Professional Documents
Culture Documents
#1-Dividend Policy
• The Larger the RETENTION, the LESSER the
dividends
• The choice between retention and payout
would depend on the kind of effect each of these
choices would have on the objective of
maximizing the wealth of the shareholder
• Payout, if such a decision would lead to
maximizing the Wealth of the shareholders:
RETAIN otherwise
#2
• Irrelevance theory of Dividends
• The theory rests on the BASIC premise that;
DIVIDEND DECISION IS A RESIDUAL
DECISION
• The Dividend decision flows from out of the
PRIMARY decision to RAISE CAPITAL or raise
finances in a particular fashion than in
another; funding is the primary decision and
dividend decision that reflects SERVICING
COSTS is only a PASSIVE RESIDUAL
#3
• If dividend policy is not a passive residual and
instead is an “active Financing decision”, the
decision to “retain or, payout” would rests on the
premise—
• --Retain if the firm requires funds for Investment
and CANNOT procure them AT A RATE
CHEAPER THAN ITS EXISTING COST OF
CAPITAL. It is of course assumed that the
returns on the New Investment will be greater
than the marginal cost of capital
#4
• Conversely, if Investment Opportunities
are few and if the “returns on the New
investments are LESS than the Cost of
Capital, PAY OUT”
• Thus the GROUND RULE for the
“adequacy of acceptable Investment
opportunities” is the comparison of the
ROI (r) with the Cost of Capital (Ke)
#5
• Theoretically, the following are the
EXTREMES-
• --When adequate acceptable opportunities
are available such that, ROI (r) is
GREATER than the Cost of Capital (Key),
the PAYOUT is ZERO
• -- OTHERWISE, the PAYOUT is 100%
#6
• In all other cases, the payout will be between 0-
100%
• The Passive Residual theory of Dividends is
thus based on the following parameters
• 1) That financing decisions are primary and
dividend decisions are a mere “fallout of the
Primary decision”
• 2)That, investors are INDIFFERENT between
CAPITAL GAINS ( emanating from a possible
BONUS ISSUE ) and Cash payout in form of
dividends. So long as the firm is able to earn
greater than its COC, investors would not
mind if the profits are retained. In contrast, if
ROR (r) is < Ke, investors would prefer to
receive the Profits as DIVIDENDS
#7
• Modigliani & Miller Hypothesis
• M&M contend that dividend decisions have
nothing to do with share prices and are of no
consequence
• What matters is the Earning Capacity of the
firm consequent to embarking on the New
Project and the decision to split the earnings
with the shareholders immediately or instead
retain the profits is a matter of detail and holds
no consequences on the share prices
#8
• If the Operational profits of a firm are to be
determined by the level of EBIT then, the
financing costs—whether as dividends or
anything else-- would have no say on the
Operational performance
• As already propounded by the two authors, if
Method of Financing and the Capital structure
were to be irrelevant in determining the Value of
the Firm, the Costs of such financing that is a
direct consequence of the above two Issues,
can be no more relevant!
#9
• Assumptions of M&M Hypothesis
• 1) Perfect Capital markets with Rational
Investors---- Securities are divisible, no
transaction costs, information is free and
available to all and there is No one Investor
or a group of them to influence the markets
• 2)There are no taxes--- no difference
between Revenue and Capital gains
#10
• 3) The Firm has a given Investment Policy
that does not change—The implication of
this parameter is that the firm could
FINANCE New Investments from OUT of
its retained earnings WITHOUT
CHANGING ITS BUSINESS RISK (i.e.
without undergoing a change in its
required rate of return-(r)
#11
• 4) There is a perfect certainty in the estimation
of the Future Profits and Dividends by ALL
investors
• The Crux of M&M approach
• The crux here again is the ARBITRAGE
ARGUMENT. If the Firm chooses to Payout and
then raise Capital from the shareholders to meet
its Capital Expenditure program, the effect of
dividend payment on the shareholder’s
wealth is EXACTLY OFFSET by the effect on
the shareholder’s wealth to raise capital
#12
• When dividends are paid to the
shareholder, the market value of the share
decreases. This decrease is Identical to
the extent of Dividends paid out.
Essentially the gain in form of dividend
receipt is offset exactly by a fall in the
price of the stock. The Total market
value PLUS Dividends of 2 firms which
are identical except for their Pay outs
must be the SAME
#13
• Proof of M&M Hypothesis
• Step 1- The market price of a share at the
BEGINNING of a period must be equal to-
the PRESENT VALUES OF THE SUMS
of-a) The Dividends received at the END
of the Year and b) The MARKET PRICE at
the END of the Year
• __1__ (D1+P1)= Po
• (1+Ke)
#14
• Step 2 –Assuming that there is No external financing,( that
the Entire capital is Equity alone!) the total capitalized value
of the firm would be the discounted value of
• no = __1__(nD1+nP1)--------(2)
• (1+ Key)
• Step 3 If the firm’s Internal sources( retained earnings) were to
fall short of the Investment outlay and delta n becomes the
New shares to be issued at the end of period 1 at a price of
P1. Equation 2 can be written as
• no= __1__(nD1+(n+delta n)P1-delta n *P1)--(3)
• (1+Ke)
• This is because (3) is the same as (2) , upon simplification!
15
• It is easy to recognize that equation (2) and equation 3 are identical
• Step 4 –If additional share Issue were to finance the additional
Investment,
• Delta nP1= I-(E-nD1)= I –E + nD1-(4)
• where delta nP1-> Amount obtained by the sale of New shares
• I->Investment
• E Earnings of the firm, nD1->Dividends paid and E-nD1 is Retained
earnings
• I—(E-nD1) is nothing but-----’ the additional funds raised for
Investment’ ie Investment LESS what is generated as Internal
Accruals’
16
• Step 5– If we incorporate equation (3) with equation (4),
• nPo= nD1+ (n+ delta n) P1- (I- E+nD1)***
• --------------------------------------------
• (1+Ke)
• Thus nPo=(n+ delta n) P1- I + E
• ------------------------------
• (1+ Ke)
• Since D ( dividends ) do not figure in the final equation they are
NOT relevant!
• ***As delta nP1= I-E+nD1 as per (4)
17
• Problem --- A company belongs to a risk class
for which the appropriate rate of capitalization is
10%. It currently has 25,000 shares outstanding,
selling at Rs 100/- a piece. The firm is
contemplating the declaration of a dividend @
Rs 5/ per share at the end of the current
financial year. It expects to have a net income of
Rs 2,50,000/ and has new Investments of Rs 5
lakhs on the block. Show under M&M hypothesis
that the payment of a dividend does not affect
the value of the firm
18
• Solution
• A) VALUE of the Firm WHEN DIVIDENDS
ARE PAID
• 1) Price per share at the END OF YEAR 1
• Po=__1___(D1+P1)
• (1+Ke)
• 100=__1__(5+P1) or, P1= Rs 105/-
• (1.10)
19
• 2) Quantity of shares to be issued at Rs 105/ share to meet the
Investment shortfall
• Additional amount = Investment outlay-{ Earnings- Payout} i.e. I-{E –
nD1 }
• = 5,00,000-{ 2,50,000- 25,000* 5}
• =Rs. 3,75,000
• NO.of shares to be issued =375000/ 105
• = 75,000/ 21 shares
• Value of the firm=nPo=(n+delta n) P1- I+E
• ----------------------------
• ( 1+Ke)
• 25000+ 75000/ 21} Rs 105-Rs 5,00,000+Rs 2,50,000
• {old shares+ New shares} Issue}-Investment + Earnings
• price}
• 1.10
• =Rs. 25,00,000/---Value of the firm when dividends are paid
20
• B) Value of the Firm when dividends are NOT
paid
• 1) PRICE per share at the END OF THE YEAR
• nPo=P1 / (1+Ke)
• 100=P1 / (1.10) P1= Rs 110/-at year end
Recognize that when dividends were paid out
in the earlier case, the market price was only
Rs 105/( lesser than Rs. 110/ now, when
dividends have not been paid) !
21
• 2) Amount required to be raised by Issue of New shares
• Delta nP1= I – E= Rs. 5,00,000-2,50,000
• =Rs. 2,50,000/-
• 3) No. of additional shares to be issued
• =Rs 2,50,000 /110=25,000/11
• 4) Value of the firm
• = 25,000+25,000/11}*Rs110-5,00,000+250000
• 1.10
• No.oldshrs+No. new shrs} Price/shr-Invst+Erngs
• =Rs 25,00,000/- Same as in (A) earlier!
#22
• A critique of M& M
• The CRITICAL observation in M&M Hypothesis rests on
the INDIFFERENCE of the Investors between gains by
way of Capital gains and by way of Revenue gains. The
balancing nature of this arbitrage can be looked at in 2
ways—
• 1) The fall in the price of the share MATCHING exactly
the DIVIDENDS PAID OUT
• 2) The Indifference of the Investor towards receiving the
profit share as either Dividends or as Bonus later on
• However the big question is “Is a balance always
struck and that too exactly?”
23
• The arguments of M/M are appealing though of practically
“no significance” The grey areas
• 1) Market imperfections—Taxes exist, floatation costs are
present
• 2) Tax effect– Taxes are present. The Tax effect on a
person’s Revenue gains would depend on the tax bracket
he is in. Capital gains are a fixed percentage and do not
vary with the Income earned There is a variance no doubt!
• 3) Statutory restrictions—Mutual funds MUST
distribute 90% of their Income i.e. there cannot be
indifference between Retention and Distribution
• 4) Informational content of Dividends, preference for
current Income etc.
24
• Relevance of Dividends theory
• A) Walter’s model b) Gordon’s model
• 1) Walter’s model—The Financing Policy, the
Investment Policy and the Dividend policy are all
INTERRELATED. The choice of an appropriate
dividend policy DOES AFFECT THE VALUE OF THE
FIRM
• 2) The main premise behind this theory is the
comparison between the Cost of Capital (Ke) and its
Internal rate of return (r). Distribute if COC( or the
reqd. rate of return) is greater than the Internal
rate of return;(ROI) not otherwise
25
• The rationale is that if r>k, the firm is able to earn more
than what the shareholders can if, the earnings were
distributed to them as dividends. On the other hand, if
r<k, the shareholders interests would be better served if
the dividends were paid to them as they seemingly have
better Investment opportunities.
• Walters model thus relates the distribution of dividends
(retention of earnings) to available Investment
Opportunities. If a firm has adequately profitable
investment opportunities, it will be able to earn more
than what investors expect so that, r>k. Such firms
are called “GROWTH FIRMS” and for these firms, the
Optimum dividend policy is ZERO
26
• Where r<k, the Optimum policy would be, for
obvious reasons, a 100% payout!
• Where r=k, there is INDIFFERENCE as to the
payout which can range from 0-100%!
• Assumptions of Walter’s model
• 1) All financing is done through RETAINED
EARNINGS-no external Debt or Equity
financing is envisaged
• 2)The Firm’s Business risk-r& k –do NOT
change with Investments
27
• 3) The firm has a perpetual life
• Walter’s model on FIRM VALUATION
• P= ___D_____ P- M.P of the share
• Ke- g Ke-Cost of capital
• D-Initial dividend
• g-Expected Growth rate of Earnings i.e
b*r
• b-Retention rate (E-D) /E
• r-Expected rate of return on the firm’s Investment
• br- measures the growth rate in dividends, which is the
product of—a) the Earnings retention percentage b) The
profitability of the retained earnings (r)
• The bias in the model lies in the assumption that Ke is>g
as otherwise P becomes an Imaginary figure
• The Assumption is that ‘Investor expectation is
ALWAYS greater than Growth rate in Dividends’
#28
• Substituting,
• Ke=D /P+ g
• Therefore, Ke=__D_ +__delta P__ ( as g=Increase in Prices ie deltaP)
• P P
• This is so since delta P is “ change in Prices” and therefore g= deltaP
• Also since delta P=__r__ (E-D)
• Ke
• Substituting the value of delta P,
• Ke=__D_+__r_ (E-D)
• Ke
• ------------------------ E EPS D DPS
• P
• Or P=D + r ( E-D)
• Ke
• ------------------
• Ke
# 29
• Meaningfully,
• P=--D+ r(E-D)
• --- ---
• Ke
• ------------------------
• Ke
• D/Ke Capitalized value. of ALL DIVIDENDS
• r/Ke (E-D)}
• ----------- }-- Capitalized valueof All Capital Gains
• Ke }
• Thus the Price of a Security is related to its DIVIDENDS!
#30
• Walter’s model w.r.t the effect of
Dividend/Retention Policy ON the Market value
of shares ( under different assumptions of ‘r’)
• The following Info. Is available in respect of a
firm
• Capitalization rate (ke)- 0.10
• EPS-10 Rs Assumed rates of return(r)
i)15%ii)8% iii) 10%
• The effect of Dividend Policy on Market Price of
a share
31
• Solution i) When r is 0.15, r>ke.
• a) When D/P=0i.e DPS is zero
• P=__D_+r__(E-D)
• Ke
• --------------- =0 + 0.15/0.10(10-0)
• Ke -------------------------
• 0.10
• = Rs 150/-
32
• B) When D/P ratio is 100% i.e DPS is Rs10/-
• P=_10_+__ {0.15}__ { 10-10}
• {0.10 }
• ____________________ =10/0.10
• 0.10 =RS 100
• Recognize that when r>ke, and DPS is ZERO,
the Market Price is Rs. 150. M.P decreases
when dividend is paid out under these
circumstances ( Rs 100/)
#33
• Assignment- calculate the market price
when r is 15%, ke is 10%, EPS is 10Rs
• and DPS is a) Rs 2.50 b) Rs 7.50
• ---------------------------------------------------
• Case 2) The data remaining the same
except for the following changes
• R=8% i.e r< Ke ( which is 10%)
#34
• A) When D/P is zero
• P=_0_+ {0.08 } {10-10}
• --------
• {0.10}
• -------------------------- = Rs. 80/
• 0.10
• Assignment; With the same data calculate the
M.P when a) DPS is Rs 5 b) When DPS is Rs
10/-
#35
• Assignment; If r=0.10 and Ke= 0.10 what would
be the MP when a)DPS is Rs2.50 b) When DPS
is Rs 10/ . What is your observation?
