Investment philosophies successful investment philosophies and the greatest investors who made them work

Models Measuring Market Risk While most risk and return models in use in finance agree on the first two steps of the risk analysis process, i.e., that risk comes from the distribution of

CHAPTER 1 INTRODUCTION

We all dream of beating the market and being super investors and spend an

inordinate amount of time and resources in this endeavor Consequently, we are easy prey

for the magic bullets and the secret formulae offered by eager salespeople pushing their

wares In spite of our best efforts, most of us fail in our attempts to be more than “average”

investors Nonetheless, we keep trying, hoping that we can be more like the investing

legends – another Warren Buffett or Peter Lynch We read the words written by and about

successful investors, hoping to find in them the key to their stock-picking abilities, so that

we can replicate them and become wealthy quickly

In our search, though, we are whipsawed by contradictions and anomalies In one

corner of the investment townsquare, stands one advisor, yelling to us to buy businesses

with solid cash flows and liquid assets because that’s what worked for Buffett In another

corner, another investment expert cautions us that this approach worked only in the old

world, and that in the new world of technology, we have to bet on companies with solid

growth prospects In yet another corner, stands a silver tongued salesperson with vivid

charts and presents you with evidence of his capacity to get you in and out of markets at

exactly the right times It is not surprising that facing this cacophony of claims and

counterclaims that we end up more confused than ever

In this chapter, we present the argument that to be successful with any investment

strategy, you have to begin with an investment philosophy that is consistent at its core and

which matches not only the markets you choose to invest in but your individual

characteristics In other words, the key to success in investing may lie not in knowing what

makes Peter Lynch successful but in finding out more about yourself

What is an investment philosophy?

An investment philosophy is a coherent way of thinking about markets, how they

work (and sometimes do not) and the types of mistakes that you believe consistently

underlie investor behavior Why do we need to make assumptions about investor mistakes?

As we will argue, most investment strategies are designed to take advantage of errors made

by some or all investors in pricing stocks Those mistakes themselves are driven by far

more basic assumptions about human behavior To provide an illustration, the rational or

irrational tendency of human beings to join crowds can result in price momentum – stocks

that have gone up the most in the recent past are more likely to go up in the near future Let

us consider, therefore, the ingredients of an investment philosophy

Human Frailty

Underlying all investment philosophies is a view about human behavior In fact, one

weakness of conventional finance and valuation has been the short shrift given to human

behavior It is not that we (in conventional finance) assume that all investors are rational, but

that we assume that irrationalities are random and cancel out Thus, for every investor who

tends to follow the crowd too much (a momentum investor), we assume an investor who

goes in the opposite direction (a contrarian), and that their push and pull in prices will

ultimately result in a rational price While this may, in fact, be a reasonable assumption for

the very long term, it may not be a realistic one for the short term

Academics and practitioners in finance who have long viewed the rational investor

assumption with skepticism have developed a new branch of finance called behavioral

finance which draws on psychology, sociology and finance to try to explain both why

investors behave the way they do and the consequences for investment strategies As we go

through this book, examining different investment philosophies, we will try at the outset of

each philosophy to explore the assumptions about human behavior that represent its base

Market Efficiency

A closely related second ingredient of an investment philosophy is the view of

market efficiency or its absence that you need for the philosophy to be a successful one

While all active investment philosophies make the assumption that markets are inefficient,

they differ in their views on what parts of the market the inefficiencies are most likely to

show up and how long they will last Some investment philosophies assume that markets

are correct most of the time but that they overreact when new and large pieces of

information are released about individual firms – they go up too much on good news and

down too much on bad news Other investment strategies are founded on the belief that

markets can make mistakes in the aggregate – the entire market can be under or overvalued

– and that some investors (mutual fund managers, for example) are more likely to make

these mistakes than others Still other investment strategies may be based on the

assumption that while markets do a good job of pricing stocks where there is a substantial

amount of information – financial statements, analyst reports and financial press coverage

–they systematically misprice stocks on which such information is not available

Tactics and Strategies

Once you have an investment philosophy in place, you develop investment strategies

that build on the core philosophy Consider, for instance, the views on market efficiency

expounded in the last section The first investor, who believes that markets over react to

news, may develop a strategy of buying stocks after large negative earnings surprises

(where the announced earnings come in well below expectations) and selling stocks after

positive earnings surprises The second investor who believes that markets make mistakes in

the aggregate may look at technical indicators (such as mutual fund cash positions and short

sales ratios) to find out whether the market is over bought or over sold and take a contrary

position The third investor who believes that market mistakes are more likely when

information is absent may look for stocks that are not followed by analysts or owned by

institutional investors

It is worth noting that the same investment philosophy can spawn multiple

investment strategies Thus, a belief that investors consistently overestimate the value of

growth and under estimate the value of existing assets can manifest itself in a number of

different strategies ranging from a passive one of buying low PE ratio stocks to a more

active one of buying such companies and attempting to liquidate them for their assets In

other words, the number of investment strategies will vastly outnumber the number of

investment philosophies

Why do you need an investment philosophy?

