FinMar (Finman2) CHMSU

MODULE 3

INTEREST RATES
RISK and RATE OF RETURN

LEARNING OBJECTIVES;

At the end of the module, the students will be able to:

1. Discuss how market interest rates are affected by borrowers’ need for
capital, expected inflation, different securities’ risks, and securities’ liquidity
2. Understand the meaning and fundamentals of risk, return, and risk
preferences.
3. Explain the differences between stand alone risk and risk in a portfolio
context.
4. Describe the procedures for assessing and measuring the risk of a
single assets.
5. .Discuss the measurement of return and standard deviation for a \
portfolio of assets
6 .Explain what the Capital Asset Pricing Model (CAPM) is and how it can
be used to estimate stock’s required rate of return.

1.1 INTEREST RATES

Fundamental factors that affect the level of interest rates:

1. Production Opportunities. This is taken in the context of the capital

provider. It has to remember that the lender could have used the money to
be lent for some other purpose. The compensation for the foregone
opportunities has to commensurate the opportunity missed.
2. Time Preference for Consumption. Longer time duration will normally
require higher compensation for lenders
3. Element of Risk. The interest rate shall incorporate the compensation for
the risk assumed by the lender. In a financial market context, the chance
that an investment will provide a low or negative return.
4. Expected Inflation. Central bank’s estimate of the future inflation will direct
affect the level of interest set by the financial institution and even the
investor
 “Nominal” vs. “Real” Rates

r = represents any nominal (quoted) rates

r* (r-star) =represents the “real” risk-free rate of interest. Example is the

interest rate on a T-bill, if there was no inflation. Typically ranges
from 1% to 4%per year. This is the pure interest (clean
compensation) rate that is theoritically received by the capital
providers.

r (Risk-free rate) = represents the rate of interest on Treasury

RF securities. This already includes the expected
inflation estimate, as such this is higher than r*.

Determinants of Interest Rate:

r = required return on a debt securities

r* = “real” risk-free rate of interest
IP = Inflation Premium. This is present in all type of securities
DRP = Default Risk Premium. This is a compensation to capital
providers for the risk that the borrower may not be able to pay.
such the character of the borrower is assed for risk of default.
Government issuances are normally not subject to DRP, since
the state can back up its payment. More of a concern for
corporate borrowers.
LP = Liquidity Premium. Looks into the liquidity of the borrower.
Risk of being illiquid increases liquidity premium
MRP = Maturity Risk Premium. Takes into account the duration of
the borrowing. Long term issuances normally has higher
maturity risk premium.

Activity 1 - Assigned Readings and Problems: From the finance book -

Essentials of Financial Management, 4th Phil. Edition by E. Brigham et
al, read Chapter 7 pages 233 - 259. Answer the following problems found in
pages 263-264 (Group Work)

Problem 7 - 3 Problem 7 - 6
Problem 7 - 10 Problem 7 - 13
Problem 7 - 12 Problem 7 - 14

Answer the above problems using MS (Word, Excel or Pdf) or a picture of

your computation in a clear paper and submit to your account file in
the Google Classroon, not later than November 23, 8pm.
 RISK AND RETURN

INTRODUCTION

We start this module (Chapter) from the basic premise that investors like
returns and dislike risk; hence they will invest in a risky assets only if those assets
offer higher expected returns. We define what risk means as it relates to
investments, examine procedures that are used to measure risk, and discuss the
relationship between risk and return. Investors should understand this concept,
as should corporate managers as they develop the plans that will shape their
firm’s futures.
Risk can be measured in different ways and different conclusions about an
asset’s riskiness can be reached depending on the measure used. Risk analysis
can be confusing, but it will help you if you keep the following points in mind:

