FIN 6302, Advanced Financial Management 1

Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:

5. Propose international and ethical considerations to financial decision-making. 5.1 Apply understanding of differences between risk and return. 5.2 Compute the capital asset pricing model.

Course/Unit Learning Outcomes

Learning Activity

5.1 Unit Lesson Chapter 10 Chapter 11

5.2 Unit Lesson Chapter 10 Chapter 11

Required Unit Resources Chapter 10: Some Lessons from Capital Market History Chapter 11: Risk and Return

Unit Lesson Introduction Corporations and government agencies need access to capital. Capital is what is necessary to support both current operations and growth. There are a variety of ways to meet capital needs, but the financial markets provide the easiest avenues. Financial managers use securities to meet these needs. Investors provide the capital through their investing. In this unit, we will look at both sides of the transaction. We will explore how firms and investors find ways to efficiently and effectively invest funds to grow their wealth. In essence, we will analyze the capital market itself. Capital Market Risks Investors and those supporting them, such as investment managers and financial planners, are not only concerned with returns on their investments but also with the risk that is taken to achieve those returns. It is critical to understand that the relationship between risk and reward is essential in making good decisions and achieving financial goals. Individuals and businesses purchasing investments face a variety of risks. Risk can be measured in an assortment of ways, including volatility (i.e., achieving a return that is different than expected). While a loss on an investment is a measure of risk, so is a smaller return. For example, what if there is a return of only 3% on an expected return of 8%? Measures such as standard deviation, variance, and beta quantify risk and provide means to study risk and make portfolio and other adjustments to mitigate risk in meaningful ways. Volatility is caused by a variety of underlying risks. With the possible exceptions of treasury bills, all securities face some type of credit risk. Viewed another way, it is likely that the issuer may become insolvent. In a business, this risk is associated with a failure to earn the required rate of return that the firm must make to

UNIT VII STUDY GUIDE

Capital Market Considerations

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cover its costs. Prices for securities are also impacted by macroeconomic variables like interest rates, currency exchange rates, and inflation. Other risks exist such as re-investment risk, which is the risk of only being able to invest in low-return projects when a current investment ends. Other types of risk are reputational and political. Reputational risk can lead to lower sales, cash flows, income, and legal costs. Political risk can challenge industries through changes to regulations and taxes. Tools to Measure Risk Standard deviation and variance are statistical tools often used to measure risk. Standard deviation is a measure of the dispersion of returns around an expected or average return. This number will be less for a lower variability. Risk can be viewed for a single asset or a portfolio of assets. For portfolios, risk can be systemic and unsystematic. Systemic risk is tied to the market and cannot be reduced through diversification. Unsystematic risk can be reduced by diversification of assets in a portfolio, and applications to do this are covered later in the course. Beta measures risk that cannot be diversified and measures relative risk of a single asset to a related market measure. Various Types of Return Returns on securities usually include a component of income as well as a capital gain or loss during the holding period of the asset. Examples of that are dividends, interest, and premiums on options. Returns can be stated in terms of currency values but are usually provided on a percentage basis to provide for comparisons between investments. Nominal returns are gross returns measured in current currency levels, whereas real returns are adjusted for inflation. Holding period return (HPR) is one measure of return used for short-term assets and combines capital gain (loss) with any dividends or interest received over the period of focus. When comparing assets, the holding periods must be comparable. HPR is used for periods of less than a year, as annualized returns are typically calculated for longer periods. Rates of returns can be measured at the individual asset level or for a collection of assets. The returns on assets are also framed based on the risk profile. Investors expect the opportunity for higher returns for more risky assets, so there are tools to measure this relationship that extend analysis beyond just the expected return. Efficient Market Hypothesis Investors and others engaged in the financial markets need to understand how markets operate and how investments perform. It is important to understand the basic theories and how they function in setting the price of securities. An understanding of these concepts allows for the construction of the models that financial professionals develop to assist in increasing their customers' wealth. By exploring the relationships between information, analysis, and performance, those engaged in investing can seek ways to maximize returns. The efficient market hypothesis is a key market analysis tool. Efficient market hypothesis is the theory that it is impossible to beat the market as security prices already reflect all known information. This theory has been broken down into three levels. They are the strong form, the semi-strong form, and the weak form. The strong form assumes that all information that exists at all, publically or privately, is reflected in the current stock price. The semi-strong form assumes that all public information is reflected in the current stock price. The weak form makes the assumption that the only thing that the stock price reflects is the information about past prices. There is significant evidence of investors who have beaten the market by superior analysis, but the theory still is of use in analyzing security price movement, and the semi-strong level has at least some analytical support. The theory is also a reminder that superior performance is not always because of superior analysis; rather, it can merely be a result of a random-walk, which is the recognition of short-term statistical out-performance. There are different levels of efficiency in processing information. Market efficiency is a related concept and measures how quickly a market reacts to new information. U.S. markets react immediately to an