• --------------------------------------------------
• Interpretations
• A) When the firm is able to earn a rate of return r,
that is greater than its Cost of Capital Ke, a lower
distribution increases the MP of the share The
Optimum Payout is Zero-when the Price of the
share is maximum. If Payout is 100% the MP is 0
#36
• 2) When r<ke, a 100% payout maximizes the
MP of the share. Here the MP is positively
correlated to the Payout
• 3) When r=Ke, the market Price is constant at all
degrees of payout i.e. MP is INDIFFERENT to
payout
• Limitations of Walter’s model
• 1) Assumption of a constant Ke; Ke changes
with the risk complexion of the firm
• 2) Assumption of a constant ‘r’. ‘r’ is rarely
constant!
#37
• GORDON”S MODEL
• Like Walter’s model, Gordon’s model
emphasizes that dividend policy of a firm is
related to the Market Price of a share and that
Investors place a ‘positive premium’ on ‘current
dividends’
• Investors are Risk- averse; they are rational
• They place a premium on returns that are
‘certain’ and penalize returns that are not
• Chart. Y axis- Discount
Retention rate
38a
• The Discount on the market Price of the
share is CONSTANT ‘but up to a certain
percentage of RETENTION. Up to this
percentage of retention, the market
does not add DISCOUNT to the share
price; beyond price, the discount
increases the discount sharply.
• This is because the Market PENALISES a
firm for uncertainty in its Dividend payment
39
• Gordon model
• P= ___E__(1-b)_ E-> EPS
• Ke- br b->% earnings retained
• 1-b-> D/P or % of earnings distributed
• Ke-> Capitalization rate or COC
• br=g=rate of return of an all equity firm.( It is
retention rate* rate of return )
40-
From the following information in respect of
the rate of return (r), the capitalization rate
(ke) and EPS of a firm determine the value
of the shares from the following data
r=12%E-> Rs 20
D-(D/P ratio) Retention ratio (b) Ke%
1 10 90 20
70 30 14
41
• Solution
• P= __E__(1-b)__ } D/P 10%->retention 90
• Ke-br } i.e ‘b’ is 0.90
• }br-> 0.90* 0.12=0.108
• P= __20_(1-0.90)__ = Rs 21.74
• 0.20- 0.108
• 2) When D/Pis 70 and retention 30
• P= __20_(1- 0.30)__ br=0.30* 12= 0.036
• 0.14- 0.036 Ans= Rs 134.62
• As can be seen, the better the payout, the better the MP
42
• Dividend Policy- factors determining it
• --Dividend Payout %
• --Stability of dividends
• ----Legal, contractual, Internal constraints
• --Owner’s requirement
• ---Capital market consideration
• ---Inflation etc.
43
• An Optimum Dividend Policy should strike a balance
between a) Maximizing the wealth of the shareholders
b) providing funds for growth
• These Objectives are NOT mutually exclusive but are
‘interrelated’
• Dividend Policy must not be viewed as a ‘Passive
residual’ but must be a decision based on solid ground
rules which could include—
• a) Earnings b) Earnings growth c) S/h preference for
current dividends 4) Investment opportunities5) Cost of
raising funds 6) The extent of ‘retention necessary’ and
therefore the Payout
44
• Stability of Dividends
• 1) CONSTANT DPS
• 2) CONSTANT PAYOUT RATIO=
DPS/EPS *100
• 3) CONSTANT DPS plus EXTRA
DIVIDENDS
Risk & return
• For any Asset, the term ‘returns’ comprises of—
• a) Revenue Yield –like Dividend yield, Interest
yield etc
• b) Capital gains
• R= ___Dt_+(Pt-Po)___
• Po
• Average return= __1__ sum of Ri
• n
#2
• Rate of return and Holding period
• Suppose you invest Re 1 in a Company for
5 years. The rates of return are 18% , 9% ,
0% (10%) and 14%. What is the worth of
your Investment?
• The Investment worth after 5years
• (1+0.18) * (1+.09) * (1+.00) *(1+ -0.10)
*(1+0.14)=1.18* 1.09* 1*0.90*1.14= 1.32 Rs
3
• Since the Initial Investment is Re 1, the
return is Rs 1.32-1= Rs 0.32 or 32%. This
is over a 5 year period assuming that the
Dividends received are re-invested in
shares. The Compound Annual rate is
5 Root of ( 1.18*1.09* 1.0*0.90*1.14 –1)
=5th root of 1.3196- 1= 0.057 0r 5.78%
The Compound annual rate is called the
Geometric Mean returns
4
• Suppose you have invested Re 1 in the
shares of HLL in the beginning of the year
1993 and held it for 2 years. If the returns
for 1993 is 16.52% and in 1994 is 22.71 %
• The Investment after 2 years is
• (1+0.1652) * ( 1+ 0.2271)= Rs 1.43= 43%
• The Compound Geometric mean return is
• 2 root of ( 1.1652* 1.2271) –1 =0.195 or
19.5%
5-Risks & Returns
• Risk is a measure of variability. Standard
deviation and Variance reflect it
• Variance=__1_sum of ( Ri- R bar)^2
• n-1
• Rates of Return under the different Economic
conditions
• Economy M.P Dividend Yield C/gain Rtns
• 1 2 3 4=3/** 5=(2)-** 6=4+5
• Growth 305.5 4.00 0.015 0.169 0.185
• Xpansion 285.5 3.25 0.012 0.093 0.105
•
6-contd.
• Eco M. P Dividend Yield C/G Retns
• Stagnation 261.25 2.50 0.010 00 0.010
• Decline 243.50 2.00 0.008 -0.068 -0.060
• **- refers to Rs. 261.25 i.e current M.P
• Ex. Yield-> 4/ 261.25=0.0153; 3.25/261.25=0.012;
2.50/261.25=0.010 2/ 261.25= 0.008
• Ex. C/G305.5-261.25 / 261.25= 0.169; 285.50-
261.25 / 261.25= 0.093; 261.25-261.25/ 261.25=
0; 243.50- 261.25/ 261.25=(0.068)
7-contd.
• Ex. Retns. R1= __4+(305.5-261.25)_=0.185
• 261.25 18.5%
• R2=__3.25+_(285.5-261.25)_=0.105 10.5%
• 261.25
• R3= 2.5+__(261.25- 261.25)_=0.01 1%
• 261.25
• R4=2.00+__( 243.5- 261.25)_=(0.060) (6%)
• 261.25
• The Total return is a anticipated to vary
between (6%) and 18.5%
8
• Having worked the returns R1 to R4 you
can now work out the “Expected rate of
Returns” by assigning PROBABILITIES to
each outcome
• Expected ROR= rate of return under
scenario1* probability of scenario 1+ rate
of return under scenario 2* probability of
scenario 2+ rate of return under
scenario3* probability under scenario3 +
rate of return under scenario4* probability
under scenario4
9
• The “ Expected rate of return” is the
“Average rate of return”. The
DISPERSION is explained by the standard
deviation. For ex. If the expected rate of
return is 6% and the std. deviation is 8%,
the investment in this asset could be a
risky proposition as there is a 68%
chance that the ‘returns’ could VARY
between + 14% and –2% assuming the
distribution to be a Normal one
10
• The shares of M have the following returns
and the following probabilities associated with
it.
• Return% -20 -10 10 15 20 25 30
• Probability
• 0.05 0.10 0.2 0.25 0.2 0.15 0.05
• Exp. return= (20)* 0.05+ (10)*0.1+10*0.2+
15*0.25+20*0.2+25*0.15+30*0.05=14.5%
Variance=(-20-14.5)^2*0.05+(-10-
14.5)^2*0.10+(10-14.5)^2*0.2 +contd.
+
11
• + (15-14.5)^2*0.25+ (20-14.5)^2*0.2+(25-
14.5)^2*0.15 +(30-14.5)^2 * 0.05
• =
59.25+60.03+4.05+0.06+6.05+16.54+12.0
=158
• Std. deviation= root of Rs.158= Rs.12.57
• There is a 68% chance that the returns will
vary between Rs 27 and Rs 2/-
12
• Risk preference
• Investors normally prefer investments with
HIGHER rate of returns and LOWER
variability( dispersion). According to the
Law of Diminishing marginal utility, as a
person runs into more and more wealth, the
utility he gets for the additional wealth
acquired by him increases but at a
declining rate
• Attitudes towards risk
12-a
• Assume you were a contestant in a game “let’s make a deal’. The host Monty
Hall explains that you get to keep whatever you find behind either Door #1 or,
door #2. Behind one door is $10,000/ and behind the other ‘nothing’
• You choose to open door #1 and claim your prize. But before you can make a
move, Monty says he will offer you a sum of money to call off the whole
deal. {before reading any further , decide for yourself WHAT DOLLAR
AMOUNT WOULD MAKE YOU INDIFFERENT BETWEEN –a) taking what is
behind the door and b) accepting the ‘call off deal money Monty pays’} That
is, determine an amount such tnat ONE DOLLAR MORE may prompt you to
take the ‘deal money’ and ONE DOLLAR LESS makes you ‘keep the door’
• Now let’s assume that you decide that if Monty offers you $ 2999 or less,
you will keep the door. At $ 3000 you cannot decide between taking the
cash and keeping the door and at $ 3001 you would like to take the ‘deal
money’ and give up the door
12-b
• Monty now offers $3500/. So you take cash (accepting the ‘deal
money’ ) and give up the door ( Never mind that there could be
$10,000/ behind it! )
• What has this example got to do with risks? Everything! We know
for sure that an average Investor is ‘averse to risks’. Let’s see why.
By keeping the door, you had a 50% chance of getting $ 10,000/
The Expected Value ‘in keeping the door’ was $ 5,000/
( 10,000*0.5+0*0.5). In our example above you find yourself
Indifferent between a RISKY ( uncertain) $5,000 return
(expected) AND a CERTAIN(Definite) sum of Rs 3000/-. In other
words, this certain or riskless amount of $3000/-- what one calls a
CERTAINITY EQUIVALENT(C/E)– provided you the SAME utility
or satisfaction as a RISKY gamble with expected value of $ 5000
• It would be AMAZING if your ACTUAL Certainty Equivalent in this
situation was exactly $3000’ the ‘deal money’ offered by the host
Monty! The Figure you wrote down is less than $ 5000/ and most
people would react the same way as you did as, they are ‘Risk
averse’
• We can possibly use the relationship of an
Individual’s Certainty equivalent to the
expected Value of a risky investment to
DEFINE THEIR ATTITUDE TOWARDS
RISK. In general, if a person’s –
• * Certainty Equivalent<Expected Value, he
is AVERSE to risks
• *Certainty Equivalent= Expected Value, he
is INDIFFERENT to Risks
• * Certainty Equivalent> Expected Value,
he is a RISK SEEKER( prefers risks!)
12-D
• In our example, any Certainty Equivalent LESS THAN THE
EXPECTED VALUE of $5000/ indicates ‘Risk Aversion’.
• For RISK AVERSE Individuals, the difference between the
Certainty Equivalent AND the Expected Value represents ‘
RISK PREMIUM”
• Risk Premium is the ADDITIONAL RETURNS that RISKY
INVESTMENTS must offer to the Individual for him to ACCEPT
the RISK and not accept the DEAL offered
• Investors are generally ‘risk averse’. This implies that risky
investments must offer HIGHER EXPECTED RETURNS than
LESS RISKY INVESTMENTS in order that they BUY and HOLD
it
• We talk of Expected returns here. And in order to have Low
risks , one must be ready to accept ‘low expected returns’
• In short, the Business of Investment has ‘no free rides and no
free lunches’ss
•
13
Risk returns for Investors in different Risk
An Investor who is ‘Risk averse’ will
choose-
i) From Investments with EQUAL rates of
returns, the Investment which has the
LOWEST risk. i.e. the Lowest std.
deviation !
ii)From Investment with the SAME risks, that
which gives the HIGHEST return
14
• A ‘Risk seeking Investor” prefers Investment with
HIGH risk irrespective of the Returns it will
provide!
• A ‘Risk Neutral Investor” looks NOT at the risks
but at the ‘Returns’; he chooses investments
that give him the HIGHEST RETURNS
• The next question
• How would a Risk averse Investor make choices
when Investments have--- > risk & > Returns;;, <
risk & < returns
15
• Portfolio theory and Asset Pricing
model
• A Portfolio is a combination/ bundle of
assets/ securities
• This Portfolio theory is based on the
assumption that Investors are ‘Risk
averse’ and that the Returns are ‘normally
distributed”
16
• Portfolio returns– 2 asset case
• The Return of a Portfolio is equal to the
Weighted average of the returns of
INDIVIDUAL assets ( or securities) in the
Portfolio with WEIGHTS being equal to the
PROPORTION OF INVESTMENT VALUE in
each asset
• Suppose you have an opportunity of
investing in Asset X or in Asset Y.
17
• Eco Probability Returns %
• X Y
• A 0.10 -8 14
• B 0.2 10 -4
• C 0.4 8 6
• D 0.2 5 15
• E 0.1 -4 20
18
• Expected rate of Return---Share X
• (-8*0.1)+ (10* 0.2)+( 8*0.4)+( 5* 0.2)+
(-4*0.1) =5%
Similarly the Expected rate of return for Yis
= ( 14* 0.1) + (-4*0.2) +( 6*0.4) + ( 15* 0.2) +
( 20*0.1)= 8%
Now suppose you decide to invest 50% of
your wealth in X and 50% in Y What is the
Expected return on a portfolio of X and Y?
