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1.Risk&Return• Return,meanreturn,andvolatility
2.Diversification• Fourviewpointsondiversification• Essentialvariablesinportfolioconstruction• Thecriticalroleofcorrelation
3.RiskRevisited• Nonsystematicrisk,systematicrisk,andbeta
4.TheCAPM• Notationandoverview
CorporateFinanceRisk,Return,Diversification,andtheCAPM
JavierEstradaSpring,2014
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Risk&ReturnThreehypotheticalstocks Go
Returns Go
Summarizingperformance• Arithmeticmeanreturn Go
Interpretation(Backward/Forward)
Evidence(Workout)
• Standarddeviation(Volatility) Go
Interpretation(Uncertainty)
Evidence(Workout)
Riskaversion Go
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
DiversificationWhydoinvestorscombineassets? Viewpoint1• Toavoid‘losingeverything’ Go
Viewpoint2• Toreducevolatility Go
Moreformally,tominimizetheportfolio’sriskforatargetlevelofreturn Technically,thisyieldstheminimumvarianceset
Correlation Formal/theoreticalaspects Evidence(Workout) Practical relevance• Veryfarfroma‘statisticalthing’ Go
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
PortfolioConstructionRelevantvariables Portfolioreturnv.Weightedaverageofreturns Portfolioriskv.Weightedaverageofrisks GoXls
• Ingeneral(unlessassetshaveρ=1) Portfoliorisk<Weightedaverageofrisks
Therefore,whencombiningassets,weaveragereturnsbutlessthanaveragerisks
Spainv.China Feasibleset,minimumvarianceset,minimumvarianceportfolio(MVP),andefficientset Gainsfromdiversification Go
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
DiversificationAgainOnemoreviewpoint Viewpoint3• Tomaximizetheportfolio’sexpectedreturnforatargetlevelofrisk Go
Technically,thisyieldstheefficientset
ImportantquestionWhywouldaChineseinvestorwanttodiversify?•Whatishisultimate benefit? Go
Onefinalviewpoint Viewpoint4• Tomaximizetheportfolio’srisk‐adjustedreturn Thisisoptimalforboth(Spanish/Chinese)investors Go
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
RiskSofar,riskismeasuredbyvolatility(SD) Thisisthetotal riskofanasset
Whatfactorsdeterminethistotalrisk? Nonsystematicfactors• Diversificationreducesnonsystematic risk
Systematicfactors• Diversificationdoesnot reducesystematicrisk Then,thebenefitsfromdiversificationarelimited Go
Fourcomplementarycomments n* changesovertimeandacrossmarkets Go
Internationaldiversification Go
Asset‐classdiversification Go
Keepinmindtheultimategoal Go
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
RiskRedefinedRiskdependsonthecontextinwhichtheassetisevaluated Assetinisolation• Risk=σi (Volatility)Ameasureoftotal risk
Assetwithinadiversifiedportfolio• Risk=βi (Beta)Ameasureofsystematic risk
Ameasureofrelativevolatility
Widelyandpubliclyavailable Go
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
TheCAPMTheCapitalAssetPricingModelisgivenby… Ri =Rf +MRP·βi• Thisexpressioniscalledthesecuritiesmarketline(SML)andisplottedontheR‐β space
Comments Ri istherequired orexpected returnofasseti Rf istherisk‐freerate• Compensationfortheexpectedlossofpurchasingpower
MRP·βi =RP istheriskpremium• CompensationforbearingriskMRP isthemarketriskpremium(Compensationforinvestinginriskyequityratherthaninrisk‐freedebt) βi istheasset’sbeta(Ameasureofsystematicrisk)
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
TheCAPMEmpirically Rf =3.0%(Jan/1/2014)MRP=5.5%(Historical/USA) Therefore,…• Ri =3.0%+(5.5%)·βi
TwoimportantpropertiesoftheCAPM Thebetaofaportfolioisequaltotheweightedaverageofthebetasoftheassetsintheportfolio• βp =x1·β1 +x2·β2 +…+xn·βn
Inequilibrium,allassetsshouldbepricedinsuchawaysothattheirriskandreturnfallalongtheSML
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Appendix
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Prices&Dividends
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Returns,MeanReturn,&Volatility
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Volatility
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SD1:10%
SD2:1.5%
SD3:5%
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
RiskAversion
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Back
RiskAversion
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Diversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
DiversificationConsiderthefollowingportfolio 13%instock1and87%instock2
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Diversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
DiversificationConsidernowthefollowingportfolio 50%instock1and50%instock3
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Diversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Correlation
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Correlation
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Correlation
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Correlation
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
CHN
SPA39.0%
11.9%
28.1%
19.6%
Correlation=0.60
(27.8%,12.9%)
(28.1%,13.9%)
AnnualDiversificationGain=2.0%
Back
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
Back
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
CHN
SPA39.0%
11.9%
28.1%
19.6%
Correlation=0.60
(27.8%,12.9%)
(28.1%,13.9%)
AnnualDiversificationGain=2.0%
Back
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
GainsfromDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
LimitstoDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
HowManyStocks?
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
HowManyStocks?
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
InternationalDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
InternationalDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Asset‐ClassDiversification
DMs– 2008
EMs– 2008
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Asset‐ClassDiversification
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Asset‐ClassDiversification
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JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Remember!
JavierEstrada
IESEBusinessSchool
BarcelonaSpain
MBACorpFinSpring,2014
Remember!
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