Financial Management Lecture No. 25 Stock Betas and Risk SML & Required Returns (CAPM) Stock Prices in Efficient Markets Copyright: M. S. Humayun

Stock Beta & Related Risks Markets as a whole DO fluctuate because of Macro Factors. Fluctuation in the Market Index is a measure of Market Risk. Rational Investors in Efficient Markets eliminate the Random Company-Specific Risk through Portfolio Diversification. So in Efficient Market the only Risk that remains is Market Risk. And so, the Price of Efficient Stocks is based on Market Risk only. Stock Beta measures the Risk of a Stock RELATIVE TO THE MARKET. Beta Stock A = % rA* / % rM* = Slope of Regression Line. Regression Line uses Experimental Data. Beta Stock A = Covariance of Stock A with Market / Variance of Market = A M AM / M (Covariance Formula based on Probability & Statistical Portfolio Theory) Links Stock Beta (Market Portion of Risk) to Stock Standard Deviation (Total Single Stock Risk) 2 Copyright: M. S. Humayun

Theoretical Beta - Example Suppose you have Analyzed the Historical Time Data for (1) Movements of the Price (or Return) of a Stock A and (2) Movements in the Value of the Stock Index. You then Apply Simple Probability Formulas to compute the following Standard Deviations: A = 30% (Stock A’s Total Risk or Standard Deviation) M = 20% (Stock Market Index Standard Deviation or Risk) AM = + 0.8 (Correlation between Stock A and the Market Index) A = A M AM / M = A AM / M =Mkt Risk Compute the Theoretical Beta of Stock A: Stock A Beta = 30% (0.8) / 20% = 24% / 20% = 1.2 2 Copyright: M. S. Humayun

Calculating Stock Beta Graphically Linear Regression through Annual Data Points for 3 Years. CALCULATION OF BETA BASED ON EXPERIMENTAL DATA OR OBSERVATION Year 2 Expected Return on Stock A (Historical) % Slope = Beta = Y / X = % rA* / % rM* = A =Risk Relative to Market = (rA* - rRF ) / (rM* - rRF) rA* - rRF Y-Intercept = Alpha = Year 1 Company Specific Risk rM* - rRF Expected Return on KSE 100 Market Index (Historical) % Year 3 Copyright: M. S. Humayun

TOTAL VARIANCE RISK Formula Total Risk of Stock A in terms of Variance ( = Std Dev 2 ) Total Risk = Market Risk + Random Specific Unique Risk A = A M A-Error Visualizing the Variance Risk Formula on the Regression Line: If a Stock is Part of a Totally Diversified Portfolio then its Company Risk = 0. Therefore Total Risk = Market Risk. And the Stock points will lie exactly on the Regression line. If a Stock is a Single Investment then it carries Company Specific or Diversifiable or Random Risk. This means that its points will not lie on the Regression line. The extent to which the points are Scattered away is a measure of the Variance Error Term (last term in the formula) 2 2 2 2 + Copyright: M. S. Humayun

How Efficiently Priced is Stock A? Regression (Beta) Line for Stock A IF STOCK A WERE EFFICIENT, ALL POINTS WOULD LIE ON A STRAIGHT LINE AND TOTAL RISK = MARKET RISK ONLY Expected Return on Stock A (Historical) % Error = Measure of Company -Specific Risk of Stock A rA* - rRF Error = Measure of Company -Specific Risk of Stock A rM* - rRF Expected Return on KSE 100 Market Index (Historical) % Copyright: M. S. Humayun

