficient, r
The correlation coefficient is often used to measure the degree of co-movement between two variables. The correlation coefficient standardizes the covariance by dividing the product of their correlation coefficients; this facilitates comparisons by putting things on a similar scale. The correlation coefficient r, is calculated as follows for any two variables A& B:
Correlation coefficient (AB) = rAB=COV (AB)/δAδB
The sign of the correlation coefficient is the same as the sign of the covariance, so a positive sign means that the variables move together, a negative sign means that, they move in positive directions & if r is close to zero, they move independently of one another. Moreover, the standardization process confines the correlation coefficient to values between -1.0 & +1.0. The above mentioned equation can be solved to find the covariance:
COV (AB) =rABδAδB
(9)Efficient portfolios
One important use of statistical relationships is to select efficient portfolios- defined as those portfolios which provide the highest expected return for any degree of risk or the lowest degree of risk for any expected return. To illustrate the concept, assume that two investment securities, A and B, are available and we can allocate our funds between the securities in any proportion. Suppose security A has an expected rate of return of kA^ =5% and a standard deviation of returns δA =4% while kB^ =8% and δB =10%. Our first task is to determine the set of attainable portfolios and then from this attainable set to select the efficient subset.
To construct the attainable set, we need data on the degree of correlation between the two securities expected returns, rAB. We will assume three different degrees of correlation, rAB =+1.0, rAB =0 and rAB=1.0 & using them develop the portfolios expected returns kP & standard deviations, δp
To calculate kp we use the following equation substituting the given values for kA &kB & then solving for kp at different values of x.
Kp = xAkA+xBkB
We use the following equation to calculate δp
δp =√{x2δA2+(1-x)2δB2+2x(1-x)rABδAδB}
(10)Company specific risk
That part of a stock’s stand alone risk which can be eliminated by holding a well diversified portfolio is called diversifiable or company specific risk. Diversifiable risk is caused by such company specific events as lawsuits, strikes, successful & unsuccessful marketing programs and winning and losing major contracts. Since occurrences that are unique to a particular firm (or to its industry) are random, their effects on a portfolio can be eliminated by diversification- bad events in one firm will be offset by good events in another. Diversifiable risk or company specific risk is sometimes called unsystematic risk. On the other hand market risk or nondiversifiable risk stems from such external events as war, inflation, recession and high interest rates which have impact on all firms, hence cannot be eliminated by diversification. It is also called systematic risk.
Q: How does investor choose his or her optimal portfolio from among the efficient set?
Efficient portfolio is defined as those portfolios which provide the highest expected return for any degree of risk, or the lowest degree of risk for any expected return.
Choosing the optimal portfolio:
The choice involves two separate d7ecisions:
- Determining the efficient set of portfolios &
Q. What is meant by “risk / return trade-off”?
The concept of market efficiency leads directly to the risk/return trade off concept. In semistrong form efficient markets, where prices reflect all public information and hence securities are fairly valued, investments that offer higher returns must also carry higher risk. Therefore, differences in expected rates of return are due primarily to differences in risk.
To illustrate, suppose AT&T’s stock had an expected rate of return of 14 percent, while its bond yielded only 9 percent. The higher expected return on the stock merely reflects its higher risk. Investors who are not able or willing to assume much risk will choose AT&T’s bonds, while those who are less risk averse will buy AT&T’s stock. From the company perspective, financing with stock is less risky than financing with debt, so AT&T’s managers are willing to pay the higher equity cost in order to limit the firm’s exposure to risk.
Transactions in financial markets generally do not provide excess returns. However, product or real goods, markets are not generally efficient, at least in the short run, and excess return can be made by selling real assets such as machine tools or toothpaste or shopping centers. For example, in the early days of personal computers, IBM and Apple had a near monopoly on the market, and high profit margins and good volume combined to produce high returns for the two companies. But these high rates of returns attracted entry by dozen of competitors, and that entry lowered prices to consumers and margins to manufacturers to normal levels. Thus, product market may be inefficient in tha short run, but they tend to be efficient in the long run.
Q:what are the implications of the efficient markets hypothesis for investors and also for managers?
One of the most important financial theories is the Efficient Markets Hypothesis (EMH). The term “efficient market” means one that is informationally efficient, which implies that prices reflect all known information.
The EMH & the resulting risk/return trade-off concept have more important implication for both investors & managers.
Implications of Efficient Markets Hypothesis for Investors
Implications of Efficient Markets Hypothesis for Investors
For investors, the EMH suggests that an optimal strategy involves:
1) Selecting a suitable risk level
2) Creating a well-diversified portfolio which has that risk level.
3) Minimizing transactions costs with a buy & hold strategy.
Implications of Efficient Markets Hypothesis for managers:
For managers, the EMH suggests that
1) A firm’s value cannot be increased by financial market transactions. If the NPVs of such transactions are zero, then a firm’s value can be increased only by product market transactions. Intel became a world leader in microchips because it was good at designing, manufacturing, & marketing products, not because of superior financial decisions.
2) Financial assets, by and large, are fairly valued, and decisions based on the assumption that a security is undervalued or overvalued must be viewed with caution.
3) Innovations in securities markets lead to abnormal returns, because new securities, which offer a risk/return combination that cannot be obtained with existing securities, can initially be priced above their true value. This was the case when Wall Street firms stripped Treasury bonds to create zero coupon Treasury securities in the early 1980s.
4) However, new securities cannot be patented, so any pent-up demand that supports the overpricing of a new security will quickly be removed from the market.
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