19
• I) This can be done in 2 ways
• a) Calculate the combined outcome under
EACH state of the Economy
• b) Multiply each combined outcome by its
Probability ( See the Table that follows)
• II) Direct Method First calculate the
Expected Return on the Portfolio i.e.
weighted average of the Expected returns
of the 2 assets X and Y in the Portfolio
• E(r)= ( 0.5*5)+ ( 0.5*8)= 6.50%
20
• Table – see Slide # 19
• Eco Prob. Comb. Rtn Exp.rtn
• 1 2 3 4=2*3
• A 0.1 (-8*0.5)+ (14*0.5)=3.0 3*.1=0.3
• B 0.2 ( 10*.5)+(-4*.5)=3.0 3*0.2=0.6
• C 0.4 (8*.5)+(6*.5)=7.0 7*0.4= 2.8
• D 0.2 (5*0.5)+(15*0.5)=10 10*0.2=2.0
• E 0.1 ( -4*0.5)+( 20*0.5)=8 8*0.1=0.8
• -----------
• 6.50
21
• Note that if ‘w’ is the proportion of
Investment in Asset X, (1-w) is the
Investment in Asset Y. Given the Expected
Returns of Individual assets, the Portfolio
return depends on the WEIGHTS
( Investment proportion) of assets X and
Y. You will be able to CHANGE the
Expected rate of Return on the Portfolio
by changing the PROPORTION
INVESTED in INDIVIDUAL ASSETS
22
• How much would you earn if you invested
20% in Asset X and the remaining in Asset
Y?
• E(Rp)= 0.2*5+ (1-0.2) * 8= 7.40%
• Thus the job of a Portfolio manager, is
to –
• 1) select appropriate assets that form the
Portfolio after aligning them to the ‘risk-
return profile’ of the portfolio participants
• 2) assign ‘weights’ to individual assets in
the portfolio
23
• Now, why invest in BOTH X and Y when Y
yields much higher than X?
• Because of ensuing risks; under
‘unfavourable state’, Y may yield a
negative return of 4%!
• The chances of incurring a negative
return gets theoretically eliminated
when X and Y combine into a Portfolio
25a-to be read with/after #25
• Does this mean that there is a 68.3% probability
that returns will vary between 40% and 0%?
• This is true of Individual assets. In a Portfolio
one needs to look at the Coeff. Of Correlation
and Covariance as a consequence. While
returns of the Portfolio could be more than the
returns of one of the Assets comprising it, the
Risks could be totally eliminated if the Coeff. Of
Correlation of the 2 Assets were Perfectly
negative
24
• Portfolio risk -2 asset case
• Returns on Individual assets fluctuate MORE
than their Port. returns. Why is this so?
• This is because a ‘scientific portfolio
diversification’ could ELIMINATE ALL RISKS
in a 2 Asset Portfolio
• Investments in A and B
• ECO Prob. Retns.A% Retns.B%
• Good 0.5 40 0
• Bad 0.5 0 40
25
• Recognize that the average returns for
Both A and B is 20%
• The expected returns
• E(R) = 0.5* 40 +0.5* 0= 20%
• Variance= 0.5( 40-20)^2+ 0.5(0-20)^2
• = 200 + 200= 400
• Std. deviation= root of 400= 20%
• So A has an Expected Value of 20% with
a std. deviation of 20%. The same is true
of asset B.{ Now go to #25a}
26
• Ans: The Expected return of the
PORTFOLIO is the SAME as the
Expected returns on INDIVIDUAL assets
A and B
• E(R)= 0.5*20+ 0.5*20= 20%
• This is the same as the return on
Individual Assets BUT the RISK is
TOTALLY ELIMINATED. Why so?
• Because if the Economy were good A
would yield 40% and B 0%. The Expected
return would be 20%
27
• Similarly, in a Bad economy, A would yield
0% and B 40% with an Expected value of
20%!
• Thus there is NO RANGE, NO
DISPERSION and NO RISK as a
consequence!
• Caveat; In reality it is very difficult to
locate 2 assets whose returns move in
“absolutely opposite” directions for
ALL States of the Economy!
28
• Measuring Portfolio risks for 2 assets
• While the Portfolio Return is the Weighted
Average of the returns on the 2 assets,
the Portfolio Risk is NOT the weighted
average of the Risks of the 2 assets!
• The Portfolio risks depends on the ‘co-
movement” of the returns from the 2
assets
• Covariance- Measures the co-
movement of 2 assets
29
• Covariance
• Step 1 ; Determine the Expected returns
of each Asset
• Step 2; Determine the Deviation of the
returns from the Expected returns
• Step 3 Determine the product of each
deviation with its Probability
• Step 4 Sum up Step 3
30
• Step 1 E(Rx)= {0.1*(-8)}+{0.2*.1}+{0.4*8}+
{0.2*5}+ {0.1*(4)} = 5%
E(Ry)={0.1*14} +{0.2*(-4)}+{0.4*6}+{0.2*15}
+{0.1*20} = 8%
If Equal amounts are invested in X and Y
the Expected returns on the PORTFOLIO
is-
E(Rp)= 5*0.5+ 8* 0.5= 6.5%
31
• The table below shows the calculation of variations
from the Expected returns and Covariance #17
• Eco Prob. Return Deviation Product of
• X Y from Ex.Rtn deviation &
• Xbr Ybr Probability
• A 0.1 -8 14 -13(-8-5) 6(14-8) -7.80
• B 0.2 10 -4 5 (10-5) -12(-4-8) -12
• C 0.4 8 6 3(8-5) -2(6-8) -2.4
• D 0,2 5 15 0(5-5) 7(15-8) 0
• E 0.1 -4 20 -9(-4-5) 12(-8-4) -10.8
• sum=--33.0
32
• In the calculations note that the value of
Xbar=5% and of Y bar= 8% as seen
earlier in #30
• Alternatively, Cov x,y can be calculated
thus
• Summation {Rx-E (Rx)} {Ry –E (R y)} Pi
• Rx- Xbar Ry- Y bar prob.
• ={0.1(-8-5)(14-8)}+ 0.2(10-5)(-4-8)+0.4(8-
5) (6-8) +0.2(5-5) (15-8)+0.1(-4-5)(20-8)
• -7.8-12-2.40+0-10.8= (33)
32-a
• A Note on the importance of the concept of COVARIANCE in
PORTFOLIO Management
• Covariance; Is a Statistical measure of the degree to which two
variables ( Ex. Securities Returns) move together. A POSITIVE
VALUE indicates that on an average,(need not always be so!)
they move in THE SAME DIRECTION
• Unlike the Portfolio returns, the Portfolio risks( measured by
the variance) is NOT the Weighted Average of the Std.
deviations of Individual Assets. To take a weighted average of
the Std. deviations of the Individual Assets would mean
IGNORING a SPECIAL RELATIONSHIP of COVARIANCE that
exists among INDIVIDUAL ASSETS
• Covariance does NOT affect Portfolio returns. It provides for
the POSSIBILITY of ELIMINATING/REDUCING risks WITHOUT
reducing POTENTIAL RETURNS The Startling revelation- The
RISKINESS of a PORTFOLIO depends MUCH MORE on the
Covariance of the paired securities THAN it does ,on the Std.
deviation of Individual assets !
32-b
• Thus a combination of INDIVIDUALLY RISKY securities could
STILL COMPRISE a ‘moderate to Low risk Portfolio’ SO LONG
AS the Securities do not LOCK-STEP each other! In short, LOW
COVARIANCES lead to low Portfolio risks!
• DIVERSIFICATION
• Is the process of “spreading” risks ACROSS a NUMBER and
VARIETY of Assets / Investments . Concentration on Numbers
by itself could make the “Diversification Process” at best,
NAÏVE. This would imply that Investing $ 10,000 across 10
securities would MAKE a PORTFOLIO MORE DIVERSIFIED than
$10,000/ being invested ACROSS 5 Securities. SILLY! The fact
remains that NAÏVE DIVERSIFICATION IGNORES the
COVARIANCE( Correlation) between / among Security’s
returns.
• DIVERSIFICATION Is a process of risk reduction. If the
Returns in an asset A is CYCLICAL-moves with the Economy in
general, it would make sense to include Asset B ( which is
Counter-cyclical) in building a 2 asset Portfolio
32-c
• The returns on these 2 assets are
Negatively correlated. Equal amounts
invested in these two assets will go to
REDUCE the DISPERSION of returns
from the portfolio because the risks of the
2 assets are ’off setting’
• Investing in the World markets can help
achieve greater financial diversification
than investing in ONE country abroad
•
33
What is the relationship between the Returns of
Security X and Security Y?
• The following possibilities exist
• 1) Positive covariance; Meaning that the returns of
BOTH X and Y are –
• a) ABOVE the AVERAGE RETURNS of Portfolio
• b) BELOW the AVERAGE RETURNS of Portfolio
• 2) Negative covariance; The returns from ONE
asset is ABOVE the AVERAGE RETURNS while
the returns from ANOTHER is BELOW its
AVERAGE and vice-versa( av.returns is 6.5%
while Xis 5% and Yis 8%. Also covariance was a
negative 33%)
34
• 3) ZERO covariance; returns on X and Y
could show NO pattern– that is, there
could be NO relationship in their
movements. This lack of relationship could
be due to ‘randomness’
• In the example seen earlier, the minus
sign denotes Negative relationship; the
number 33 cannot however be explained
35
• Correlation
• Is the measure of LINEAR relationship between 2
variables. There is a relationship between Covariance
and Correlation
• Covariance XY=Std. deviation X * Std. deviation Y
*Correlation x, y
• Corrln. x,y= Covariance x,y / SD x, SD y
• The value of the correlation known as Correlation Co-
efficient can be Positive, Negative or Zero. Here
again the ‘sign’ of the Correlation coefficient
depends on the ‘sign’ of the Covariance (as SD
cannot be negative)
36
• Using the earlier data for assets X and Y,
• Variance X= 0.1(-8-5)^2+ 0.2(10-
5)^2+0.4(8-5)^2+0.2(5-5)^2+0(-4-5)^2
• =16.9+ 3.6+0+8.1 =33.6
• Std. dev.=root of 33.6=5.80%
• Variance Y= 0.1(14-8)^2+0.2(-4-
8)^2+0.4(6-8)^2+0.2(15-8)^2+0.1(20-8)^2
• =3.6+ 28.8+1.6+9.8+14.4=58.2
• Std.dev.y=root of 58.2=7.63
37
• The Correlation of the 2 securities X and Y
• Corx,y= __Cov x,y_________
• Std.dev.x, Std. dev. Y
• = ____-33_ =___-33_ =-0.746
• 5.8* 7.63 44.25
• --0.746 represents a HIGH degree of
Negative relationship
38
• Variance and Std. deviation of a 2 asset
Portfolio
• The Variance
• =Sda^2 Wa^2+Sdb^2Wb^2+2Wa Wb Pab
where,
• P ab=Cov a b=Sda.* Sdb *Corrln a b
• Therefore variance of a Portfolio
• =Sda^2 Wa^2+ Sdb^2 Wb^2+ 2 Wa Wb
Sda. Sdb Corrln a, b
• s
• It may be noted that
39the Variance of a
Portfolio INCLUDES the Proportionate
Variances of Individual Securities AND the
Co variances of the securities put together
• The Risk of a Portfolio will be LESSER
than the Risk of Individual assets for
LOW or Negative correlation
• The Portfolio risk depends on the
Correlation between the assets. The
concept of a weighted average Risk,
which is just an average of the risks of
the 2 assets is SILLY -----contd.
40
• This is because the concept of a risk for a
Portfolio must take cognizance of the
correlation between the assets in the
Portfolio
• The Weighted average (silly) of the SD
(risk) of securities X and Y is 6.70 as is
seen { 5.8 *0.5+ 7.63* 0.5= 6.70%}.
However, at a Coeff. of Corrln. of 1, the
Portfolio risk represented by its Sstd.
deviation is the SAME as its weighted
average i.e. 6.70%
41
• So, unless the Coeff. Of correlation is
LESS than ONE, the risk in combining
two assets is the SAME as the risk in
NOT DOING SO!
• There is this concept of a MINIMUM
VARIANCE PORTFOLIO the risk of the
Portfolio is the LEAST.
• MVP= Wx*= ___SDy____ approximately
• SDx+ SDy
• Wy*= 1-Wx
42
• In our earlier example we had the Standard
deviation of Y as 7.63, the standard dev. of
X as 5.80 and the Covariance as –33. the
MVP is
• W*x=___7.63* 7.63__--(-33)_____=0.578
• 7.63*7.63+5.8*5.8- 2(-33)
• W*y=1-0.578= 0.422 Accurate Minimum
Variance Portfolio The Sd for this Portfolio
is worked out in the next slide
• contd.
43
• Var.p=Sd x ^2 * W x^2+ Sdy^2 *Wy^2+ 2.0
Wx Wy Sd x Sdy. Cov x,y
• =33.6(0.578)^2 + 58.2(0.422)+ 2 (0.578)
(0.422) (5.8)(7.63) (-0.746)
• = 11.23+ 10.36-16.11= 5.48(Port.Variance
• Std. deviation=root of 5.48= 2.34
• A portfolio comprising of an investment of
57.8% in asset x and 42.2% in Asset y
would lead to the Lowest risk of 2.34% .