Variance Risks - Example If the Market Risk = 20% and Stock A’s Beta = 1.5 then what is the Relevant Market Risk Component of Stock A? Stock A’s Market Variance = Beta A2 x Market Variance = 1.52 x (20%)2 = 2.25 x 400% = 900% (Variance) So the Stock A’s Market Risk (in Standard Deviation terms) = Square Root of Variance = 30% = Beta A M Note that Total Risk of Stock A can be calculated directly by calculating the Standard Deviation of the Possible Future Returns. That was the first Risk Formula we studied in Risk Theory. Suppose Total Risk = 35%. Then Company Specific or Diversifiable or Random Risk of Stock A = Total Risk - Market Risk = 35% - 30% = 5%. So 86% (= 30/35 x 100) of Stock A’s Total Risk is Market Risk - quite likely that Stock A is Part of a well Diversified Portfolio or Mutual Fund. Copyright: M. S. Humayun

Security Market Line (SML) Cornerstone of C.A.P.M. Straight Line Model for Beta Risk and Required Return. Similar to the Relationship for the 2-Stock Portfolio with Ro>0. Beta Risk is Directly Proportional to Required Return. The Investors Require an extra Return which exactly compensates them for the extra Risk of the Stock relative to the Market. SML Linear Equation for the Required Return of any Stock A: rA = rRF + (rM - rRF ) A . Terms: rA = Return that Investors Require from Investment in Stock A. rRF = Risk Free Rate of Return (ie. T-Bill ROR). rM = Return that Investors Require from Investment in an Average Stock (or the Market Portfolio of All Stocks where M = + 1.0 always). A = Beta for Stock A. (rM - rRF ) A = Risk Premium or Additional Return Required in Excess of Risk Free ROR to compensate the Investor for the Additional Market Risk of the Stock. Copyright: M. S. Humayun

Required Rate of Return, Risk Premium & Market Risk SML Model for Efficient Markets establishes a Straight Line relationship (or Direct Proportionality) between a Stock’s Required ROR and its Risk Premium. rA = rRF + (rM - rRF ) A A Stock’s Risk Premium depends on its Market Risk Portion (and NOT the Total Risk) In Efficient Markets, Market Price of a Stock is based on Required Return which depends on Risk Premium which depends on Stock’s Market Risk Component (and NOT the Total Risk). Copyright: M. S. Humayun

Stock Prices in Efficient Markets A Single Stock Investor who owns No Stocks and wants to buy a Share A will have to face more Risk (Market Risk + Specific Risk) than a Rational Fully Diversified Investor. The Single Stock Investor will want to buy the Stock at a lower price to compensate him for the higher risk. However, Efficient Markets do NOT price stocks based on Single Stock Investors who want compensation for taking on Unnecessary Company-Specific Risk which they should have Diversified away. Efficient Markets price the Stocks based on their Market Risk Component only. So, Efficient Stock Prices are based on Rational Investors holding Diversified Portfolios of many stocks. Copyright: M. S. Humayun

SML - Numerical Example Calculate the Required Rate of Return for Stock A given the following data: A = 2.0 (ie. Stock A is Twice as Risky as the Market) rM = 20% pa (ie. Market ROR or ROR on a Portfolio consisting of All Stocks or ROR on the “Average Stock”) rRF = 10% pa (ie. T-Bill ROR) SML Equation (assumes Efficient Stock Pricing, Risk, Return) rA = rRF + (rM - rRF ) A . = 10% + (20% - 10%) (2.0) = 30% Interpretation of Result: Investors Require a 30% pa Return from Investment in Stock A. This is higher than the Market ROR because the Stock (Beta = 2.0) is Riskier than the Market (Beta = 1.0 always). If Required Return (30%) is Higher than Expected Return (20%) it means that Stock A is Unlikely to Achieve the Investors’ Requirement and Investors will NOT invest in Stock A. Copyright: M. S. Humayun

Security Market Line (SML) For Market of Efficient Stocks rA = rRF + (rM - rRF ) A . Required Return (r*) y = c + mx where x = and m = Slope = (rM - rRF) / ( M - 0) = (rM - rRF) /1 rA= 30% Security Market Line rM= 20% Market Risk Premium for Avg Stock = 10% Risky Stock A’s Total Risk Premium = 30-10 = 20% rRF= 10% A =+ 2.0 M =+ 1.0 Beta Risk ( ) Copyright: M. S. Humayun