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announcement of a merger; a negative earnings announcement, which was not expected; or a change in leadership. Some emerging markets may not reflect this reaction. Pricing efficiency is another measure of a market's efficiency. Some markets are more efficient than others. Large companies that are traded on the main exchanges around the world are usually covered by numerous analysts who compete for clients based on their ability to predict future company performance. It is difficult for investors to beat the market in these well-covered stocks. In emerging markets and even in the case of small companies in established markets, there may be few or no analysts. These situations may be related to opportunities for investors to find price anomalies and take advantage of efficiencies. Diversification Assets, such as financial securities, are exposed to volatility in the financial markets, U.S. and global economies, government regulations and taxes, interest rates, and currency exchange rates. Additionally, each firm or project has its own unique type of uncertainties. Firm specific risks can be addressed through diversification. Diversification is an approach that looks at investing through a portfolio. By structured methods, investors can minimize volatility (risk) by selecting assets with limited correlations. Simple ways to do this are to choose stocks from different industries, locations, and sizes along with other asset types, like bonds and commodities. Even choosing two stocks in the same industry may lower risk. For example, Tesla and General Motors (GM) will have different factors impacting stock prices, including a different product mix and different geographic footprints. To help visually demonstrate the impact of diversification, consider the following example. Assume two stocks (A and B) are available to the investor. Stock A is a stable, large capitalization stock with a low standard deviation (volatility of returns). Stock B is from an emerging market and has a wide distribution of possible returns (high standard deviation) due to the volatility of its home currency, unstable government, and inconsistent management. Diversification is an important concept to understand because it can achieve a high relative return for a specific level of portfolio risk. Portfolio objectives vary for each investor. Institutional investors, like foundations and pension funds, may need a portfolio of assets that generate regular cash flows to fund grants and retirement payouts. Other institutional investors may use funds as a safety net and be interested in long-term gain versus short-term income. Another consideration is taxes. Charitable foundations and pension funds are generally not taxed on gains. Taxable institutions would have the additional objective of minimizing taxes. For individuals, life-cycle investing is critical. Young people saving for retirement have long-term perspectives focusing on long-term asset value and are not focused on current income. Their risk tolerance may be higher as funds are not needed for a few market cycles. Someone nearing retirement will seek less volatility, while those who have reached retirement will want to obtain sufficient current income to fund current distributions. Capital Asset Pricing Model This capital asset pricing model (CAPM) provides a means to estimate the required return on a risk-asset based on its beta, the risk-free and market-expected rates of return. There are significant assumptions embedded in the model, including those regarding individual behavior and market structure as described in your textbook. Individuals are assumed to want to maximize the return-risk relationship, have the same single-period horizon, and possess equal access to information. Market structure assumes all assets are publicly traded, there are no taxes and transaction costs, and investors can borrow at the risk-free rate. These assumptions need to be considered when applying the model to specific markets. For a beta of 1.0, the return is equal to the expected return for the market. If the beta is greater than 1, then that specific stock has a risk greater than the market. If the beta is less than 1, then the volatility of the stock is less than that of the overall market. This model has several applications to both the theoretical and applied financial world. The most common of them is that firms utilize this equation to calculate their cost of equity, as described in Chapter 12 of the textbook.

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Suggested Unit Resources

In order to access the following resources, click the links below. The article below describes the relationship between investors, returns, and trading. Daniel, K., & Hirshleifer, D. (2015). Overconfident investors, predictable returns, and excessive trading.

Journal of Economic Perspectives, 29(4), 61–88. Retrieved from https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=110755186&site=ehost-live&scope=site

The following article explains how institutional investors analyze and manage firm-specific risk in investing. Lydenberg, S. (2016). Integrating systemic risk into modern portfolio theory and practice. Journal of Applied

Corporate Finance, 28(2), 56–61. Retrieved from https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=116709240&site=ehost-live&scope=site

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. Review key concepts from this unit by answering the questions in the following activity: Unit VII Check for Understanding.

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