Any other combination would only entail
HIGHER risks
44
• Suppose the Coeff. Of correlation was +ve
0.25. What would the measure of risk be
like? Equal weights
• Variance= 33.6(0.5)^2+ 58.2(0.5)^2+ 2(0.5)
(0.5)(5.8)(7.63)(0.25)
• =8.4+14.55+5.53= 28.48
• Std. deviation= root of 28.48= 5.34
• This Portfolio risk though lower than the
weighted average risk of 6.70% is FAR
HIGHER than the Minimum Variance risk of
2.34
45
• Illustration Securities M and N are ‘equally
risky’ but have DIFFERENT expected
returns
• M N
• Expected returns(% ) 16% 24%
• Weight 0.50 0.50
• Stand.dev. 20 20
• What is the Portfolio risk (variance) if a)
Corr m, n = +1 b) Corr = -1 c) Corr = 0
d) Corr= +0.1 e) Corr= -0.10?
45a
• Var.P= (Wx*SDx +Wy*SDy)^2 When P=+1
• SDp =WxSDx+WySDy
• Var.P= (Wx*SDx-Wy*SDy)^2 When P=-1
• SDp = Wx*SDx- Wy*SDy
A C
B
53
• If we ADD up figures that we saw for
Perfectly + Correlation and the figure on
slide#50 for Perfectly –ve Correlation, we
get the figure on slide #52. This triangle
ACB represents the LIMITS of
diversification which has a boundary
between +1 and -1. It is only within this
triangle that various risk and return
combinations can lie in a 2 Asset portfolio
54
• 3) Zero correlation
• As seen earlier, assets with Zero correlation help
REDUCE risks of the Portfolio( compared to the
risk associated with Individual assets) without
reducing( often increasing) returns in the
process. You could increase the weight of a
MORE RISKY ASSET in the Portfolio
WITHOUT increasing the risks of the
Portfolio possibly
54a-Limits of Diversification
• An analysis of the Diagram on slide#52
• Lines AT and BT denote Lines formed by
Perfectly Negatively correlated assets
while the Line AB represents the line
formed by assets that are Perfectly
positively correlated. Thus the triangle
ABC represents the LIMITS OF
DIVERSIFICATION as even assets not at
all correlated-( zero correlation) must lie
within +1 and -1!
• Let us Examine a clock-wise movement
from point A along the pivots B and T
54-b
• As you move from A to T in a clock wise
direction and inside the Triangle ABT, we find
that as we move from perfectly positively
correlated asset(+1.0) to perfectly negatively
correlated asset and upto the extreme T where
Std. deviation or risk is ZERO, we find that—
• A) For the same returns the risk actually
reduces-- lines 1-6 on Xaxis
• B) In fact as the risk goes about decreasing, the
returns actually are increasing-Line BT
• C) After the point T, along TA any further
increase in returns comes only with increasing
risks! Lines 61
55****
• Systematic and Unsystematic risks
• We have seen that combining Assets that are
NOT perfectly positively correlated, helps
LESSEN the risk of a Portfolio. The Questions
that then crop up are---
• 1) How much Risk reduction is reasonably
possible?
• 2 ) How many DIFFERENT security holdings
would be required in a Portfolio?
• The Figure would help. X axis No.of securities
in a Portfolio Y Std. deviation
56
• Research studies have looked at what
happens to ‘Portfolio risk” as RANDOMLY
SELECTED STOCKS ARE COMBINED to
form an Equally Weighted Portfolio
• When we look at a SINGLE STOCK the
risk of the Portfolio is the Std. deviation
of that stock. As the NUMBER ( and
value) of RANDOMLY selected stocks
held in the portfolio is increased, the
TOTAL RISK of the Portfolio is
reduced. Such a reduction is at a
DECREASING RATE however!
57
• Thus a substantial amount of risk of a portfolio
is ELIMINATED by ‘relatively moderate’ extent
of DIVERSIFICATION say 15 to 20 RANDOMLY
SELECTED stocks in EQUIDOLLAR amounts
(not just numbers)
• Total risk=Systematic risk+ Unsystematic risk
• Systematic risk Undiversifiable or unaviodable
• Unsystematic risk- - Diversifiable/ avoidable
This is denoted by the Flattening of the Total
Risk curve
58
• Systematic risks affect the OVERALL MARKETS by way
of such changes as increase in Interest rates, Increase
in Oil Prices etc. These CANNOT be ‘diversified away”.
In other words even Investors who hold well-
diversified portfolios are subject to these risks!
• Unsystematic risks are UNIQUE to a PARTICULAR
INDUSTRY or a PARTICULAR COMPANY. They are
unaffected by Economic, Political and other factors
that that affect all other securities. A Wild cat strike
can affect only one company or only one Industry, a
technological break through cannot make all
products obsolete!
59
• For most stocks, Systematic risks account
for almost 50 % of the stock’s TOTAL
RISK! By ‘considered diversification’
these risks are reduced or sometimes
eliminated at least in a 2 asset
Portfolio! Thus not all the Std.
deviation in a stock is relevant as some
portion pertaining to Unsystematic risk
can be diversified away!
• Investors who bear Systematic risks need
to be compensated for it. This logic is the
essence of CAPM
60-CAPM
• The Capital Asset Pricing Model
• Based on the behaviour of Risk averse
investors, there is an IMPLIED
EQUILIBRIUM RELATIONSHIP between
Risk and Expected returns for each
security. In MARKET EQUILIBRIUM, a
security is supposed to provide an
‘Expected return’ COMMENSURATE’ with
its SYSTEMATIC risk. The relationship
• Between a)Expected return b) Systematic
risks is the basis of CAPM
61
• Developed by Nobel Laureate William Sharpe,
the model helps us draw certain implications
about RISKS and the SIZE OF RISK
PREMIUMS necessary to compensate Risk
bearing.
• Before trying to understand the concept of
CAPM we need to understand the combination
of assets in a Portfolio, the feasible region and
the Efficient Frontier, The Indifference curves
Optimal portfolio, the concept of Beta and the
Characteristic and Security market Line
EFFICIENT FRONTIER.
RETURNS B Z
RISK
62***
• Feasible Region and Efficient Frontier
• The collection of all possible portfolios
represents the feasible region.(the Portfolio
Opportunity Set) The feasible region is the
shaded region in the Portfolio combination
• Given the Feasible region, which portfolio
should the Investor choose?
• The Investor should choose the portfolio that
MAXIMISES his UTILITY FUNCTION
• The choice involves the 2 steps— #63
63
• 1) Delineation of the set of Efficient Portfolios
• 2) Selection of an OPTIMAL PORTFOLIO from
the set of Efficient Portfolios
• A Portfolio is EFFICIENT if a) It gives the SAME
returns for a lower std.deviation
• b) Gives higher returns for the same std.
deviation
• Thus Portfolios lying along BC forms the
EFFICIENT portfolio. The boundary may be
referred to as the ‘Efficient Frontier” All other
Portfolios are “inefficient”. A portfolio Z is
Inefficient as portfolio B dominates it. The
Efficient frontier is the SAME for ALL investors
as the Portfolio theory assumes that ALL
investors have HOMOGENOUS expectations.
64
• How does one obtain an OPTIMAL Portfolio
from a Efficient frontier? By graphical analysis
for a 2 asset portfolio and with Quadratic
Programming for a n asset portfolio
• Selection of Optimal portfolio from an Efficient
Portfolio
• After selecting the efficient portfolio by Quadratic
analysis, one will then have to select an Optimal
portfolio
INDIFFERENCE CURVES
I4
I3
I2
I1
EXPECTED Y Z
RETURN X
RISK
65***
• The selection of an Optimal Portfolio
starts with one ‘defining the risk- return
preferences’ of an Investor. For this we
start by plotting “Indifference curves”.
Any point on ONE Indifference curve is as
good as ANY OTHER POINT on the same
Indifference curve. This is because the
risk- return proportions at these two points
make no difference!
• However this is NOT SO for points on 2
different Indifference curves!
OPTIMAL PORTFOLIO.
Y3
X3 Y
Y2
C
Y1
RETURNS X
B
D
X2
X1 A
RISK
66***
• The Utility or the ‘level of satisfaction’
INCREASES as one moves LEFTWARDS I-2
gives a higher level of satisfaction than I-1 and
so on. For ex. IF points X Y and Z represented
an expected return of RS. 5 on I/C curves I-3, I-2
and I-1 respectively, it is clear that the SAME
RETURN is being achieved at LESSER RISKS
as the Std. deviation at I-1 is lesser than at I-2
which again is lesser than at I-3; all for the
SAME returns! This gives the Investor Higher
satisfaction as he achieves the SAME returns
with Lesser risk as he moves fromI-1 to I-3!
67
• OPTIMAL PORTFOLIO
• GIVEN the Efficient frontier(step1) and the Risk-
return indifference curves (step 2), the OPTIMAL
PORTFOLIO is located at the’ point of
Tangency BETWEEN the EFFICIENT
FRONTIER and the INDIFFERENCE curves’
• 2 investors X and Y, confronted with
DIFFERENT Indifference curves X1,X2and X3
AND Y1,Y2 and Y3 locate their OPTIMAL
PORTFOLIOS at X* and Y*-the points of
tangency- as in the diagrams
68
• The Point of Tangency locates the OPTIMAL
PORTFOLIO as it is the meeting point ‘of what
best the stock can offer (Efficient Portfolio- best
returns at that level of risk) AND what the
Investor best expects( Indifference curves)
• Optimal Portfolio with LENDING and
Borrowing at Risk less rate
• Suppose Investors can LEND and BORROW at
‘risk less rate’. Per se this looks trivial but is NOT
SO as, the risk less Asset has some SPECIAL
CHARACTERISTICS. To get this we look at the
equation for the Std. deviation of a Portfolio of 2
assets
SHIFTING THE EFFICIENT FRONTIER.
I NG
W
RRO
BO
.
I NG
ND
E
.
L G
V
. M
RETURNS Rf
.
U . Q
B
C
RISK
69**
• Std, deviation of a Portfolio, SDp
• = ROOT (W1^2* SD 1^2) +( W2^2* SD2^ 2) + (2
W1W2*P12*SD1*SD2)
• If one of the Assets, say Asset2 is a RISK FREE
ASSET, it means that SD2=0
• Therefore SDp= W1* SD1- What a
transformation!
• If an Investor LENDS a portion of his funds at Rf
and invests the remaining in asset M a risky
asset( M is the Optimal Portfolio), the Efficient
Frontier which was BC all the while, gets shifted
to any point he prefers along the line Rf M
70
• For obvious reasons, a point U on RfM
DOMINATES the point B on the Efficient frontier
BC
• Further if he BORROWS money at risk free
rate and invests it in M ( he will be called an
‘Aggressive Investor”) he can , if he wishes,
reach the point G, which is EVEN BEYOND M
(beyond even the Optimal Portfolio)!!
• Since RfMG dominates BC, every investor
would do well to choose some combination
of Rf and M. A conservative investor may
choose a point U, an Aggressive Investor
may choose a point V. A conservative
investor includes and weighs more of Rf in
his Portfolio while an Aggressor weighs
more of M in his Portfolio!
71
• At the point V discussed earlier, the
Weight of Rf turns NEGATIVE as money
is borrowed and invested into Asset M
• Wf+ Wm=1. Now by Borrowing,
• Wf+ Wm + Wb=1. Since Wb is another
form of Wm, to keep the equation intact,
Wf should be less than than 1! ( because
we started off saying Wf + Wm =1
72
• The task of a Portfolio manager can be separated
into—
• 1)Location of M, the Optimal Portfolio of risky assets
• 2) Choice of a Combination of Rf and M depending
on one’s tolerance for risks
• Ex. I have located Tisco and Reliance as the assets
constituting an Optimal Portfolio. Now for my client S’
how much should he Borrow at the treasury rate at 6%
and invest even that amount into Tisco and
Reliance( portfolio M)?
• This is the Separation Theorem propounded by James
Tobin for which he was awarded a Nobel Prize
• RV= ___{ E(Rm)- Rf}______________
• Std.deviation of Portfolio M
• RV Reward Variability Ratio
73
• The Concept of a Market Portfolio
• In CAPM there are 2 types of Investment opportunities
which concern Investors
• 1) A RISK FREE Security whose holdings over the
Holding Period is KNOWN WITH CERTAINTY-(Risk free
Treasury Bonds of a Sovereign State , for example)
• 2)A MARKET PORTFOLIO of Common stocks
• Frequently , the rate on Short term to Intermediate term
Treasury securities is used as a SURROGATE for a
Risk Free Security. And a MARKET PORTFOLIO is a
portfolio of ALL COMMON STOCKS and Weighted
according to the Aggregate Market values
outstanding. As a Market Portfolio is unwieldy to work
with, people use a S&P500/ NIFTY/ SENSEX as a
surrogate
• A Market Portfolio represents a Limit to ‘attainable
diversification” as one CANNOT hold a Portfolio that
is more diversified than a Market Portfolio. Thus ALL
risks associated with a Market Portfolio are
Systematic / Unavoidable risks
• THE CHARACTERISTIC LINE*******
• We are now in a position to compare the Expected
Returns for an Individual Stock WITH the Expected
returns for a Market Portfolio( S&P 500, proxy). In our
comparison it is useful to deal with ‘returns in excess of
risk- free rate’– a BENCH MARK against which the
returns from the risky assets are contrasted. The Excess
return is simply the EXPECTED RETURN LESS the
RISK FREE RETURN. The Chart shows the comparison
of the Expected excess for a specific stock with the returns
from the Market Portfolio
URN
R ET K
E SS TOC
C S
EX ON
NE
LI
C
STI
RI
T E
C
A RA
CH
EXCESS RETURN
ON MARKET
75****
• The DARK red line is the Characteristic line ; it depicts
the expected relationship between EXCESS RETURNS
for a stock AND the Excess returns for a Market
Portfolio.
