Chapter 2

Valuation, Risk, Return, and

Uncertainty

Portfolio Construction, Management, & Protection, 5e, Robert A. Strong

Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

1
Its what we learn after we think we know it
all that counts.

Kin Hubbard

2
 Outline
Introduction
Valuation
Safe Dollars and Risky Dollars
Relationship Between Risk and Return
The Concept of Return
Some Statistical Facts of Life

3
 Introduction
The occasional reading of basic material in
your chosen field is an excellent
philosophical exercise
Do not be tempted to conclude that you know
it all
e.g., what is the present value of a growing
perpetuity that begins payments in five years?

4
 Valuation
Valuation may be the most important part of
the study of investments
Security analysts make a career of estimating
what you get for what you pay
The time value of money is one of the two key
concepts in finance and is very useful in
valuation

5
 Growing Income Streams
A growing stream is one in which each
successive cash flow is larger than the
previous one
A common problem is one in which the cash
flows grow by some fixed percentage

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 Growing Annuity
A growing annuity is an annuity in which
the cash flows grow at a constant rate g:

C C (1 g ) C (1 g ) 2 C (1 g ) n
PV ...
(1 R) (1 R ) 2
(1 R) 3
(1 R) n 1
C1 1 g
N

1
R g 1 R

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 Growing Perpetuity
A growing perpetuity is an annuity where
the cash flows continue indefinitely:

C C (1 g ) C (1 g ) 2 C (1 g )
PV ...
(1 R ) (1 R ) 2
(1 R ) 3
(1 R)

Ct (1 g )t 1 C1

t 1 (1 R) t
Rg

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Safe Dollars and Risky Dollars
A safe dollar is worth more than a risky
dollar
Investing in the stock market is exchanging
bird-in-the-hand safe dollars for a chance at a
higher number of dollars in the future

9
 Safe Dollars and
Risky Dollars (contd)
Most investors are risk averse
People will take a risk only if they expect to be
adequately rewarded for taking it

People have different degrees of risk

aversion
Some people are more willing to take a chance
than others
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 Choosing Among
Risky Alternatives
Example

You have won the right to spin a lottery wheel one time.
The wheel contains numbers 1 through 100, and a pointer
selects one number when the wheel stops. The payoff
alternatives are on the next slide.

Which alternative would you choose?

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 Choosing Among
Risky Alternatives (contd)
A B C D

[150] $110 [150] $200 [190] $50 [199] $1,000

[51100] $90 [51100] $0 [91100] $550 [100] $89,000

Average
payoff $100 $100 $100 $100

Number on lottery wheel appears in brackets. 12

 Choosing Among
Risky Alternatives (contd)
Example (contd)
Solution:
Most people would think Choice A is safe.
Choice B has an opportunity cost of $90 relative
to Choice A.
People who get utility from playing a game pick
Choice C.
People who cannot tolerate the chance of any
loss would avoid Choice D.

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 Choosing Among
Risky Alternatives (contd)
Example (contd)

Solution (contd):
Choice A is like buying shares of a utility stock.
Choice B is like purchasing a stock option.
Choice C is like a convertible bond.
Choice D is like writing out-of-the-money call
options.

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 Risk Versus Uncertainty
Uncertainty involves a doubtful outcome
What birthday gift you will receive
If a particular horse will win at the track

Risk involves the chance of loss

If a particular horse will win at the track if you
made a bet

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Dispersion and Chance of Loss
There are two material factors we use in
judging risk:
The average outcome

The scattering of the other possibilities around

the average

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Dispersion and Chance of Loss
(contd)
Investment value

Investment A
Investment B

Time
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Dispersion and Chance of Loss
(contd)
Investments A and B have the same
arithmetic mean

Investment B is riskier than Investment A

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 Types of Risk
Total risk refers to the overall variability of
the returns of financial assets

Undiversifiable risk is risk that must be

borne by virtue of being in the market
Arises from systematic factors that affect all
securities of a particular type

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 Types of Risk (contd)
Diversifiable risk can be removed by proper
portfolio diversification
The ups and down of individual securities due
to company-specific events will cancel each
other out
The only return variability that remains will be
due to economic events affecting all stocks

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Relationship Between Risk and
Return
Direct Relationship
Concept of Utility
Diminishing Marginal Utility of Money
St. Petersburg Paradox
Fair Bets
The Consumption Decision
Other Considerations
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 Direct Relationship
The more risk someone bears, the higher
the expected return
The appropriate discount rate depends on
the risk level of the investment
The riskless rate of interest can be earned
without bearing any risk

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Direct Relationship (contd)
Expected return

Rf

0 Risk
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 Direct Relationship (contd)
The expected return is the weighted
average of all possible returns
The weights reflect the relative likelihood of
each possible return

The risk is undiversifiable risk

A person is not rewarded for bearing risk that
could have been diversified away
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 Concept of Utility
Utility measures the satisfaction people get
out of something
Different individuals get different amounts of
utility from the same source
Casino gambling
Pizza parties
CDs
Etc.

