Fixed Income and Equity Markets

Outline

  • Introduction to the return-risk framework of security pricing.

  • Overview of fixed income securities.

  • Focus on equity securities.

  • Distinction between systematic and non-systematic risks.

  • Capital Asset Pricing Model (CAPM) as a tool to price systematic risk.

  • Challenges in estimating CAPM parameters.

  • Applications of CAPM.

  • Reference: CFA Level I 2020 curriculum pages 46, 51-53.

Return-Risk Framework of Security Pricing

  • Decomposition of investors’ required rate of return includes:

    • Spread

    • Benchmark

    • Risk Premium: Combination of systematic and non-systematic risks.

    • Risk-Free Rate of Return: Serves to compensate for inflation.

Review: Discounted Cash Flow of a Bond

  • Definition: The market price (PB) of a fixed income instrument.

  • Specifications: \$1000\$ par value, \$8\%\$ coupon rate paid at each year end, maturity of 3 years.

  • Current required market rate of return for similar securities is \$10\%\$.

Return-Risk Framework Applied to Fixed Income

  • Assumptions behind the discounted cash flow model:

    1. The bond is held to maturity.

    2. No default by the issuer occurs.

    3. Coupon interest payments are continually reinvested at the same required rate of return during the holding period.

  • Consequences of Violating Assumptions:

    • Liquidity risks.

    • Credit risks.

    • Interest rate risks.

  • Further Reading: CFA Level I 2020 curriculum Reading 46.

Return-Risk Framework Applied to Equity

  • Formulas:

    1. Return: ( ext{Return}t = ext{Log} rac{ ext{Price}_t}{ ext{Price}{t-1}} ) or ( ext{Return}t = rac{ ext{Price}_t}{ ext{Price}{t-1}} - 1 )

    2. Risk: Variance and standard deviation of returns.

    3. Arithmetic Average of Returns: ( R^{ ext{avg}}i = rac{1}{T} extstyle igg( ext{Sum from } t=1 ext{ to } T R{i,t} \bigg) )

    4. Variance of Returns: ( ext{VAR}(R_i) = rac{1}{T-1} extstyle igg( ext{Sum from } t=1 ext{ to } T (R_{i,t} - R^{ ext{avg}}_i)^2 \bigg) )

    5. Standard Deviation of Returns: ( ext{StdDev}(R_i) = ext{sqrt}( ext{VAR}(R_i)) )

  • Note: In EFB201, values for measures 3-5 will be provided in assessments.

Investment Comparison: Woolworth vs. Flight Center

  • Examination of largest 200 listed companies on the Australian Stock Exchange including Woolworth (WOW) and Flight Center (FLT).

  • Data from Historical Monthly Returns (2011-2021):

    • Woolworth (WOW): Historical Returns: -1.2 to 0.4

    • Flight Center (FLT): Historical Returns: -1.2 to 0.4

Systematic versus Non-Systematic Risks

  • Illustration of Historical Monthly Returns (2011-2021) for companies:

    • Woolworth (WOW):

    • Arithmetic Average: (0.28\%)

    • Standard Deviation: (4.80\%)

    • Return/Risk: (0.06)

    • Beta Estimate: (0.51)

    • Flight Center (FLT):

    • Arithmetic Average: (-0.20\%)

    • Standard Deviation: (15.02\%)

    • Return/Risk: (-0.01)

    • Beta Estimate: (2.51)

    • ASX200 (XJO):

    • Arithmetic Average: (0.29\%)

    • Standard Deviation: (3.84\%)

    • Return/Risk: (0.07)

    • Beta Estimate: (1.00)

  • Combination Investments:

    • 30% WOW + 70% FLT: Arithmetic Average: (-0.06\%)

    • Standard Deviation: (10.84\%)

    • Beta Estimate: (1.91)

    • 50% WOW + 50% FLT: Arithmetic Average: (0.04\%)

    • Standard Deviation: (8.24\%)

    • Beta Estimate: (1.51)

    • 70% WOW + 30% FLT: Arithmetic Average: (0.13\%)

    • Standard Deviation: (6.03\%)

    • Beta Estimate: (1.11)

  • Conclusion: Diversification mitigates non-systematic risks while maintaining exposure to systematic risks.