1. All business assets are expected to produce cash flows, and the riskiness of an
asset is based on the riskiness of its cash flows. The riskier the cash flows, the
riskier the asset.
2. Assets can be categorized as financial assets, especially stocks and bonds,
and as real assets or physical assets, such as fixed assets like plant, property
and equipment.
3. A stock’s risk can be considered in two ways: a) on a stand alone or single-
stock basis or b) in a portfolio context, where a number of stocks are combined
and their consolidated cash flows are analyzed.
4. In a portfolio context, a stock’s risk can be divided into two components: ( a) a
diversified risk, which can be diversified away and is thus of little concern to
diversified investors, and (b) market risk which reflects the risk of a general stock
market decline and cannot be eliminated by diversification.
5. A stock with high market risk must offer a relatively high expected rate of return
to attract investors. Investors in general are averse to risk, so they will not buy
risky assets unless they are compensated with high expected return.
6. All investors, on average, think a stock’s expected return is too low to
compensate for its risk, they will start selling it, driving down its price and boosting
its expected return.
7. Stand alone risk is important in stock analysis primarily as a lead in to portfolio
risk analysis. However, stand alone risk is extremely important when analyzing
real assets, such as capital budgeting projects.

RISK Defined:

In the most basic sense, risk is the chance of financial loss. Assets having
greater chances of loss are viewed as among risky than those with lesser
chances of loss. More formally, the term risk is used interchangeably with
uncertainty to refer to the variability of return associated with a given asset.The
more nearly certain the return from an asset, the less the variability and therefore
the less risk.
RETURN Defined:

Obviously, if we are going to assess risk on the basis of variability of return, we

need to be certain we know what return is and how to measure it. Return is the
total gain or loss experienced on an investment over a given period of time. It is
commonly measured as cash distributions during the period plus change in value,
expressed as a percentage of the beginning-of-period investment value

Risk Preferences:

Feelings about risk differ among managers (and firm), Thus it is important to
specify a generally accepted level of risk. The three basic preference behavior
are as follows:

Risk Averse - The attitude toward risk in which an increased return would be
required for an increase in risk.
Risk-Indifferent - The attitude toward risk in which no change in return would be
required for an increase in risk
Risk-Seeking - The attitude toward risk in which a decreased return would be
accepted for an increase in risk.

STAND ALONE RISK (Risk of a Single Asset)

The concept of risk can be developed by first considering a single asset held in
isolation. We can look at expected-return behaviors to assess risk, and statistics
can be used to measure it.

Risk Assessment:

1. Sensitivity Analysis - an approach for assessing risk that uses several

possible return estimates to obtain a sense of the variablility among outcomes.
One common method involving making pessimistic (worst), most likely (expected)
and optimistic (best) estimates of the returns associated with a given asset. In this
case the asset’s risk can be measured by the range of returns.
2. Probability Distributions - provides more quantitative insight into an asset’s
risk. The probability of a given outcome is its chance of occurring.

Risk Measurement:

In addition to considering its range, the risk of an asset can be measured

quantitatively using statistics, the standard deviation and the coefficient of
variation of asset returns.

Standard Deviation - the most common indicator of asset’s risk, which measures
the dispersion around the expected value.

Coefficient of Variation (CoV) - measure of relative dispersion that is useful in

comparing the risk of assets with differing expected returns. The higher the C0V,
the greater the risk, therefore the higher the expected return.
Example:

The expected values of return of Norman Company’s assets A and B are

presented in table 5.4 below. Column 1 gives the probability and column 2 gives
the rate of return. In each case n equals 3. The expected value of each asset’s
return is 15%.

Table 5-5 below presents the standard deviation for Alex Company’s assets A
and B. The standard deviation for asset A is 1.41% and the standard deviation
for asset B is 5.66%. The higher risk of asset B in its highest standard deviation.

When the stardard deviation (from table 5-5) and the expected return (from
table 5-4) for asset A and B are substituted into equation to compute the
Coefficient of Variation (CoV) which is Standard Deviation/Expected return. So
the CoV of asset A is 0.094 (1.41%/15%) while asset B is 0.377 (5.66%/15%).
Therefore asset B withs higher Coefficient of Variation is more risky than asset A
.

PORTFOLIO CONTEXT - Risk of a Portfolio

In the real-world situations of any single investments would not be viewed

independently of other assets. New investments must be considered on light of
their impact on the risk and return of portfolio of assets. The financial manager’s
goal is to create an efficient portfolio, one that maximizes return for a given level
of risk or minimizes risk for a given level of return. We therefore need a way to
measure the return and the standard portfolio of assets. Once we can do that, we
will look at the statistical concept of correlation, which underlies the process of
diversification that is used to develop an efficient portfolio.

