CHAPTER 8

RISK AND RETURN: A CAPITAL MARKET THEORY

A. EXPECTED RETURN (PORTFOLIO)

Example:

E(rportfolio) = (0.50*4.0) + (0.25*8) + (0.25*12.0) = 7.0%

B. STANDARD DEVIATION (PORTFOLIO)

σportfolio = √(𝑊1 )2 (𝜎1 )2 + (𝑊2 )2 (𝜎2 )2 + 2(𝑊1 )(𝑊2 )(ρ1,2 )(𝜎1 )(𝜎2 )

W = Weight or percent invested

σ = s. deviation (always given)
ρ = correlation coefficient (always given)

Example: If ρ = .75

σportfolio = √(. 50)2 (. 20)2 + (. 50)2 (. 20)2 + 2(. 50)(. 50)(.75)(. 20)(. 20)
= √. 035 = 0.187 or 18.7%

C. PORTFOLIO BETA
Example: Consider a portfolio that is comprised of four investments with betas equal to 1.5, .75, 1.8
and .60. If you invest equal amount in each investment, what will be the beta for the portfolio?

W β
.25 1.5
.25 .75
.25 1.8
.25 .60

Portfolio Beta
= .25(1.5) + .25(.75) + .25(1.8) + .25 (.6)
= 1.16
 CHAPTER 9
DEBT VALUATION AND INTEREST RATES

A. Corporate Borrowings
• There are two main sources of borrowing for a corporation:
1. Loan from a financial institution (known as private debt)
2. Bonds (known as public debt since they can be traded in public financial markets)
Smaller firms choose to raise money from banks in the form of loans because of the high costs associated
with issuing bonds.
• Larger firms generally raise money from banks for short-term needs and depend on the bond market for
long-term financing needs.

B. Borrowing Money in the Private Financial Market

• Financial Institutions are an important source of capital for corporations. The loan might be used to
finance firm’s day-to-day operations or it might be used for the purchase of equipment or property.
• Such loans are considered private market transactions since it only involves the two parties to the loan.
In the private financial market, loans are typically floating rate loans i.e. the interest rate is periodically
adjusted based on a specific benchmark rate.
• The most popular benchmark rate is the London Interbank Offered Rate (LIBOR)
C. LIBOR is the daily interest rate that is based on the interest rates at which banks offer to lend in the
London wholesale or interbank market.
– Interbank market is the market where banks loan each other money.

For example, a corporation may get a 1- year loan with a rate of 300 basis points (or 3%) over LIBOR with a
ceiling of 11% and a floor of 4%.
 D. Calculating the Rate of Interest on a Floating Rate Loan
The Slinger Metal Fabricating Company entered into a loan agreement with its bank to finance the firm’s
working capital. The loan called for a floating rate that was 25 basis points (.25%) over an index based on
LIBOR. In addition, the loan adjusted weekly based on the closing value of the index for the previous week
within the bounds of a maximum annual rate of 2.5% and a minimum of 1.75%. Calculate the rate of
interest for the weeks 2 through 10.

Add .25% (floating rate

or spread) starting
week 1

+ .25
+ .25
+ .25
+ .25
+ .25
+ .25
+ .25
+ .25
+ .25

These are always given. Get by adding floating rate. Copy previous column but change to
the floor or ceiling rate in case it
went above or below. In this case,
Week 4 went below floor rate of
1.75% so just put the floor rate. If a
value went above ceiling rate, put the
ceiling rate.
 E. VALUING CORPORATE DEBT
Annual Interest = Par value × coupon rate

• Example 9.1: The annual interest for a bond with coupon interest rate of 7% and a par value of
$1,000 is equal to $70,
($1,000 × .07 = $70)

YIELD TO MATURITY

 We can think of YTM as the discount rate that makes the present value of the bond’s
promised interest and principal equal to the bond’s observed market price.

Example: Calculate the yield to maturity for the following bond issued by Ford Motor Company (F) with a
price of $744.80, where we assume that interest payments are made annually at the end of each year and
the bond has a maturity of exactly 11 years. We are expecting a principal amount at the end of the period
of $1,000.00 with a coupon rate of 6.5%.

ANNUAL INTEREST = PAR VALUE * COUPON RATE

= 1000 * 0.065 = $65.00 (Annual PMT)

You must use excel to solve this. Install SHEETS on your iPhone.
In one of the cells, type in RATE(per,npmt,pv,fv) or type in the values given for each inside the parenthesis.
Example:
Code Description Remarks In this case
Per Ignore Ignore
N Number of Years Should be given 11
PMT Annual Payment Should be given 65
PV Present Value Should be negative -744.80
FV Future Value Exclusive of PMT 1000.00

Type: RATE(11,65,-744.80,1000)
YTM = 10.52%

DON’T DO IT MANUALLY. You’ll go crazy.