• The Expected relationship may be based on a past
experience in which case the Actual excess return for
the stock and the Market Portfolio would be plotted on
a graph and a REGRESSION LINE best characterizing
the relationship is drawn. Each point represents
‘excess returns for a stock and the excess return of
S&P 500, say in the past given month and in the last
60 months in total
• The Monthly returns are- Returns=
• __ Dividends+_ ( Ending price-Opening Price)_____
• Beginning price
76
• The Narrower the spread, the GREATER the CORRELATION;
alternatively, the wider the spread, the GREATER the Unsystematic
risks and LESSER the Correlation with the excess return on the Market
Portfolio
• The concept of BETA-- an Index of Systematic risks Beta is simply
the SLOPE of the Characteristic Line i.e. the change in the Excess
returns on the Stock OVER the change in the Excess returns for
the Market Portfolio __ Y2-Y1___
• X2- X1
If the slope is 1, it means that the
Excess returns on the Stock varies PROPORTIONATELY with the
excess returns on the Market Portfolio. In other words, the stock
has the same Systematic risks as the Market as a whole! If the
market goes up 5% on the whole, we could expect the Stock to go
up around 5% as well. If the slope is>1, it would mean that the
excess returns on the stock would be more than proportionate to
the Excess returns on the Market portfolio –in other words the
stock is riskier than the WH OLE MARKET !
76a
• The wider the relative distance of the points
FROM the characteristic line, the greater the
Unsystematic risks of the stock. This means that
the Excess return from the stock shows
increasingly LOWER correlation WITH the
Excess return on the Market Portfolio.
• We know that Unsystematic risks can be
reduced / eliminated through Efficient
diversification. For example for a Portfolio of say
20 carefully selected stocks, the data points will
hover close to the characteristic line
R N
E TU B>1
S R CK
C ES STO B=1
EX ON
B<1
EXCESS RETURN
ON MARKET
77***
• A stock with a Beta of >1, is an Aggressive stock while the one with
a Beta of <1 is a Defensive stock
• The greater the slope of the Characteristic line for a stock, as
depicted by Beta>1.0, the GREATER THE SYSTEMATIC RISK
• This means that for BOTH upward and downward movements
in the Market’s Excess returns, movements in the ‘excess
returns in Individual stocks ‘ are greater or lesser, depending
on its beta
• With the Beta of a Market Portfolio equal to 1 by definition, Beta
thus becomes an INDEX of the Systematic or Unavoidable risks
relative to that of the Market Portfolio.
• In addition a Portfolio’s Beta is simply a weighted average of
the Individual’s stock betas with, the weights being assigned in
proportion of total portfolio’s market value, represented by
each stock. Thus the Beta of a stock is—
• A stock’s contribution to the RISK of a HIGHLY diversified
portfolio of stocks
78
• Required Rate of Return and the Security Market
line ( SML)
• Unsystematic risks can be diversified away. The
major risk associated with a stock is therefore the
Systematic risk. The greater the Beta of a stock,
the greater the Systematic risks and greater the
Required rate of return. The required rate of
return is in case of Inefficient Portfolio--
• Rj=Rf+ { ( Rm- Rf) Bj}
• Where Rj is the Reqd. rate of return
• Rm-> Is Expected return for Market Portfolio
• Rf -> Risk free return, Bj-> Beta coefficient for the
stock j.
79
• Put another way, the Required rate of
Return for a stock is equal to the return
required by the market for riskless
Investment PLUS a Risk Premium
• The Risk Premium is a function of—
• 1) The Expected market return LESS the Risk
free rate of return, which represents the risk
premium required for that stock in the market
AND is a function once again of its--
• 2) Its Beta coefficient
80
• Suppose the Expected return on Treasury
security is 8%, the Expected return on the
Market Portfolio is 13 % and the Beta of A Corp.
is 1.30.
• The Beta indicates that A Corp. has MORE
Systematic risks than a typical stock index.
• Rj= 0.08+ {(0.13-0.08) 1.30}= 14.5%
• This means that the Market expects A Corp. to
return 14.50% as against the Expectation of
13% on the Market Portfolio. This is because
Acorp. has a higher Systematic risks(30% more
than on the Market security) and therefore
Investors in it demand a higher rate of return for
investing in it
SECURITY MARKET LINE.
L
SM
RISK
EXPECTED RETURN
PREMIUM
Rf
RISK FREE
RETURN
1
BETA
81***
• Security Market Line
• The Equation Rj= Rf + {( Rm- Rf) B} describes
the relationship between an individual Security’s
Expected returns and its Systematic risk as
denoted by Beta. This linear relationship is
known as Security Market Line and is illustrated
in the figure. The expected one year return is
shown on the Y axis. Beta, the Index of
Systematic risks is on the Horizontal axis.At zero
risk, the SML has an intercept equal to the Risk
free rate of return as, investors expect to be
compensated for the Time value of money. Of
course as risk increases, the Required rate of
return also increases
82
• CAPM provides us the means to estimate the
‘REQUIRED rate of return’ on a security. The
RROR can then be used as a ‘Discounting rate’
in a Dividend Valuation model. Recall the
Intrinsic value of a share can be expressed as
the Present Value of a stream of ‘Expected
future dividends’ Po= __-sum of Dt____
• (1+ Ke)
• Where ‘growth’ is seen P= Dt____
• Ke-g
83
• If A ltd.declares a dividend of Rs 2/ share,
the expected annual growth in dividends
per share is 10% and if the Required rate
of return for A ltd. is 14.5%
• P= ___2.0___ = Rs. 44.44
• 0.145- 0.10
• If this value of Rs. 44.50 is the SAME as
the Current Market Price, the ‘ Actual
Return on the stock and the “required rate
of return would be Equal, denoting a state
of Equilibrium.
84
• In the Previous Example, the Required
rate of returns---based on the Investors
expectations regarding such factors as 1)
returns on riskless assets 2) Company
performance expected 3) The state of the
economy as such etc--- matches the
market price. If the match does not remain
the state of equilibrium is lost and
recognizable price changes are the result!
85
• Suppose Inflation in the Economy has come down and a state of
relatively stable growth has set in. Interest rates have declined and
the risk aversion of the Investors have decreased with a decrease in
the growth in dividends( Dividends Rs 2/-)s
• Before After
• Risk free rate 0.08 0.07
• Expected market return Rm 0.13 0.11
• Beta of A ltd. 1.30 1.20
• Dividend growth A ltd 0.10 0.09
• The RROR for A ltd Rj(or Ke) = 0.07+ { ( 0.11-0.07)* 1.20} = 11.80%
• P= __D____= ___2.0_______= Rs 71.43 ( See #83)
• Ke-g 0.118- 0.09
• Thus, with an improvement in the economic and company specific
factors, there is an appreciation in the price of the company’s stock.
If these expectations represented ‘market consensus’ the price of Rs
71.50 Rs would be the Equilibrium price
BETA AND R R O R.
REQUIRED RATE OF RETURN
Rf
STOCK Y (Over Priced)
BETA
86***
• Underpriced and Overpriced stocks
• At market equilibrium, the Required rate of return on a stock is equal
to its Expected rate of return ( We generally do not use Actual rate of
return in place of Expected rate of return as, markets generally
discount the future and at any point in time it is the future price that is
to be looked at). What happens when the asset is not in Equilibrium?
• Let us say that for some reason stocks X and Y are ‘improperly
priced’. Stock X is underpriced relative to SML and Stock Y is
overpriced relative to SML
• A look at the Chart indicates that Y axis represents the Required
rate of return. This is akin to the DISCOUNT the stock is trading
at compared to its relevant fundamentals
• Stock X, some investors DEMAND, should provide a ‘rate of
return’ GREATER than that required based on its relevant
fundamentals and consequently a return GREATER than that
required, based on its SYSTEMATIC RISKS
87
• Some Investors seeing an OPPORTUNITY would go about buying
the asset. This would push the Market prices up, and the required
rate of return down. The process would continue till the RROR hit
the SML.
• Similarly in the case of Stock Y, investors holding the stock would
sell it recognizing that they would obtain a ‘higher return for the
SAME AMOUNT of Systematic risks( should they invest in
other stocks with ‘ comparable systematic risks’) the selling
pressure would drive the prices of the stocks down increasing
the RROR in that process, till such RROR ( the Discount to the
price based on fundamentals) meets with SML
• Prices adjust quickly to new Information.
• The SML concept becomes a useful means of determining the
Expected RROR for an asset. The RROR can then be used as a
DISCOUNTING rate while valuing the asset.
• P= ___D_____ P= ___Dt____ where RROR=Ke
• (1+ Ke) Ke- g
88
• THE CAPM after all!
• Portfolio theory is a normative which PRESCRIBES how ‘utility
maximizing’ investors should behave; rationally though!
• The CAPM was developed later to examine “ the
RELATIONSHIP between Risk and Returns in the Capital
markets IF INVESTORS BEHAVED IN CONFORMITY WITH THE
PRESCRIPTIONS OF THE PORTFOLIO THEORY”. CAPM is thus
an extension of the Portfolio theory and basically concerns
itself with 2 sets of Questions---
• 1) What is the appropriate measure of Risk for an EFFICIENT
portfolio?
• 2) What is the relationship between Risk and Returns for an
Efficient Portfolio?
• 3) What is the appropriate measure of risk for an ‘Inefficient
Portfolio’?
• 4) What is the relationship between Risk and Returns for an
Individual security or an Inefficient portfolio?
89
• ASSUMPTIONS of CAPM
• 1) Individuals are risk averse
• 2) Individuals seek to maximize the ‘expected utility’ of their
Portfolios over a single period planning Horizon
• 3) Individuals have HOMOGENOUS EXPECTATIONS. This means
that they have IDENTICAL subjective estimates of the means,
variances and co variances among returns
• 4) Individuals can BORROW and LEND freely at Risk free rate of
return
• 5) The markets are Perfect with no taxes, transaction costs etc.
• 6) Securities are completely divisible and the markets are
competitive
• ------------------------------------------------------------------------------------------
BOND CONCEPTS
• A BOND is a Debt Instrument requiring the Issuer ( also called the
Debtor or the Borrower) to repay the LENDER or the Investor---
• a) the amount borrowed b) Interest over a specified period of time
• The Date on which the Bond is to be repaid is called ‘Maturity Date’
• Assuming that the Issuer does not default or redeem the Issue
PRIOR to the Maturity Date, an Investor holding this Bond till the
Maturity date is assured of a known cash flow pattern
• ISSUERS of Bonds
• 1 The Federal Govt. & its Agencies
• 2 Municipal Govts.
• 3 Corporate Sector
• Term to Maturity of a Bond
• Is the number of years over which, the Issuer has promised to meet
his ‘obligations towards the Bond’
• Maturity of the bond ; Is the date on which the Bond will cease to
exist i.e. the Borrower will redeem the debt
2
• 1-5 years maturity--- Short term Bonds
• 5-12 years-- Medium term Bonds
• > 12 years- Long term bonds
• Importance of the concept ‘Bond Maturity’
• 1) Indicates the number of years over which the Bond Holder can
expect to receive his payments of COUPONS and the number of
years over which the Bond Principal will be ‘repaid’
• 2) The Yield on a Bond depends on its ‘Term to maturity’
• 3) the Price of a Bond will fluctuate over its life, as yields in the
Market change!
• Greater the TERM TO MATURITY with other factors being
constant, the GREATER the VOLATILITY (in the Price) resulting
from a change in Market Yields
• The PRINCIPAL is the amount that the Issuer agrees to repay the
Bond holder on the Maturity Date. This is also referred to as
Redemption value/Maturity value/Par/Face Value of the Bond
3
• The Interest paid to the Holders of the Bond is called COUPON
• In USA and Japan coupon is Semiannual. Zero Coupon Bonds carry
‘no coupon’ They are issued at a ‘huge discount’ to the FV and are
redeemed at FV
• Floating Rate Bonds
• Here coupon rates are RESET in tune with a pre-determined
BENCH MARK generally linked to a FINANCIAL INDEX
• In some cases the coupon rate INCREASES with a FALL in the
INDEX and FALLS with an INCREASE in INDEX. Rates designed
on these parameters are called ‘Inverse Floaters’. Institutional
Investors hold them as ‘HEDGE VEHICLES”
• Junk Bonds
• Are HIGH YIELD BONDS issued generally by Corporates, very
often not enjoying a high financial standing
• A Leveraged Buy out(LBO) or a Re-capitalization financed by
‘high yield bonds’ with consequent heavy interest payment
burdens, can place severe cash flow constraints on the Issuer
4
• To reduce this burden, firms involved in Leveraged Buy Outs and re-
capitalization, issue ‘deferred coupon bonds’ that let the Issuer
AVOID making CASH payments for some ‘specified period of time’
( Ballooning Interest Payments) thereby reducing the cash strain
on the acquirer.
• There are 3 types of ‘deferred coupon structures”---
• 1) Deferred Interest Bonds
• 2)Step-up bonds
• 3) Payment-in –kind Bonds
• In STEP-UP Bonds, the coupon the coupon rate for the first few
years is low; it increases thereafter, giving the required return on an
average
• In Payment –in-kind bonds, the coupon is satisfied by issue of Baby
bonds
• There is another High Yield bond structure which helps the Issuer
RESET the coupon rate so that the bond trades at a predetermined
price
5
• In addition to indicating the coupon payments that an Investor
should expect to receive over the term of the bond, the COUPON
RATE also indicates the degree to which a BOND’S PRICE is
expected to be affected by changes in INTEREST RATES
• As will be illustrated later, with ALL OTHER FACTORS
REMAINING CONSTANT, the HIGHER the coupon rate, the
LESSER the PRICE CHANGE, in response to a change in
INTEREST RATES. Consequently, the coupon rate and the
Term to Maturity have OPPOSITE EFFECTS on the ‘PRICE
VOLATILITY” of a bond, when interest rates change.