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 Diminishing Marginal
Utility of Money
Rational people prefer more money to less
Money provides utility

Diminishing marginal utility of money

The relationship between more money and added
utility is not linear

I hate to lose more than I like to win

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 Diminishing Marginal
Utility of Money (contd)
Utility

$
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 St. Petersburg Paradox
Assume the following game:
A coin is flipped until a head appears
The payoff is based on the number of tails
observed (n) before the first head
The payoff is calculated as $2n

What is the expected payoff?

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 St. Petersburg Paradox
(contd)
Number of Tails
Before First Probability
Head Probability Payoff Payoff
0 (1/2) = 1/2 $1 $0.50
1 (1/2)2 = 1/4 $2 $0.50
2 (1/2)3 = 1/8 $4 $0.50
3 (1/2)4 = 1/16 $8 $0.50
4 (1/2)5 = 1/32 $16 $0.50
n (1/2)n + 1 $2n $0.50
Total 1.00
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 St. Petersburg Paradox
(contd)
In the limit, the expected payoff is infinite

How much would you be willing to play the

game?
Most people would only pay a couple of dollars
The marginal utility for each additional $0.50
declines

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 Fair Bets
A fair bet is a lottery in which the expected
payoff is equal to the cost of playing
e.g., matching quarters
e.g., matching serial numbers on $100 bills

Most people will not take a fair bet unless

the dollar amount involved is small
Utility lost is greater than utility gained
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 The Consumption Decision
The consumption decision is the choice to
save or to borrow
If interest rates are high, we are inclined to save
e.g., open a new savings account

If interest rates are low, borrowing looks

attractive
e.g., a bigger home mortgage

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 The Consumption
Decision (contd)
The equilibrium interest rate causes savers
to deposit a sufficient amount of money to
satisfy the borrowing needs of the economy

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 Other Considerations
Psychic Return
Price Risk versus Convenience Risk

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 Psychic Return
Psychic return comes from an individual
disposition about something
People get utility from more expensive things,
even if the quality is not higher than cheaper
alternatives
e.g., Rolex watches, designer jeans

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 Price Risk versus
Convenience Risk
Price risk refers to the possibility of adverse
changes in the value of an investment due to:
A change in market conditions
A change in the financial situation
A change in public attitude

e.g., rising interest rates influence stock prices,

and a change in the price of gold can affect the
value of the dollar

36
 Price Risk versus
Convenience Risk (contd)
Convenience risk refers to a loss of
managerial time rather than a loss of dollars
e.g., a bonds call provision
Allows the issuer to call in the debt early, meaning
the investor has to look for other investments

37
 The Concept of Return
Return can mean various things, and it is
important to be clear when discussing an
investment
A general definition of return is the benefit
associated with an investment
In most cases, return is measurable
e.g., a $100 investment at 8 percent, compounded
continuously is worth $108.33 after one year
The return is $8.33, or 8.33 percent

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 Holding Period Return
The calculation of a holding period return
is independent of the passage of time
e.g., you buy a bond for $950, receive $80 in
interest, and later sell the bond for $980
The return is ($80 + $30)/$950 = 11.58 percent
The 11.58 percent could have been earned over one
year or one week

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 Arithmetic Mean Return
The arithmetic mean return is the
arithmetic average of several holding period
returns measured over the same holding
period:
n ~
Ri
Arithmetic mean
i 1 n
~
Ri the rate of return in period i
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 Arithmetic Mean Return
(contd)
Arithmetic means are a useful proxy for
expected returns

Arithmetic means are not especially useful

for describing historical return data
It is unclear what the number means once it is
determined

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 Geometric Mean Return
The geometric mean return is the nth root
of the product of n values:

1/ n
n
~
Geometric mean (1 Ri ) 1
i 1

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 Arithmetic and
Geometric Mean Returns
Example

Assume the following sample of weekly stock returns:

Week Return Return Relative

1 0.0084 1.0084
2 0.0045 0.9955
3 0.0021 1.0021
4 0.0000 1.000
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 Arithmetic and Geometric
Mean Returns (contd)
Example (contd)

What is the arithmetic mean return?

Solution: n ~
Ri
Arithmetic mean
i 1 n

0.0084 0.0045 0.0021 0.0000

4
0.0015
44
 Arithmetic and Geometric
Mean Returns (contd)
Example (contd)

What is the geometric mean return?

