Iwan Meier

52-252 Corporate Finance II

January 27, 2008

Mini Case

Risk and Return, Diversification, and the Efficient Set

Iwan Meier

Royal Bank is Canadas largest bank as measured by assets and market capitalization. The bank operates in Canada, the U.S. and 36 countries around the world, and offers jobs for 70,000 employees. The services include personal and commercial banking, wealth management, insurance, corporate and investment banking (Table 1, Business Segment Performance). EnCana, formed in 2002 with the merger of PanCanadian Energy and Alberta Energy Company, is headquartered in Calgary, Alberta, and is one of North Americas leading natural gas producers. The company holds large natural gas and oil resource lands onshore North America and is specialized in in-situ recovery of oilsands bitumen. EnCanas other operations include the transportation and marketing of crude oil, natural gas and natural gas liquids, as well as the refining of crude oil and the marketing of refined petroleum products. In January of 2007, EnCana increased its interests in the refining industry and completed the creation of an integrated heavy oil business, joint with ConocoPhillips. The shares of Royal Bank of Canada (RY) and EnCana Corporation (ECA) are both traded on the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). Figure 1 plots the stock prices over the past five years. How do the returns and variation in returns of these stocks compare? The average return on a stock can be estimated from a set of returns and corresponding probabilities or from a sample of past returns. The expected return of a security is simply the sum of all possible returns multiplied by their probability. When we estimate the average return from historical data, we typically use equal weights for each observation. The (arithmetic) mean or average return is computed as the sum of all past returns divided by the number of observations. The risk of a security refers to the variability of the returns. The most commonly used measures are the variance and standard deviation that quantify the dispersion of returns around their expected return. The variance measures the squared deviations of the individual observations from the expected return. For technical reasons, we divide by T 1 rather than T if we compute the variance from a sample of past returns. In the example of stock returns measured in percentage, the variance takes the sum of all squared deviations of the individual returns from

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Iwan Meier

52-252 Corporate Finance II

the mean return and, hence, it is measured in percentage squared. However, a more intuitive measure of dispersion should have the same units as the original data. The obvious thing to do is to take the square root which is the standard deviation.1 How do the returns on the stock of Royal Bank and EnCana two stocks commove? The answer to this question is important to gauge the risk of a portfolio consisting of those two stocks. Furthermore, using the two stocks we can illustrate the diversification effects and plot the efficient set of all feasible combinations of risk and return. The covariance measures the simultaneous variation of two random variables. The covariance becomes more positive the more observations of the two variables deviate from their respective means in the same direction at the same time, and more negative the more often at a given time the values of the two variables deviate in opposite directions from their mean. The correlation normalizes the covariance such that it is always between -1 and 1. A correlation coefficient of one means that the two return series move perfectly together at all times. Whereas the unit of covariance is units squared (e.g. percentages squared), the correlation coefficient has no units. The Excel workbook Returns RY, ECA, which is posted on the course web site, contains historical returns of the shares of Royal Bank and Encana. The appendix summarizes the equations to compute the basic statistics that you need for the assignments below.

Besides having an easier interpretation it is also important to compute confidence intervals. 2/8

Iwan Meier Assignments

52-252 Corporate Finance II

1. Suppose for the next period you estimated the following expected returns and corresponding probabilities for the stock of Royal Bank of Canada. Return -15% -12% -9% -6% -3% 0% 3% 6% 9% 12% 15% 18% 21% Probability 1% 2% 4% 7% 11% 15% 20% 16% 9% 6% 5% 3% 1%

Compute the expected return and standard deviation. Assume that risk-free investments currently yield a return of 5% annually. What is the expected risk premium for the stock of Royal Bank? 2. Estimate the mean return and standard deviation for the two stocks Royal Bank and EnCana from historical data. Use the five years of monthly returns that are provided in the Excel workbook Returns RY, ECA that is posted on the course web site. Before you start your calculations, take a look at the two charts provided in Figure 1. Which standard deviation do you expect to be higher? Compute the covariance and the correlation coefficient between the two shares. 3. Analyze the following two portfolios: - A portfolio with 87% invested in Royal Bank and 13% in EnCana. - A portfolio with $13,500 invested in the Royal Bank and $1,500 in EnCana. What are the expected returns and standard deviations of the two portfolios? Which of the two portfolios would you prefer? Explain why.

