week 8

• When analysing markets, a range of assumptions are made about the rationality of economic agents involved in the transactions
• The Wealth of Nations was written

  1776
• Rational


  (in classical economic theory) economic agents are able to consider the outcome of their choices and recognise the net benefits of each one
• Rational agents will select the choice which presents the highest benefits
• Consumers act rationally by


  Maximising their utility
• Producers act rationally by


  Selling goods/services in a way that maximises their profits
• Workers act rationally by


  Balancing welfare at work with consideration of both pay and benefits
• Governments act rationally by


  Placing the interests of the people they serve first in order to maximise their welfare
• Rationality in classical economic theory is a flawed assumption as people usually don't act rationally
• Demand curve shifting right

  Increases the equilibrium price and quantity
• Marginal utility


  The additional utility (satisfaction) gained from the consumption of an additional product
• If you add up marginal utility for each unit you get total utility
• Advanced Corporate Finance (34369)
• Week 8
• Valuation under Uncertainty
• Learning Objectives


  • Understand the concept of market risk and return
  • Understand the development of asset pricing theories and their applications
• Reading


  • Brealey, Myers and Allen (2020), Chapter 8
  • Hillier, Ross, Westerfield, Jaffe and Jordan (2014), Chapter 10
  • Brealey, Myers and Marcus (2012), Chapter 12
  • Ross, Westerfield, Jaffe and Jordan (2007), Chapter 11
  • Berk, DeMarzo and Harford (2020), Chapter 11
  • Berk and DeMarzo (2011), Chapter 11
  • Welch (2009), Chapter 9
  • Copeland, Weston, and Shastri (2005), Chapter 5
  • Vernimmen, Quiry, Dallocchio, Fur, and Salvi, (2005), Chapter 21
  • Megginson (1997), Chapter 3
  • Parrino and Kidwell (2009), Chapter 7
• Lecture Outline
• Beta


  A relative measure of systematic risk, the responsiveness or sensitivity of a stock's return to the return on the market portfolio
• Capital Asset Pricing Model (CAPM)


  A model that describes the relationship between risk and expected return
• Arbitrage Pricing Theory (APT)


  A model that describes the relationship between risk and expected return
• Fama and French's multi-factor models


  Models that describe the relationship between risk and expected return
• Recap


  • Key principle: Risk and return trade off
  • By investing in more than one asset in a portfolio, some risk can be reduced
  • There are two types of risk: Systematic and Unsystematic
  • If we assume that investors would invest in a well diversified portfolio or in the market portfolio, the risk that is left would be systematic risk
• Market portfolio


  A valued weighted portfolio of all assets in the economy
• Beta (β)


  A relative measure of systematic risk, the responsiveness or sensitivity of a stock's return to the return on the market portfolio
• Beta


  • The ratio of covariance to variance
  • Measures a stock's contribution to portfolio risk
  • > 1.0: tend to amplify the overall movements of the markets
  • Between 0 and 1.0: tend to move in the same direction as the market, but not as far
  • <1.0: less sensitive
  • <0: tend to move in the opposite direction to the market
• Market model


  A simple linear regression used to estimate Beta
• Total risk


  Diversifiable risk + market risk
• Market risk


  Measured by beta, the sensitivity to market changes
• Returns on Ford change on average by 1.53% for each additional 1% change in market return
• Beta = 1.53
• Betas of selected companies


  • Step 1: Need to gather data for the stock market and the individual asset i over the same time frame (normally 5 years!)
  • Step 2: Calculate the variance of returns on the market, m^2
  • Step 3: Calculate the covariance of the market and the individual investment, cov (i, m)
  • Step 4: Calculate the Beta, i = cov(i,m) / m^2
• Four Steps in Calculating Beta


  1. Gather data

  2. Calculate the Variance of returns for the market

  3. Calculate the Covariance of returns for the market and the share

  4. Calculate Beta
• Portfolio's Beta


  When a risky asset is combined with a riskless asset, the portfolio beta is the weighted sum of the betas
• You have a portfolio which consists of two risky assets and a risk-free asset. You invest 30% in asset A with a beta of 1.20 and 50% in asset B with a beta of 0.75. What is the portfolio's beta?
• Assumptions of CAPM


  • An investors' goal is to maximise returns
  • Investors are rational and risk-averse
  • Portfolios are well diversified across a range of investments
  • There is no limit to the amount investors can lend or borrow at the risk-free rate
  • Investment in treasury bills is risk-free
  • The framework only focuses on the one period investment
  • The market is perfect; all assets are marketable, there are no transaction costs or taxes, and all investors are price takers
  • All information is available to everyone at the same time and investors' beliefs are homogeneous
  • Asset returns are normally distributed
  • Variance (or standard deviation) is an adequate measure of total risk and beta of systematic risk
  • Only systematic risk (beta) has an impact on expected return
  • The proxy for the market portfolio is the stock index
• Risk premium


  The excess returns received by investing in a risky asset/portfolio in comparison to risk-free assets
• Market risk premium


  The difference between the return on the market and the risk free, the additional expected return investors require to be willing to hold a broadly-diversified equity portfolio rather than simply holding the risk-free asset
• Capital Asset Pricing Model (CAPM)


  A model that describes the relationship between risk and expected return, introduced by Sharpe (1964) and Lintner (1965)
• CAPM expression


  E(ri) = rf + [cov(i,m)/var(m)] * [E(rm) - rf]