International Financial Management lectures 1-4

1. Treasury bills: short term (1y), safe, stable prices
2. Government bonds: price fluctuation w interest rate
3. Common stocks: fluctuates w well being of company, high restrn, long term

everyone buys from this portfolio but at different proportions depending on risk aversion 

• variance: expected suqared deviation from expected return
• standard deviation: square root of variance 
• estimate variability of stocks: by estimating probability of alternative outcomes and estimate their variance or SD 
  • probabilities based on past variability 

• unsystematic risk is specific to a company
• systematic risk is economywide 
• diversification: reduce risk by spreading portfolio acorss many investments 
  • market portfolio = sum of all assets in market, the most diversified
• diversification eliminates unsystematic risk -> market risk is main risk of well-diversified portfolio

• portfolio expected return: weighted average of epxected returns on individual stocks
• for risk: weighted avg of SD of stocks, only if prices of stocks move in lockstep
• cov = covariance btw stocks 
• P = correlation btw stocks 
  • P = 0 : stocks are wholly unrelated 
  • P < 0: stocks move in opposite directions
  • P > 0: stocks move together (-> most common case) 
  • p = + 1 : stocks are perfectly correlated (no gain from diversification)
  • P = -1: stocks move in opposite directions, risk can be completely eliminated

• many securities: covariances > variances --> variability of diversified portfolio reflects mainly covariance 
• covariance of 0 = eliminating all risk bc stocks would move independently 
• most stocks are tied together w positive covariances -> limits benefits of diversification 

• measures sensitivity of a stock to the market movements (covariance ÷ variance)
• beta > 1 : stock is more volatile than movement of market 
• beta < 1 : stock moves in same direction as market but not as far 
• portfolio beta = avg beta of securities included in portfolio 
  • market beta = 1
• risk of well diversified portfolio is proportional to porfolio beta

• an investor can reduce standard deviation of portfolio returns by choosing stocks that don't move together 
• past rates of return of a stock considered as conform to normal distribution -> epxected return and standard deviation are only measures that investors need 
• graph expected return / standard deviation: efficiency curve btw perfectly correlated and perfectly opposite stocks 
  • efficient portfolios on that line have highest expected return for given SD (or lowest SD for given return)
  • any point on that line is equally efficient, choice depends on preferences 

• borrow or lend at risk free rate as another investment possibility 
• S: best efficient portfolio, is the tangent to heavy efficiency line 
  • S portfolio = tangent porfolio (market portfolio)
• highest expected return as mixture of S and borrowing/lending -> blend S w borrowing / lending 

ratio of risk premium to standard deviation 

expresses performance of a portfoilio

how much return you get for one unit of risk

difference btw nominal return (%) of T bills and return of bonds / stocks 

• if beta is not 0 or 1, expected risk premium varies in direct proportion to beta 
• all investments must plot along sloping line btw beta of 1 and market return, starting at risk free return: security market line 
• expected risk premium: beta * expected risk premium on market 
• (false) assumptions 
  • T bills are risk free 
  • investors can borrow and lend at same rate of interest

1. chose portfolios form efficient frontier (high return, low SD) 
2. lend / borrow at risk free rate of interest w efficient portfolio w highest ratio of risk premium to SD 
3. invest in risky market portolio and risk free loan, proportions depends on risk aversion
4. contribution of risk of stock to portfolio risk depends on sensitivity to changes 
5. beta measures marginal contribution of a stock to risk of market portfolio 

expected return on a portfolio of all company's existing stocks 

= opportunity cost of capital for investment in firm's assets 

blend costs of debt and costs of equity 

• cost of debt: opportunity cost for investors holding firm's debt 
  • cost of debt < company cost of capital bc debt is safer than assets
• cost of equity: opportunity cost for investors holding firm's shares
  • cost of equity > company cost of capital bc equity is riskier than assets
• company cost of capital: weighted avg of cost of debt and cost of equity 

• tells us how much on avg the stock price changed when market return was 1% higher or lower 
• calculate WACC: regress stock returns on market returns to estimate beta 
  • to measure cost of equity 
• regression line fitted through returns on stocks and markt, slope is beta factor
• R^2: measures proportion of total variance in stock's return explained by market movements 

• measured by asset beta
• blend of seperate betas of debt and equity 
• diversifiable risks don't affect asset betas or cost of capital 
• helps understand why project may be above or below avg risk

• CEQ to risk cash flow: smallest certain payoff for which investor would exchange the risky cash flow 
  • used bc project risk changes, is not constant 

• discount risky cash flow at risk adjusted discount that is higher than rf 
• find CEQ cash flow and discount risk-free interest rate rf