• AMORTIZATION FEATURE
• The repayment of the PRINCIPAL of a bond can be either a) By
way of the Principal being repaid IN FULL at MATURITY b) The
Principal being repaid over the life of the bond( staggered
repayments over the life of the bond)—called AMORTIZATION .
Investors do not talk of BOND MATURITY while referring to
Amortizing securities; they’d rather compute a ‘weighted
average life’ while dealing with Bond maturity
7
• EMBEDDED OPTIONS
• It is common for a Bond Issue to include a PROVISION in the
INDENTURE ( AGREEMENT)-- a clause that gives the BOND
HOLDER or the ISSUER-- an OPTION to initiate the stated action
mentioned in the bond which could affect the interests of the
counter party The most common feature is the call feature . The
provision grants the ISSUER the RIGHT ( optionally
exercisable) to RETIRE the debt, fully or partially, BEFORE THE
SCHEDULED MATURITY DATE
• Inclusion of a CALL FEATURE benefits ‘bond Issuers’ by
allowing them to replace the ‘old bond’ by a new bond at a
‘lower rate of interest’ This call feature could be ‘detrimental’ to
the interests of the Bond holder
• The right to call an Obligation is included in in MOST LOANS and
therefore in all securities created ‘from out of all such Loans.
This is because the Borrower typically should enjoy the right to
repay/payoff the loan anytime he pleases. The borrower has the
right to alter the amortization schedule if he is so pleased !
8
• An Issue may also include a provision that allows a BOND HOLDER
to effect a change in the MATURITY of the bond. An Issue with a
PUT provision included in the Indenture , grants the BOND
HOLDER the RIGHT to sell the Issue BACK TO THE ISSUER at
PAR VALUE on the DESIGNATED DATES Here the advantage to
the Investor is that if Interest rates rise after the Issue date,
thereby reducing a BOND’S PRICE , the investor can force the
Issuer to redeem the bond at PAR VALUE He can then invest this
‘PUT’ amount in new bonds at HIGHER rates of interest!
• A Convertible bond is an Issue giving the Bond Holder the RIGHT to
EXCHANGE the bond for a specified number of Common Stock.
Such a feature helps the Bond Holder to take advantage of favorable
movement in stock prices
• Some Issues allow either the Issuer or, the Bond Holder, the RIGHT
to SELECT THE CURRENCY in which the cash flows will be paid.
• Multi feature Embedded options are ‘difficult to value’
9
• Risks associated with investing in Bonds
• 1) Interest rate Risk 2) Reinvestment risk 3) Call risk 4) Default risk 5)
Inflation Risk 6) Exchange rate risk 7)Liquidity risks 8)Volatility risks 9)
RISK RISK
• Interest rate risk The Price of a typical bond will vary inversely with
change in interest rates. If an investor has to sell a bond PRIOR to
the MATURITY DATE, an INCREASE in INTEREST rates at that
time, will mean REALIZATION OF CAPITAL LOSSES ( selling the
bond BELOW the Purchase Price). This risk is referred to as Interest
Rate Risk/ Market risk. This risk is by far the BIGGEST risk faced by
the Investors in bonds
• The actual degree of sensitivity of a Bond’s Price to CHANGES in
Market interest rates depends on various characteristics of an issue
such as Coupon rates, maturity, the options embedded in the issue
• Reinvestment Risks Calculation of the yield of a bond assumes that
all cash flows received are ‘reinvested’ at the YTM / IRRi.e. interest
received from A is reinvested in B The additional income from such re-
investment called ‘interest on Interest’ would depend on the
Interest rate prevailing at the time of REINVESTMENT
10
• Variability in the rates of interest at the time of Reinvestment
( reinvestment rate variability) is called REINVESTMENT RISK. This
risk is that Interest rate at which the cash Inflows received interim,
are re-invested, could FALL
• Reinvestment risk is GREATER for
• 1) LONGER HOLDING PERIODS and
• 2) HIGH COUPON BONDS with LARGE, EARLY cash flows
• It is to be noted that Interest rate risk and Re-investment risk have
‘OFF SETTING EFFECTS’. The reason; Interest rate risk is that risk that
interest rates will INCREASE ( thereby, reducing the Bond Price) and
‘Reinvestment Risk’ is the risk that interest rates WILL FALL!
• A strategy based on ‘offsetting effects’ is called IMMUNIZATION.
• CALL RISK
• Many Bonds include a provision that allows the Issuer to CALL, all or
any part of the bond BEFORE THE Maturity date. The Issuer often as
a part of Indenture, appropriates this right for himself so that, he can
refinance the bond in future if market rates fall below Coupon rates
11
• From the Investor’s perspective, there are 3 disadvantages to a call
provision i.e Bonds with embedded optiond.
• 1) The cash flow pattern of a callable bond is NOT known with
certainty
• 2) Since it is highly likely that the ISSUER will CALL the bond
when Interest rates DROP, the investor gets exposed to
REINVESTMENT RISKS
• 3) CAPITAL APPRECIATION of the bond stands reduced as the
price of the callable bond, will only VERY VERY rarely RISE above
the price at which the Issuer is entitled to call!
• Even though, the investor is compensated usually for taking a ‘call
risk’ by means of a LOWER PRICE or a HIGHER YIELD, it is NOT
easy to determine if this compensation is sufficient! In any case,
the returns from a callable bond is very different from an
‘otherwise similar non callable bond’
• Call risk is so pervasive in Bond Portfolio Management that
many market participants consider it SECOND ONLY TO
INTEREST RATE RISK in importance
12
• DEFAULT RISK
• Also referred to as Credit risk, it refers to the probability of default by the
Issuer of the Bond ( inability of the Issuer to make Timely coupon payments
as also the return of Principal). Default risks is gauged normally by the
‘credit standing ‘ assigned to the issuer by ‘credit rating agencies’
• Bonds carrying ‘credit risks” trade in the market at prices LOWER than
comparable government securities, no matter that they offer higher
rates of interest
• Except in the case of JUNK BONDS, an investor is normally more
concerned with changes in PERCEIVED DEFAULT RISKS than with
ACTUAL DEFAULT! Even though the actual default of the Issuing
Corporation may be ‘highly unlikely’, they reason that the impact of a change
in the ‘perceived default risk’ or, the ‘spread’ demanded by the market, for a
given level of default risk, can have an IMMEDIATE IMPACT on the price of
the Bond
• INFLATION RISK
• Also called ‘Purchasing power risk’ arises because of the Variation in the
value of the Cash flows measured in terms of ‘what money can buy’
13
• The Real rate of return could reduce drastically and in extreme
circumstances even turn ‘negative’ under ‘galloping Inflation’ To counter this
risk—to the extent possible– Floating rate Bonds have been structured
• FRB’s have a lower rate of Inflation risk; especially Inverse Floaters
• EXCHANGE/ CURRENCY RATE RISK
• An investor who invests across the border attracts this risk
• LIQUIDITY RISK
• Also known as ‘marketability risk’ it represents the EASE with which an
Issue can be SOLD at or near its value. The Primary measure of
Liquidity is the “size of the spread” between the ‘Bid price” and the
‘Ask price” quoted by the dealer. The WIDER the ‘dealer spread’, the
HIGHER the Liquidity risk! For a person who is clear about holding the
security till Maturity, the Liquidity risk is Very low!
• VOLATILITY RISK
• Typically, the VALUE of an option RISES when ‘expected interest volatility’
INCREASES. -------- CONTINUED-----
14
• In the case of a CALLABLE BOND or in the case of a MORTGAGE
BACKED SECURITY, in which the investor has granted the ISSUER an
option, the price of the Security FALLS as, the Investor has given away
a very valuable option. The risk that a CHANGE in VOLATILITY will
affect the PRICE of a Bond is called ‘Volatility risk’
• RISK, RISK
• Is NOT KNOWING the RISK OF A SECURITY; this could happen when
the Bond gets saddled with several embedded features not all of which
subject themselves to to financial evaluation! While the future is not
very predictable, there is no reason why the outcome of an Investment
strategy cannot be known in advance
• There are 2 ways to MITIGATE these risks
• 1)Extensive use of research models to evaluate these securities
• 2) Generally trying to AVOID investing in Securities that CANNOT be
understood!
15
• Pricing of Bonds
• Future Value Pn= Po (1+r)^n when interest is
paid once a year
• Interest paid more than once a year
• r = ___Annual interest rate_________
• no. of times interest is paid per year
• If interest is 9.20 Rs/ annum, period 6years and if
payment are semi-annual
• r =0.092 /2 =0.046 n=2*6=12
• If Rs 10m is invested,
• P12= 100,00,000 (1+0.046)^12 =$171,54,600
•
• Future Value of an Ordinary Annuity
16
• F.V.= A{ (1+r)^n-1}
• r
• Suppose a Portfolio Manager purchases $ 20 million par value 15 yr. 10% bond. Interest is paid
yearly. How much will the Portfolio Manager have if a) If the bond is held to maturity? B) annual
payments are reinvested at 8%p.a?
• The Portfolio manager will have—
• A) $ 20 million when the Bond matures
• B)15 annual interest payments of $ 2 million
• C) The RE-investment returns @8%
•
17
• If we rework assuming that the Bond is being
paid every 6 months ( based on Annual rate)
with immediate reinvestment @ 8%p.a.
• Interest 6 monthly 200,00,000*6/12*10/100 =
$ 10,00,000=A
• R=0.08/2 = 0.04, n= 15*2=30 periods
• P30= 10,00,000{( 1.04)^30-1}=560,85,000
• 0.04
• Maturity value-> $ 200,00,000 Interest-> $
300,00,000 Therefore, interest on re-
investment of interest is $ 260,85,000/-
18
• Present Value of any inflow/outflow=
• Po= Pn{1/ (1+r)^n}
• “If the Present Value of a $ 50,00,000/ bond
@10% over 7years is $ 25,65,791/-” means-
this sum of $ 25,65,791/ - at 10% p.a. over a
period of 7 years will grow to $ 50,00,000/ If this
Financial instrument is trading for MORE THAN
$ 25,65,791/-now, a person investing in it now
will get less than 10% when it matures 7 years
from now
19
• There are 2 properties of a present value-
• A) For a GIVEN FUTURE VALUE, at a specified time in the
future, the HIGHER the interest rate or the Discount rate, the
LOWER the Present Value AND
• The HIGHER THE INTEREST RATE, on any sum to be
invested today, the LESSER the Investment to realize a
specified future sum
• B) For a given Interest rate, (discount rate) the FURTHER
into the Future the future value is received, the GREATER
the period for the interest to accumulate and GREATER the
sum. To accumulate a certain sum, greater the interest rate
and greater the period it t is allowed to accumulate, the
LESSER the Principal required to accumulate it!
20
• Present Value of an Ordinary Annuity
• P.V.a= A{ (1+r)^n-1}
• {r(1+r)^n }
• The terms in the brackets denote the Value of an
Ordinary Annuity of $1 for n periods
• Suppose the Investor expects to receive $100 at
the end of each year for the next 8 years, and if
the cost of capital is 8%, the PV of the Annuity-
• PVa= 100{ __(1.09)^8-1)} = 553| 48 $
• { .09(1.09)^8 }
21
• P.V. annuity- payments occur >1/year
• 1) Annual interest rate is to be divided by 2 if
semiannual; by 4 if Quarterly etc
• 2)The annual periods are to be adjusted by
multiplying by 2 for semi-annual payments and
by 4 for Quarterly payments
• --------------------------------------------------
• BOND PRICING
22-BOND PRICING
• The Price of any Financial Instrument is equal
to the Present Value of the Expected cash
flows from the instrument. Therefore
determining the prices requires
• a) An ESTIMATE of the EXPECTED CASH
FLOWS
• b) An ESTIMATE of the APPROPRIATE
REQUIRED YIELD
• The “required yield” reflects the yield for
financial instruments with COMPARABLE
RISK or, ALTERNATE/ IDENTICAL/
SUBSTITUTE Instruments
23
• The Cash flows of a non-callable bond would be—
• 1) Periodic coupon interest payments to the Maturity
date
• 2) the Maturity Value
• Our assumptions in calculating cash flows
• a) Coupon payments are semi-annual
• b) The coupon interest is FIXED for the term of a Bond
• For a 20 year bond with a 10% coupon rate and a par
value $1000/- has the foll. Cash flows
• Annual coupon interest= $1000* 0.10= $100/-
• Semi-annual interest= $100/2= $50
• Or, r/2=5% 5%*1000$=50$
• There are 40 semiannual cash flows of $50 and a final
1000$ flow ---contd--
24
• The ‘Required yields “ is an ‘opportunity
concept” and is determined by checking the
yields offered on ‘Comparable bonds in the
Market”. By ‘comparable” we mean ‘Non-
callable” bonds of the same CREDIT QUALITY,
same Maturity etc. The Required Yield is
expressed typically as an “Annual Interest rate’
When the cash flows occur semi-annually, the
market convention is to use ONE-Half the
annual Interest Rate as the periodic interest
rate with which to DISCOUNT the Cash Flows
25
• Price P= C + C2 + Cn +M
• (1+r) (1+r)^2 (1+r)^n (1+r)^n
• Where n no.of periods, C=peiodical
coupon payments; M maturity value
• Consider a 20year bond 10% coupon
bond of par value $1000/ If the Required
yield is 11% and the coupon are paid
semi-annually, the Price of the Bond can
be calculated thus---
26
• The semi-annual coupon payments are equivalent to an
Ordinary annuity, the PV is = C{( 1+r)^n-1}
• (1+r)^n*r
• There are 1) 40 semi-annual coupon payments of $50
each 2) $1,000? Is to be received 40 six months from
now
• 50{ (__1.055)^40-1}__ = $ 802.31
• (1.055)^40 (0.055)
• PV of Maturity value= 1000/ (1.055)^40= $117.46
• PRICE of the Bond=802.31+ 117.46= 919.77
• Suppose instead of 11% yield,(5.50% for 6 months, the
Required yield is 6.80%
• CONTD.