Solution: 1/ n
n
%
Geometric mean
i 1
(1 Ri ) 1

[ 1.0084 0.9955 1.00211.0000]
1/ 4
1
0.001489
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Comparison of Arithmetic and
Geometric Mean Returns
The geometric mean reduces the likelihood
of nonsense answers
Assume a $100 investment falls by 50 percent
in period 1 and rises by 50 percent in period 2

The investor has $75 at the end of period 2

Arithmetic mean = [(0.50) + (0.50)]/2 = 0%
Geometric mean = (0.50 1.50)1/2 1 = 13.40%

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 Comparison of Arithmetic and
Geometric Mean Returns (Contd)
The geometric mean must be used to
determine the rate of return that equates a
present value with a series of future values

The greater the dispersion in a series of

numbers, the wider the gap between the
arithmetic mean and geometric mean

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 Expected Return
Expected return refers to the future
In finance, what happened in the past is not as
important as what happens in the future

We can use past information to make estimates

about the future

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 Return on Investment
Return on investment (ROI) is a term that
must be clearly defined
Return on assets (ROA)
Return Total Assets

Return on equity (ROE)

Return Total stockholders Equity
ROE is a leveraged version of ROA

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 Standard Deviation and
Variance
Standard deviation and variance are the
most common measures of total risk

They measure the dispersion of a set of

observations around the mean observation

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 Standard Deviation and
Variance (contd)
General equation for variance:
n 2

Variance 2 prob( xi ) [ xi x ]
i 1

If all outcomes are equally likely:

n 2
1
[ xi x ]
2

n i 1
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 Standard Deviation and
Variance (contd)
Equation for standard deviation:

n 2

Standard deviation 2 prob( x ) [ x x ]

i 1
i i

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 Semi-Variance
Semi-variance considers the dispersion only
on the adverse side
Ignores all observations greater than the mean
Calculates variance using only bad returns
that are less than average
Since risk means chance of loss, positive
dispersion can distort the variance or standard
deviation statistic as a measure of risk
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 Some Statistical Facts of Life
One has to understand key terms:
Constants, Variables, Populations,
Samples, and Sample statistics
Properties of Random Variables
Linear Regression
R Squared and Standard Errors

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 Constants
A constant is a value that does not change
e.g., the number of sides of a cube
e.g., the sum of the interior angles of a triangle

A constant can be represented by a numeral

or by a symbol

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 Variables
A variable has no fixed value
It is useful only when it is considered in the
context of other possible values it might assume

In finance, variables are called random

variables
Designated by a tilde
e.g., x%
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 Variables (contd)
Discrete random variables are countable
e.g., the number of trout you catch

Continuous random variables are

measurable
e.g., the length of a trout

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 Variables (contd)
Quantitative variables are measured by
real numbers
e.g., numerical measurement

Qualitative variables are categorical

e.g., hair color

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 Variables (contd)
Independent variables are measured
directly
e.g., the height of a box

Dependent variables can only be measured

once other independent variables are
measured
e.g., the volume of a box (requires length, width,
and height)
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 Populations
A population is the entire collection of a
particular set of random variables
The nature of a population is described by
its distribution
The median of a distribution is the point where
half the observations lie on either side
The mode is the value in a distribution that
occurs most frequently
60
 Populations (contd)
A distribution can have skewness
There is more dispersion on one side of the
distribution
Positive skewness means the mean is greater
than the median
Stock returns are positively skewed
Negative skewness means the mean is less than
the median

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 Populations (contd)
Positive Skewness Negative Skewness

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 Populations (contd)
A binomial distribution contains only two
random variables
e.g., the toss of a coin (heads or tails)

A finite population is one in which each

possible outcome is known
e.g., a card drawn from a deck of cards

63
 Populations (contd)
An infinite population is one where not all
observations can be counted
e.g., the microorganisms in a cubic mile of
ocean water

A univariate population has one variable

of interest

64
 Populations (contd)
A bivariate population has two variables
of interest
e.g., weight and size

A multivariate population has more than

two variables of interest
e.g., weight, size, and color

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 Samples
A sample is any subset of a population
e.g., a sample of past monthly stock returns of a
particular stock

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 Sample Statistics
Sample statistics are characteristics of
samples
A true population statistic is usually
unobservable and must be estimated with a
sample statistic
Expensive
Statistically unnecessary

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 Properties of
Random Variables
Example
Central Tendency
Dispersion
Logarithms
Expectations
Correlation and Covariance

68
 Example
Assume the following monthly stock returns for Stocks A
and B:
Month Stock A Stock B
1 2% 3%
2 1% 0%
3 4% 5%
4 1% 4%