Portfolio Returns and Standard Deviation

The return on the portfolio is the weighted average of the return on the individual
assets from which it is formed. The standard deviation of a portfolio return is
found by applying the formula for the standard deviation of single asset.

Example:

RISK AND RETURN - The Capital Asset Pricing Model (CAPM).

The most important aspect of risk is the overall risk of the the firm as viewed by
the investors in the marketplace. Overall risk significantly affects investment
opportunities and - even more important - the owners’ wealth. The basic theory
that links risk and return for all assets is the capital asset pricing model
(CAPM). We will use CAPM to understand the basic risk-return tradeoffs involved
in all types of financial decision.

Types of Risk
Total Risk of the security can be viewed as consisting of two parts:
Nondiversifiable risk + Diversifiable risk

Diversifiable risk - (sometimes called unsystematic risk) represents the

portion of an asset risk that is associated with random causes that can eliminated
through diversification. It is attributable to firm specific events like strike,
lawsuits,regulatory actions, and loss of a key account.
Nondiversifiable risk (also called systematic risk) - is attributable to market
factors that affect all firms, it cannot be eliminated to diversification. It is the
shareholders-specif market risk. Factors such as wars, inflation. International
incidents and political events account for nondiversifiable risk.

Because any investor can creae a portfolio of assets that will eliminate virtually
all diversifiable risk, the only relevant risk is nondiversifiable risk. The
measurement of nondiversifiable risk is thus of primary importance in selecting
assets with the most desired risk-return characteristics.

The Model: CAPM

The capital asset pricing model (CAPM) links nondiversifiable risk and returns for
all assets. The first discussion deals about beta coefficient, which is the measure
of nondiversifiable risk, the second presents the equation of the model itself and
the third describes the relationship between the risk and return.

Beta Coefficient (b), is a relative measure of nondiversifiable risk. It is an index

of the degree of movements of asset’s return in response to a change in the
market return. The market return is the return on the market portfolio of all traded
securities.

The CAPM can be divided into two parts: 1) the risk free rate of return, Rf,
which is the required return on a risk free assets or securities, like the treasury
bills or IOU issued by the Bureau of Treasury or the Banko Sentral ng Pilipinas. 2)
The Risk Premium which is the difference between the Market Return, Rm and
the risk free rate Rf. The market risk premium represents the investor must
receive for taking the average amount of risk associated with holding the market
portfolio of assets.

PORTFOLIO BETA

Represents the weighted beta of all assets in the portfolio. This can easily
estimated by using the betas of the individual assets it includes. Letting wj
represents the proportion of the portfolio’s total value represented by asset j, and
letting b equal the beta of asset j.
Example:
The equation:

Using the beta coefficient, (b) to measure nondiversifiable risk the CAPM
equation is:
Kj = Rf + (Km - Rf) b

Kj = required return of an asset

Rf = Risk free rate of return
Km = Market return on the market portfolio of assets
b = beta coefficient or index of non-diversifiable risk for asset

Example of CAPM Equation:

Case Risk free Rate Rf Market return Km Beta,b Required Return

A 5% 8% 1.30 ?
B 8% 13% 0.90 ?
C 10% 15% -0.20 ?
D ? 12% 1.0 12%
E 6% ? 0.60 9%
F 5% 16% ? 10%

Required: Using CAPM equation, compute the missing value (?)

Activity 2 -Assigned Readings and Problems: From our finance book of E.

Brigham, et al., read Chapter 8 pages 260-301. Then, answer problems found in
pages 309-310.
Problem 8 - 13 Problem 8-19
Problem 8 - 17 Problem 8 - 20

Answer the problems using MS (Word, Excel or Pdf) or in a clean paper,

take a shoot and submit to your account file in the Google Classroom, not later
than November 25 8pm.

Case Study No. 1: Flirting with Risk

Case Study Analysis by group should be submitted to your Google Classroom

account not later than November 28 at 8pm. The case study analysis will be
presented in the class by the assigned group.