27
• Price of the bond
• 50{(1.034)^40-1} = 50(21.69029)
• {.034) (1.034)}
• = 1084|50
• The PV of the Maturity amount= 1000/
(1.034)^40 = 262.53
• PRICE= 1084|50 + 262|53= 1347|04
• If the Required yield were EQUAL to the
coupon rate of 10%, the price of the Bond
would be equal to its Maturity Value of Rs.
1,000/- ( Verify this)
28
• Pricing Zero coupon Bonds
• Some bonds DO NOT make any “periodic
coupon payments”. Instead, the Investor realizes
the interest as the ‘difference between the
Maturity value and Purchase price” These
bonds are called “Zero coupon bonds’
• The Price of a zero Coupon bond=
• Po= M/ ( 1+r)^n ! ( because all C’s are zero)
• Note In PV calculations, it is the number of
half- years and NOT the no. of years that are
used!
29
• The Price of a $1,000/- zero coupon bond which
matures 15 years from now with a required yield
• r=0.094/2= 0.047 n=30
• P= $1000 / (1.047)^30= $252|12
• -----------------------------------------------
• Price- yield relationship
• The fundamental property of a bond is that “its
price moves in the opposite direction to its
required yield” REASON; the Price of a Bond
is the PV of its cash Flows. A higher required
return leads to a Lower ‘discounted value” and
vice-versa!
• The Price-yield relationship is a Convex curve
30
• Coupon rate, Required yield, Price relationship
• As Yields in the Market place change, the only variable
that can change to ‘compensate’ for the NEW
required rate of return is the PRICE of the bond
• When COUPON rate is EQUAL to the REQUIRED RATE
, the Price of the bond will be equal to its PAR VALUE
• When YIELDS in the Market place RISE above the
Coupon rate, at a given point in time, the PRICE of the
Bond ADJUSTS itself so that investors
contemplating the purchase of the bond can realize
some ADDITIONAL INTEREST! If it did not, the
Investor would NOT buy this Bond! A lack of
Demand would push the prices down- making this
bond attractive too!
31
• Yield to call
• In respect of callable bonds, the Price at which the Bonds may be called is
called the ‘call price’. For some issues, the CALL PRICE IS THE SAME
REGARDLESS OF WHEN THE BOND IS CALLED. For other callable
issues, the call price depends on when the Issue is called. That is there is a
CALL SCHEDULE that specifies a CALL PRICE for EACH CALL DATE!
45
• For Callable Issues, the practice has been to calculate BOTH a Yield to call
and a Yield to Maturity. The YTC assumes that the Issuer will call the
Bond at some CALL DATE. Typically investors calculate a YIELD TO
FIRST CALL and a YIELD TO PAR CALL; yield to par value is when the
Issuer can call the Bond at Par Value
• For ANY YTC one needs to look at the Cash flows till the Call date as
well as the amount receivable as Capital sum on the assumed date of
call(M)
• To illustrate, consider an 18 yr 11% coupon Bond with a Maturity value of $
1000/ selling for $1,169/- suppose the FIRST call is 8 years from now and that
the call price is $1,055/- The Cash flows for the bond if called in 13 years
are---
• 1) 26 coupon payments of $55/ (i.e. 11/100*1000=110/2=55)
• 2) $1,055 due in 16 six months periods from now
• Date of_____________ issuer eligibility_______________ CALL Made
• Issue Year 8 at $1,055 13th year
• Yr0----3Yr---------| |-------------------------------Yr 20
• $258.74 1098.67
• PV of 34 coupons+ PV of $1000
• Total= $ 1357.25
• Step 4 To obtain semi-annual return
• {1,357.25} ^1/6 -1 = .0858= 8.58%
• { 828.40 }
• Step 5 Double 8.58% for a total return of 17.16%
68
• APPLICATION OF THE CONCEPT OF TOTAL RETURNS
• Horizon Analysis allows a Portfolio manager to project the
performance of a bond on the basis of Planned Investment Horizon
and ‘expectations’ concerning reinvestment rates and ‘future market
yields’. This permits the Portfolio manager to evaluate which of the
several potential bonds considered for acquisition will perform
the best over the planned Investment horizon.
• This job cannot be done using YTM– hence the need for ‘total
return concept’/ ‘Horizon Analysis’
• Horizon Analysis can also be used for ‘Bond swaps’. One
evaluates the total returns of a bond in a Portfolio WITH
another Bond outside the Portfolio with an idea of a SWAP
• Limitations
• 1) Reinvestment rates 2) Investment Horizon #) Future yields
and Projected sales price
• Bond Price Volatility
69
• To employ effective Bond Portfolio Strategies, it is essential that one
understands ‘volatility in the prices of Bonds, consequent to a change in
the rate of Interest in the Economy.
• This Principle flows from the fact that the price of a Bond is equal to
the PV of the Expected Cash Flows from it. An Increase/ (Decrease) in
the REQUIRED YIELD decreases( increases) the PV of its expected
cash Flows and therefore decreases( increases) the Bond’s Price
•
70
• The Sensitivity of Bond Prices to change in interest rates is measured
by the ‘Duration of a bond’. There is an Inverse relationship
between bond prices and yields, as we have seen already. As interest
rates move up or down, bond holders experience Capital losses or
Capital gains. These gains or losses make Fixed income investments
‘risky’ even if the Coupon & Principal payments are guaranteed!
• Why do Bond Prices respond to changes in Interest rates?
• In a competitive market all securities must offer the Expected rate of
return . If interest rates increase from 8% to 9%, the 8% bond loses
ground so that the YIELD, as a consequence, is 9%! Likewise the fall
in interest rates from 8% to 7% makes the 8% Bond attractive. The
Yield falls to around 7%, pushing the Price up in the process
•
71
• It is interesting to note that ‘decreases in yields ‘ have a
BIGGER impact on prices THAN increases in yields of EQUAL
MAGNITUDE have on prices! An increase in the bond’s ‘yield
to maturity’ results in a SMALLER PRICE
CHANGE( downwards) than a decrease in the bond yield of
‘equal magnitude’
• The other interesting observations—
• ---Prices of LONG TERM Bonds tend to be MORE SENSITIVE to
interest rate changes THAN prices of short term bonds
• It is plain that longer the period, greater the uncertainty and
greater the sensitivity
• ---The sensitivity of the Bond Prices to CHANGES IN YIELDS
increases at a DECREASING RATE as Maturity increases.
• In other words, INTEREST RATE RISK is less than proportional
to ‘period to maturity’
72
• --Interest rate risk is INVERSELY related to the BOND’s Coupon
rate
• Prices of ‘high coupon Bonds’ are LESS SENSITIVE to changes in
Interest rates THAN the PRICES of LOW COUPON BONDS
• ---The Sensitivity of a Bond’s Price to a CHANGE IN YIELD is
INVERSELY RELATED to the YTM at which the Bond is
currently selling
If Bonds C and D are identical EXCEPT for their YTM’s, Bond C with
a HIGHER YTM, is LESS SENSITIVE to changes in Yields than
Bond D
The first five rules are called “ Malkeil’s Bond Pricing
Relationship’ while the last was demonstrated by Homer
73
• The 6 propositions confirm that Maturity is
a MAJOR determinant of Interest rates.
However they also show that MATURITY
ALONE is NOT sufficient to measure
interest rate sensitivity . For ex. Bonds B
and C could have the same maturity (30
yrs.) but a higher coupon rate in Bond B
gives it lower sensitivity in bond PRICES
to interest rate changes. Obviously we
need to know MORE THAN a Bond’s
maturity to quantify its interest rate risk!
74
• To see why Bond characteristics such as
Coupon rates or YTM affects interest rate
sensitivity, let us start with a simple
example. The table gives Bond Prices for
8% semiannual coupon bonds at different
a) Yields to maturity and b) Time to
Maturity T
• YTM T=1yr T=10yr T=30 yrs
• 8% 1000 1000 1000
• 9% 990.84 934.96 907.99
• 0.94% 6.50% 9.20%
75
• Prices of zero coupon Bond (semi annual
compounding)
• YTM T=1yr T=10 yrs T=20 yrs
• 8% 924.56 456.39 208.19
• 9% 915.73 414.64 171.93
• Change 0.96% 9.15% 17.46 %
• In price %
76
• The interest rates are expressed as an Annual
Percentage rates (APR) meaning that 6 months
yield is doubled to obtain Annual yields.
• The shortest term bond (1yr) falls by <1% when
interest rate increases from8% to 9% ie 1%).
The 10 yr bond falls by 6.50%!! And the 20 yr by
>9%!!! The SAME computation in a Zero coupon
bond above shows that for EACH MATURITY,
the PRICE of a zero coupon bond falls by a
greater proportional amount than the price of
a 8%(non-zero bond)!
77
• We know that LONG TERM BONDS are MORE sensitive to interest
rate changes than short term bonds. The 20 yr,8% bond makes
many coupon payments ALMOST ALL OF THEM coming obviously
BEFORE the BOND’S MATURITY DATE. EACH of these payments
may be considered to have its own Maturity date In this sense, a
Coupon Bond is a Portfolio of coupon payments. The
EFFECTIVE MATURITY of a Bond is therefore some sort of an
AVERAGE of the maturities of ALL cash flows paid by the
bond. The zero coupon has a well defined maturity concept—at
the end of its life!
• Higher coupon bonds have a HIGHER fraction of value tied to
coupons RATHER THAN to the (closing) or PAR VALUE . So the
‘portfolio of coupons’ is more heavily weighted towards the
EARLIER SHORT TERM PAYMENTS which gives it LOWER
EFFECTIVE MATURIRT! This explains the fifth rule that ‘price
sensitivity falls with coupon rate!
78
• Similar logic explains the 6th rule that price
sensitivity falls with yield to maturity. A
higher yield REDUCES the PV of ALL of the
bond’s payments; but more so, for the the
MORE DISTANT PAYMENTS. Therefore, at
Higher yields, a HIGHER fraction of the
Bond’s value is accounted for by EARLIER
receipts and hence have LOWER EFFECTIVE
MATURITY and INTEREST RATE
SENSITIVITY. The overall sensitivity of the
bond’s price to changes in yield is thus
LOWER
79-Duration
• We need a measure of AVERAGE MATURITY of a Bond’s promised
cash Flows to serve as a useful summary statistic of the EFFECTIVE
MATURITY OF THE BOND. We would also like to use the measure as
a guide to the Sensitivity of a Bond reacting to the changes in
interest rates, because we have noted that the PRICE SENSITIVITY
tends to increase with the TIME TO MATURITY
• Fredrick Maculay termed this “Effective maturity concept”, the
DURATION of the Bond ( basically an AVERAGE maturity concept)
• Maculay’s Duration is computed as the “weighted average” of the
TIMES of each coupon or Principal payment made by the bond.
The weight associated with EACH payment time clearly, should be
related to the importance of that payment TO the VALUE OF THE
BONDthat is accounted for by THAT PAYMENT This PROPORTION
is just the PRESENT VALUE of the payment DIVIDED BY THE
BOND PRICE!
•
80
• Characteristics of a bond that affect its Price Volatility
• There are 2 characteristics of an Option Free Bond that
determine its Price Volatility 1) Coupon rate 2) Term to Maturity
• Characteristic 1; For a given TIME TO MATURITY and INITIAL
YIELD, the Lower the Coupon rate, GREATER the PRICE
VOLATILITY
• Characteristic 2 ; for a given COUPON RATE , the LONGER the
TIME TO MATURITY, the GREATER the PRICE VOLATILITY
• An application of the 2nd characteristic is that investors who
want to increase a Portfolio’s Price Volatility BECAUSE THEY
EXPECT THE INTEREST RATES TO FALL, (other factors held
constant), SHOULD HOLD BONDS WITH LONG MATURITIES IN
THE PORTFOLIO. Just the same way, in order to subject
oneself to a LOWER PRICE VOLATILITY in a RISING RATE
REGIME, one should hold Portfolios of bonds WITH SHORT
TIME TO MATURITIES
81
• Effects of YTM
• We cannot ignore the fact that CREDIT CONSIDERATIONS cause
different bonds to trade at different yields, EVEN IF THEY HAVE
THE SAME COUPONS AND THE SAME MATURITY It is seen
that Higher the Initial Yield, LOWER the Price Volatility , when a
change in the Yield takes place
• Measures of Bond Volatility
• There are 3 measures commonly employed to measure the
‘Price Volatility’ of a Bond
• 1) Price value of a Basis Point
• Also referred to as a Dollar Value of an 01 it is the CHANGE in
the PRICE of a Bond if the REQUIRED YIELD CHANGES BY 01
Basis Point. This exhibits “Dollar Price Volatility” as opposed
to the Percentage Price Volatility( Price change as a % of Initial
Price).