Risk Types Explained

  • Systematic Risk: Inherent risk within the market that cannot be diversified away; affects all assets.

  • Non-Systematic Risk: Risk specific to a particular asset or industry that can be avoided through diversification; also known as idiosyncratic risk.

Identifying Non-Systematic Risks

  • Examples of non-systematic risks include:

    • A. Employee strikes.

    • B. CEO health issues affecting company decisions.

    • C. Global pandemics.

    • D. New regulatory bans on specific materials (e.g., coal).

    • E. Changes in national interest rates.

    • F. Innovations in a company's R&D department.

Rational for Compensation for Systematic Risks Only

  • Non-systematic risks can be diversified, negating their impact; good news in one firm can offset bad news in another.

  • Prices are influenced by the demand of diversified investors, therefore they dictate compensations based on systematic risks.

  • Example Scenario: Investor A (non-diversified) values a stock at \$30, while Investor B (diversified) values it higher at \$35, leading to the stock being sold to B.

CAPM as a Model to Price Systematic Risk

  • Assumptions of CAPM:

    1. Market risk is the sole systematic risk factor for which compensation is required.

    2. Investors are risk-averse price takers.

    3. All investors are concerned with a single investment horizon.

    4. Investors have homogeneous expectations.

    5. Assumptions of market efficiency hold.

  • CAPM Formula: E(R_i) = R_f + eta_i (E(R_m) - R_f)

    • Where:

    • ( R_f ): Risk-free rate, uncorrelated with market risk.

    • ( E(R_m) ): Expected return on the market portfolio of risky assets.

    • ( E(R_m) - R_f ): Market Risk Premium.

    • ( eta_i ): Beta of the asset, representing its risk relative to the market risks.

      • ( eta = 0 ): Not correlated with market risk.

      • ( eta < 1 ): Less risky than the market.

      • ( eta = 1 ): Risk level equal to the market.

      • ( eta > 1 ): More risky than the market.

    • Note: In EFB201, specifics on computation of ( eta_i ) are not required; values provided.

CAPM Assumptions Analysis

  • Revisiting the meanings of CAPM assumptions:

    1. Market risk as the only systematic factor needing compensation.

    2. Investors are risk-averse and price-sensitive.

    3. A single investment horizon clings universally.

    4. Investors share the same expectations.

    5. Market efficiency’s principles apply uniformly.

Historical Data Review: Monthly Returns (2011-2021)

  • Company Performance Metrics:

    • Woolworth (WOW.AX):

    • Average Return: (0.28\%), Standard Deviation: (4.80\%), Beta: (0.51)

    • Flight Center (FLT.AX):

    • Average Return: (-0.20\%), Standard Deviation: (15.02\%), Beta: (2.51)

    • ASX200 (XJO.AX):

    • Average Return: (0.29\%), Standard Deviation: (3.84\%), Beta: (1.00)

  • Understanding Risks:

    • Standard deviation measures total risk (includes both systematic and non-systematic risks), whereas beta strictly focuses on systematic risk exposure.

Challenges in Estimating CAPM Parameters

  • Key Considerations for Parameter Estimation:

    • Assessing the time period for beta estimation: Options range from two weeks to ten years.

    • Selecting proxies for risk-free and market returns:

    • Risk-free rate source considerations include Treasury notes or bonds from different countries.

    • Identifying a market return proxy, which represents the true market portfolio among various indices.

  • Limitations of CAPM:

    • Despite being a forward-looking model, CAPM relies significantly on historical data trends for estimation.

Main Applications of CAPM

  • For financial managers: Utilized to ascertain the present value of future cash flows from projects; calculation of the cost of equity (average return required by investors supplying external equity funds).

  • For investors in equity markets: Applied to determine the anticipated stock price based on market assessments of value.