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 Central Tendency
Central tendency is what a random variable
looks like, on average
The usual measure of central tendency is the
populations expected value (the mean)
The average value of all elements of the population

n
~ 1 ~
E ( Ri )
n
i 1
Ri

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 Example (contd)
The expected returns for Stocks A and B are:

n
~ 1 ~ 1
E(RA )
n
i 1
R A (2% 1% 4% 1%) 1.50%
4

n
~ 1 ~ 1
E ( RB )
n
i 1
RB (3% 0% 5% 4%) 3.00%
4
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 Dispersion
Investors are interested in the variation of
actual values around the average
A common measure of dispersion is the
variance or standard deviation

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 Example (contd)
The variance and standard deviation for Stock A are:

[
2 E (~ ]
xi x ) 2
1
[
(2% 1.5%) 2 (1% 1.5%) 2 (4% 1.5%) 2 (1% 1.5%) 2
4
]
1
(0.0013) 0.000325
4

2 0.000325 0.018 1.8%

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 Example (contd)
The variance and standard deviation for Stock B are:

[
2 E (~ ]
xi x ) 2
1
[
(3% 3.0%) 2 (0% 3.0%) 2 (5% 3.0%) 2 (4% 3.0%) 2
4
]
1
(0.0014) 0.00035
4

2 0.00035 0.0187 1.87%

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 Logarithms
Logarithms reduce the impact of extreme
values
e.g., takeover rumors may cause huge price
swings
A logreturn is the logarithm of a return relative
Logarithms make other statistical tools more
appropriate
e.g., linear regression
75
 Logarithms (contd)
Using logreturns on stock return
distributions:
Take the raw returns

Convert the raw returns to return relatives

Take the natural logarithm of the return

relatives
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 Expectations
The expected value of a constant is a
constant:
E (a) a
The expected value of a constant times a
random variable is the constant times the
expected value of the random variable:
) aE ( x%
E (ax% )
77
 Expectations (contd)
The expected value of a combination of
random variables is equal to the sum of the
expected value of each element of the
combination:
E ( x% y%
) E ( x%
) E ( y%
)

78
 Correlations and Covariance
Correlation is the degree of association
between two variables

Covariance is the product moment of two

random variables about their means

Correlation and covariance are related and

generally measure the same phenomenon
79
 Correlations and Covariance
(contd)

COV ( A% ) AB E ( A% A)( B% B )
, B%

COV ( A%, B%
)
AB
A B
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 Example (contd)
The covariance and correlation for Stocks A and B are:
1
AB [ (0.5% 0.0%) (2.5% 3.0%) (2.5% 2.0%) (0.5% 1.0%) ]
4
1
(0.001225)
4
0.000306

COV ( A%%
, B) 0.000306
AB 0.909
A B (0.018)(0.0187)
81
 Correlations and Covariance
(contd)
Correlation ranges from 1.0 to +1.0.
Two random variables that are perfectly
positively correlated have a correlation
coefficient of +1.0

Two random variables that are perfectly

negatively correlated have a correlation
coefficient of 1.0

82
 Linear Regression
Linear regression is a mathematical
technique used to predict the value of one
variable from a series of values of other
variables
e.g., predict the return of an individual stock
using a stock market index
Linear regression finds the equation of a line
through the points that gives the best
possible fit
83
 Linear Regression (contd)
Example

Assume the following sample of weekly stock and stock

index returns:
Week Stock Return Index Return
1 0.0084 0.0088
2 0.0045 0.0048
3 0.0021 0.0019
4 0.0000 0.0005
84
Linear Regression (contd)
Example (contd)
0.01
Intercept = 0
Slope = 0.96 0.008
R squared = 0.99 0.006
Return (Stock)

0.004
0.002
0
-0.01 -0.005 -0.002 0 0.005 0.01
-0.004
-0.006
Return (Market)
85
 R Squared and Standard Errors
R squared and the standard error are used to assess the
accuracy of calculated securities

R squared is a measure of how good a fit we get with the

regression line
If every data point lies exactly on the line, R squared is 100%

R squared is the square of the correlation coefficient

between the security returns and the market returns
It measures the portion of a securitys variability that is due to the
market variability

86
 Standard Errors
The standard error is equal to the standard
deviation divided by the square root of the
number of observations:

Standard error
n

87
 Standard Errors (contd)
The standard error enables us to determine
the likelihood that the coefficient is
statistically different from zero
About 68 percent of the elements of the
distribution lie within one standard error of the
mean
About 95 percent lie within 1.96 standard errors
About 99 percent lie within 3.00 standard errors
88