82
• Price Value of a Basis Point
• Bond Initial Price Price @ 9.01% Price value
• @9% yield yield of a Basis Point
• 5yr 9% coupon 100.000 99.9604@ 0.0396 ( 100-99.9604)
• 25yr 9% coupon 100.000 99.9013 0.0987
• 5Yr 6% coupon *** 88.1309 88.0945 0.0364
• 25 yr 6% coupon 70.3570 70.2824 0.0746
• 5 yr zero coupon++ 64.3928 64.3620 0.0308
• 25 yr zero coupon 11.0710 11.0445 0.0265
• @ 9/1.0901+9/1.0901^2+---109/1.0901^5=99.9604
• ***6/1.0901+ 6/1.0901^2+----6/1.0901^5+ 100/1.0901^5
• ++ 100/1.0901^5
• Note; Some small differences seem to be cropping up in the
calculations—check why
83
• Yield Value of Price change
• Another measure of the Price Volatility of a Bond used by
investors is the change in the yield for a SPECIFIED PRICE
CHANGE. This is estimated by FIRST CALCULATING the
Bond’s YTM If the Price decreases by X dollars. The difference
between the INITIAL YIELD and the NEW YIELD is the YIELD
VALUE of an “X Dollar Price Change” The SMALLER this value,
the GREATER the Price Volatility—the reason; it would take a
SMALLER CHANGE IN YIELD, to produce a PRICE CHANGE OF
X Dollars!
• Treasury Notes and Bonds Quoted in 32nds of a Percentage point
of Par. Consequently, in the Treasury Market, investors compute the
Yield value of a 32nd!
84
• BOND Initial Price Yield at Initial Yield Yield Value
• minus a 32nd New Price of a 32nd
• 5yr,9% 99.96875# 9.008** 9.000 0.008
• 25yr,9% 99.96875# 9.003 9.000 0.003
• # 100-(1/32*1)
• ** 99.96875= 9/(1+x) + 9/(1+x)^2+------109/(1+x)^5
• By trial & Error, x=1.09008
• So the New Yield= 0.09008 or 9.008
• By similar process the Value of an 8th can also be calculated
•
85-Bond Duration
• The Price of an ‘option free bond’ can be expressed as
• P=C/(1+y) + C/ (1+y)^2+---C/(1+y)^n+ M/ (1+y) ^n-----(1)
• Where ‘n’ is the no. of Semi-annual periods (yrs*2)
• Now if the required Yield is changed by a very small amount,
what happens to PRICE is the question
dP/ dY = -- 1/(1+y){ __1C_ + __2C__ ------ nC___ +nM___} ----(2)
{(1+y) (1+y)^2 (1+y)^n (1+y)^n}
The terms in the Brackets indicate the WEIGHTED AVERAGE
“term to Maturity” of the CASH FLOWS from the Bond where the
weights are the PRESENT VALUES of the CASH FLOWS
Dividing Both the sides by P, we get the approximate PERCENTAGE
PRICE CHANGE
dP/dY*1/P = -- 1/(1+y){ 1C_+__2C__+-----nC___- + __nM} _1__ -(3)
{ (1+y) (1+y)^2 (1+y)^n (1+y)^n} P
The Expression in the Brackets Divided (or Multipled by the
reciprocal) of the Price is called MACAULAY DURATION
86
• Macaulay Duration
• _1C___ + __2C___ +___3C-_+ nC-__ +__nM__
• (1+y) (1+y) ^2 (1+y)^3 (1+y)^n (1+y)^n
• __________________________________________ -----(4)
• P
• Which is SUM __tC__ + __nM__
• (1+y)^t (1+y)^n
• ---------------------------- ----(5)
• P
• Substituting (5) in Equation (3) above’
• dP/ dY *1/p = -- 1/(1+y) * Macaulay Duration---(6)
• This is called MODIFIED DURATION
87
• Modified Duration= Macaulay Duration / (1+y)-----(7)
• Substituting Equation (7) into (6)
• dP/dy * 1/p = -- Modified duration -(8)
• Equation (8) states that MODIFIED DURATION is related to the
approximate PERCENTAGE CHANGE in PRICE for a GIVEN CHANGE
IN YIELD
• Because for all OPTION FREE BONDS, MODIFIED DURATION is
POSITIVE, Equation (8) states that” there is an INVERSE
RELATIONSHIP between MODIFIED DURATION __and_ “the
approximate PERCENTAGE CHANGE IN PRICE __for_ a GIVEN
CHANGE IN YIELD” ( this flows from the principle that ‘Bond prices move
Opposite to the direction of change in Interest rates)
• Duration in YEARS= Duration in ‘m’ periods per year
• m
•
88
• Fredrick Macaulay coined this term and used this measure as a PROXY
FOR THE AVERAGE LENGTH OF TIME , a Bond is OUTSTANDING
• To deal with the AMBIGUITY of the ‘Maturity of a Bond making several
payments”, we need a measure of AVERAGE MATURITY of the Bond’s
promised cash flows to serve as a useful statistic of the “EFFECTIVE
MATURITY OF A BOND”
• This measure serves as a GUIDE to the SENSITIVITY of a Bond to
INTEREST RATE CHANGES, because we have noted that’the Price
sensitivity tends to INCREASE WITH INCREASE IN TIME TO
MATURITY”
• Macaulay Duration is computed as the ‘weighted average’ of the TIMES to
EACH PAYMENT ( whether coupon or Principal payment) made by the
Bond. Therefore, the weight associated with Each PAYMENT TIME should
be related to the importance of THAT payment TO the PRICE of the
BOND. Therefore the WEIGHT applied to EACH “payment time” should
be “ the PROPORTION of the TOTAL Value of the Bond that is
ACCOUNTED for, BY THAT PAYMENT” . THIS PROPORTION IS THE
“Present value of the payment DIVIDED BY the Bond Price!
89
Macaulay’s duration and Modified duration for 6 hypothetical Bonds –
Bond Macaulay Duration Modified Duration
9% 5Yr 4.13 3.96
9% 25 yrs 10.33 9.88
6% 5yr 4.35 4.13
6% 25 yr 11.10 10.62
0% 5yr 5.00 4.78
0% 25yr 25.00 23.92
Rather than use Equation (5) and then Eqn. (7) to obtain Modified
duration, we derive an Alternate Formula that Does NOT require
Extensive calculations required by Eqn.(5). This is done by re-
writing the PRICE of a BOND in terms of 2 Components--;
1) The PV of the ANNUITY where the annuity is the Sum of the
Coupon payments
2) The PV of the PAR VALUE
90
• The Price of the Bond can be written as
• P= C { {1- __1__ }
• {___{ (1+y)^n }__ + ___100____
• { y } (1+y)^n
• Macaulay & modified duration of a 5Yr 65 Bond selling to yield 9%
• Coupon rate 6%, 5Yr, Par value 100$
• Period Cash flow PV of $1@4.50% PV of CF t*PV C/F
• 1 2 3 4=2*3 5=4*1
• 1 $3.00 0.956937 2.870813 2.870813
• 2 do 0.915729 2.747190 5.49437
• 3 do 0.872696 2.628890 7.8866
• 4 do 0.838561 2.515684 10.06273
• 5 do 0.802451 2.407353 12.03676
• -
• 10 103 0.643927 66.324551 663.24551
• 88.130923 765.8952
91
• Macaulay Duration in Half-Years = 765.8950 / 88.130923= 8.69
• ____do___ in years= 8.69/2 =4.35
• Modified Duration 4.35/(1+.0450) = 4.16
• NOTE Column 2= 6$/2 =3$, Column 3= 1/(1.0450)^n The Period in Column
is Half years ANOTHER METHOD 8% coupon Bond
Period Time to Cash flow PV of Weight Column (B)
• payment Cash Flow times Column (E)
• A B C D E F=B*E
• 1 0.50 yr 40 38.095 0.0395** 0.0197
• 2 1.0 40 36.281^^ 0.0376 0.0376
• 3 1.50 40 34.554 0.0358 0.0537
• 4 2.00 1040 855.611 0.8871 1.7741
• sum 964.54 1.000 1.8852(Duration)
• Weight=PV of Each Payment /Bond Price= D column / D Total
• =38.095 /964,54= 0.0395**
• 40/ (1.05)^n = 40/1.05^2 = 36.281^^Yield assumed is10%or5% for half year
92
• For a Zero coupon bond since cash flows are zero till period of
maturity( say 2 yrs) the Duration is Obviously 2 yrs( the full weight
1.00 comes in year 2 ; till then it is 0 all the way!) So the Duration of
a zero coupon bond is EQUAL to its TIME TO MATURITY
• The coupon payments being made before maturity, the Effective
Maturity( weighted average maturity) is LESS than Actual time to
maturity, for all coupon bonds
• Duration is a Key concept in FIXED INCOME PORTFOLIO
MANAGEMENT for at least 3 reasons—
• 1) It is a simple statistic of the EFFECTIVE AVERAGEMATURITY of
the Portfolio
• 2)It is an essential tool in IMMUNIZING a Portfolio from Interest rate
risk
• 3) It is a measure of the Interest rate sensitivity of a Portfolio
93
• It can be shown that Delta P/ P= --D* delta Y --(1)
• Where D* is called MODIFIED DURATION. This in turn is
something like the “Present value of Duration’
• Delta y=delta (1+y)=change in the YTM
• It can be shown that when interest rates change, the
PROPORTIONAL CHANGE in a Bond’s Price can be related to a
“change in its YTM” i.e “y”
• Referring to the Equation(1), we can say that a percentage
change in a Bond’s Price is nothing but “the Product of
Modified Duration and a change in the Bond’s Yield to maturity
• Because the Percentage change in a Bond’s Price is
PROPORTIONAL to the MODIFIED DURATION, the Modified
duration is a Natural measure of the Bond’s Response to
changes in interest rates
•
94
Consider a 2 year maturity 8% coupon bond making semi-annual payments
and selling at $964.54, for a YTM of 10%. The Duration of the Bond is
1.8852 years (seen earlier) or 1.8852* 2=3.7704 periods (half-years) with a
per period interest rate of 5%. The Modified duration of the bond is
3.7704/ (1+r)= 3.7704 /1.05=3.591 periods
• Suppose the semi annual interest rate increases from 5.0 to 5.01%. The
Bond Prices should FALL BY delta P/ P=-D*delta y= (3.591)*0.01=--
0.3591%
• Computing the Price change of the bond DIRECTLY, the Bond PRICE
will Fall by 964.54* .03591/100 = 0.3464
• Price= 964.54-0.3464=964.1936$
• The Zero Coupon 2year Bond initially sells for 1000/ (1.05)^3.7704=
831.9704. At HIGHER YIELDS the Bond sells for1000/(1.051)^3.7704=
831.6717$ This Price ALSO FALLS BY 0.0359%
• We Conclude that Bonds with EQUAL DURATION do in fact have
EQUAL INTEREST RATE SENSITIVITY! And that (atleast for small
changes in Yields) the PERCENTAGE PRICE CHANGE is the
“Modified Duration TIMES the Change in Yield delta P/P= -D*delta y
95
• What is it that determines “DURATION”?
• Malkeil’s Bond Price relations seen earlier characterizes the
DETERMINANTS of INTEREST RATE SENSITIVITY. Duration
helps us Quantify that sensitivity This helps us in devising
Investment Strategies!
• Put up the Chart Pg 8 here
96
• Rule 1 for Duration
• The Duration of a Zero coupon Bond is Equal to its Maturity-
already seen
• Rule 2 for Duration
• Holding MATURITY CONSTANT, a Bond’s Duration is HIGHER
when the COUPON RATE IS LOWER!
• Let’s look at a Bond which offers HIGHER Cash flows in the
Initial Years and a Lower Cash Flow in the LATER years. The
bond duration for this Bond will be LOWER than the Duration
of another Bond that HAS THE SAME ‘time to maturity” but
whose initial cash flows are lower and later cash flows higher.
This is because Higher weights are attached to higher cash
flows in the initial periods in the earlier bonds.
• This is corroborated by the Chart in #95 where the plot of the
15% coupon lies below the plot of the 3% coupon( though both
have the same YTM)!!
97
• Rule 3 for Duration
• Holding Coupon rate Constant, a Bond’s Duration
GENERALLY increases with it’s TIME TO MATURITY
• Duration ALWAYS increases for Bond’s selling at PAR or at
PREMIUM compared to the one selling at discount
• This Property corresponds to Malkiel’s 3rd relationship. What is
however surprising is that the Duration NEED NOT necessarily
INCREASE with Time to Maturity! For some Deep Discount
Bonds THE DURATION MAY ACTUALLY FALL WITH INCREASE
IN MATURITY!!!. Generally however—excepting these discount
Bonds– it is safe to assume that Bond duration INCREASES
with increase in Time to maturity!
98
99
100
101- Working capital
• C/A refers to those Assets that get converted to
Cash within 1 year, WITHOUT--;
• A) undergoing a diminution in value
• B) disrupting the Operations of the firm
• Current liabilities are those liabilities which are
intended, at their inception, to be paid 1) in the
Ordinary course of the business within 1 year 2)
from out of the current assets 3) or, from out of
the Earnings of the firm
• Gross working capital= Total current assets
• Net W/c= C/A- C/L
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• Sometimes, the term ‘Working capital’ is referred to as
that PORTION of the Current assets that are financed
from out of LONG TERM FUNDS ( because the
‘differential amount of the ( excess) of the C/A over the
C/l is a ‘PERMANENT FEATURE’ of any going concern!
• The 3 basic features reflecting the LIQUIDITY in a firm
are– 1) Current Ratio 2) Acid test ratio 3) NWC
• NWC helps in comparing the Liquidity of the SAME firm
“over time” The Goal of a Finance manager is to
maintain current assets and Current Liabilities in
such a way that an a acceptable level of NWC is
maintained Greater the NWC or, the Excess of C/A over
C/L, the Greater the ability of the firm to pay up
obligations when they become due. It is the non-
synchronous nature of cash flows that makes NWC
necessary! Cash ‘outflows’ especially payments of
current liabilities, are quite predictable—contd.
103
• It is only the Current assets—especially the ‘receipts
from the Debtors” that is quite ‘unpredictable’! NWC
funding also becomes necessary as cash outflows and
cash inflows do not match due in 1) quantum 2) Timings