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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

2

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

3

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

4

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)

5

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

6

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Prices&Dividends

Back

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Returns,MeanReturn,&Volatility

Back

7

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Volatility

Back

SD1:10%

SD2:1.5%

SD3:5%

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

RiskAversion

8

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Back

RiskAversion

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Diversification

Back

9

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

DiversificationConsiderthefollowingportfolio 13%instock1and87%instock2

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Diversification

10

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

DiversificationConsidernowthefollowingportfolio 50%instock1and50%instock3

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Diversification

Back

11

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Correlation

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Correlation

12

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Correlation

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

Correlation

Back

13

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

14

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

15

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

GainsfromDiversification

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

GainsfromDiversification

Back

16

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

LimitstoDiversification

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

HowManyStocks?

17

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

HowManyStocks?

Back

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

MBACorpFinSpring,2014

InternationalDiversification

18

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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