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Iwan Meier

52-252 Corporate Finance II

4. Compute the efficient set for the two stocks Royal Bank and EnCana. Start with a 100% investment in Royal Bank, then a portfolio that is 90% invested in Royal Bank and 10% in EnCana, etc. Compare your results with the answers you get using the Excel workbook Mean-Variance Analysis for 2 Assets which is posted on the course web site or the java applet of Professor Campbell R. Harvey at Duke: http://www.duke.edu/~charvey/applets/java.html. 5. Draw a histogram of the returns for each of the two stocks and compare the distributions to a normal distribution with the mean and standard deviation that you estimated in 2. Take the same classes for the histogram as in question 1. Is an approximation by a normal distribution reasonable?

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Iwan Meier Table 1: Company facts. Panel A: Royal Bank of Canada.

Abbreviations:

52-252 Corporate Finance II

ttm = trailing twelve months. fye = fiscal year ending mrq = most recent quarter

Source: http://ca.finance.yahoo.com

Source: www.rbc.com, Quick Facts. Panel B: EnCana Corporation.

Abbreviations: ttm = trailing twelve months. fye = fiscal year ending mrq = most recent quarter

Source: http://ca.finance.yahoo.com

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Iwan Meier

52-252 Corporate Finance II

Figure 1: Evaluation of stock prices and volume over the past five years. Royal Bank of Canada (RY):

Source: http://ca.finance.yahoo.com EnCana Corporation (ECA):

Source: http://ca.finance.yahoo.com

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Iwan Meier Appendix A: Mean and variance of individual assets. 1. Expected return of an asset.

52-252 Corporate Finance II

E(R) =

p R
i i =1

The expected return equals the sum of all possible returns multiplied by their probability. 2. Arithmetic mean return.
R= 1 T

R
t =1

Excel: AVERAGE(number1, [number2],) returns the average (arithmetic mean) of its arguments. 3. Variance of returns.

2 =

p [R
i i =1

E(R)]

The deviation of each possible return from its expected value is squared and multiplied with the corresponding probability. The sum of all products measures the variance 4. Estimate the variance from a sample of historical returns.

2 =

2 1 Rt R T 1 t =1

[
T

Excel: VAR(number1, number2, ) estimates the variance based on a sample. 5. Standard deviation.

= =2 =

2 1 Rt R T 1 t =1

[
T

Excel: STDEV(number1, number2, ) estimates the standard deviation based on a sample.

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Iwan Meier
Appendix B: Return and variance of a portfolio of two assets.

52-252 Corporate Finance II

6. Expected return of a portfolio with two assets.

E(RP ) = x RBC E(RRBC ) + x EnCana E(REnCana )

7. Covariance between the returns of two assets. Cov(RRBC , REnCana ) = RBC,EnCana =

p [R
i i =1

RBC,i

E(RRBC )] [REnCana,i E(REnCana )]

The unit of the covariance measures is percentages squared. 8. The covariance is the average of the products of the deviations of each variable from its respective mean.
Cov(RRBC , REnCana ) = RBC , EnCana = 1 RRBC ,t R RBC REnCana,t R EnCana T 1 t =1

[
T

][

Attention!

Excel: COVARIANCE(array1, array2) x T/(T-1) returns the covariance, the average of the products of deviations for each data point pair in two data sets. 9. The correlation coefficient, which derives directly from the covariance, is a measure of linear dependence and has no units.

Corr(RRBC , REnCana ) = RBC,EnCana =

RBC,EnCana RBC EnCana

Excel: CORRELATION(array1, array2) returns the correlation coefficient between two data sets. 10. The variance of a portfolio with two assets.
2 2 2 2 2 P = x RBC RBC + x EnCana EnCana + 2 x RBC x EnCana RBC,EnCana

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