Most investors have no investment philosophy, and the same can be said about

many money managers and professional investment advisors They adopt investment

strategies that seem to work (for other investors) and abandon them when they do not Why,

if this is possible, you might ask, do you need an investment philosophy? The answer is

simple In the absence of an investment philosophy, you will tend to shift from strategy to

strategy simply based upon a strong sales pitch from a proponent or perceived recent

success There are two negative consequences for your portfolio:

a Lacking a rudder or a core set of beliefs, you will be easy prey for charlatans and

pretenders, with each one claiming to have found the magic strategy that beats the

market

b As you switch from strategy to strategy, you will have to change your portfolio,

resulting in high transactions costs and you will pay more in taxes

c While there may be strategies that do work for some investors, they may not be

appropriate for you, given your objectives, risk aversion and personal characteristics

In addition to having a portfolio that under performs the market, you are likely to

find yourself with an ulcer or worse

With a strong sense of core beliefs, you will have far more control over your destiny Not

only will you be able to reject strategies that do not fit your core beliefs about markets but

also to tailor investment strategies to your needs In addition, you will be able to get much

more of a big picture view of what it is that is truly different across strategies and what they

have in common

The Big Picture of Investing

To see where the different investment philosophies fit into investing, let us begin by

looking at the process of creating an investment portfolio Note that this is a process that we

all follow – amateur as well as professional investors - though it may be simpler for an

individual constructing his or her own portfolio than it is for a pension fund manager with a

varied and demanding clientele

Step 1: Understanding the Client

The process always starts with the investor and understanding his or her needs and

preferences For a portfolio manager, the investor is a client, and the first and often most

significant part of the investment process is understanding the client’s needs, the client’s tax

status and most importantly, his or her risk preferences For an individual investor

constructing his or her own portfolio, this may seem simpler, but understanding one’s own

needs and preferences is just as important a first step as it is for the portfolio manager

Step 2: Portfolio Construction

The next part of the process is the actual construction of the portfolio, which we

divide into three sub-parts

• The first of these is the decision on how to allocate the portfolio across different

asset classes defined broadly as equities, fixed income securities and real assets

(such as real estate, commodities and other assets) This asset allocation decision

can also be framed in terms of investments in domestic assets versus foreign assets,

and the factors driving this decision

• The second component is the asset selection decision, where individual assets are

picked within each asset class to make up the portfolio In practical terms, this is the

step where the stocks that make up the equity component, the bonds that make up

the fixed income component and the real assets that make up the real asset

component are selected

• The final component is execution, where the portfolio is actually put together Here

investors must weigh the costs of trading against their perceived needs to trade

quickly While the importance of execution will vary across investment strategies,

there are many investors who fail at this stage in the process

Step 3: Evaluate portfolio performance

The final part of the process, and often the most painful one for professional money

managers, is performance evaluation Investing is after all focused on one objective and one

objective alone, which is to make the most money you can, given your particular risk

preferences Investors are not forgiving of failure and unwilling to accept even the best of

excuses, and loyalty to money managers is not a commonly found trait By the same token,

performance evaluation is just as important to the individual investor who constructs his or

her own portfolio, since the feedback from it should largely determine how that investor

approaches investing in the future

These parts of the process are summarized in Figure 1.1, and we will return to this

figure to emphasize the steps in the process as we consider different investment

philosophies As you will see, while all investment philosophies may have the same end

objective of beating the market, each philosophy will emphasize a different component of

the overall process and require different skills for success

Figure 1.1: The Investment Process

The Client

Risk Tolerance/

The Portfolio Manager’s Job

- Measuring risk

- Effects of diversification

Execution

- How often do you trade?

- How large are your trades?

- Do you use derivatives to manage or enhance risk?

Asset Classes: Stocks Bonds Real Assets Countries: Domestic Non-Domestic

1 How much risk did the portfolio manager take?

2 What return did the portfolio manager make?

3 Did the portfolio manager underperform or outperform?

- The APM

Categorizing Investment Philosophies

We will present the range of investment philosophies in this section, using the

investment process to illustrate each philosophy While we will leave much of the detail for

later chapters, we will attempt to present at least the core of each philosophy here

Market Timing versus Asset Selection

The broadest categorization of investment philosophies is on whether they are based

upon timing overall markets or finding individual assets that are mispriced The first set of

philosophies can be categorized as market timing philosophies, while the second can be

viewed as security selection philosophies.

Within each, though, are numerous strands that take very different views about

markets Consider market timing first While most of us consider market timing only in the

context of the stock market, there are investors who consider market timing to include a

much broader range of markets – currency markets, bond markets and real estate come to

mind The range of choices among security selection philosophies is even wider and can

span charting and technical indicators, fundamentals (earnings, cashflows or growth) and

information (earnings reports, acquisition announcements)

While market timing has allure to all of us (because it pays off so well when you are

right), it is difficult to succeed at for exactly that reason There are all too often too many

investors attempting to time markets, and succeeding consistently is very difficult to do If

you decide to pick stocks, how do you choose whether you pick them based upon charts,

fundamentals or growth potential? The answer, as we will see, in the next section will

depend not only on your views of the market and empirical evidence but also on your

personal characteristics

Activist versus Passive Investing

At the broadest level, investment philosophies can also be categorized as active or

passive strategies In a passive strategy, you invest in a stock or company and wait for your

investment to pay off Assuming that your strategy is successful, this will come from the

market recognizing and correcting a misvaluation Thus, a portfolio manager who buys

stocks with low price earnings ratios and stable earnings is following a passive strategy So

is an index fund manager, who essentially buys all stocks in the index In an activist

strategy, you invest in a company and then try to change the way the company is run to

make it more valuable Venture capitalists can be categorized as activist investors since they

not only take positions in promising companies but they also provide significant inputs into

how these firms are run In recent years, we have seen investors like Michael Price and the

California State pension fund (Calpers) bring this activist philosophy to publicly traded

companies, using the clout of large positions to change the way companies are run We

should hasten to draw a contrast between activist investing and active investing Any investor

who tries to beat the market by picking stocks is viewed as an active investor Thus, active

investors can adopt passive strategies or activist strategies

Time Horizon

Different investment philosophies require different time horizons A philosophy

based upon the assumption that markets overreact to new information may generate short

term strategies For instance, you may buy stocks right after a bad earnings announcement,

hold a few weeks and sell (hopefully at a higher price, as the market corrects its over

reaction) In contrast, a philosophy of buying neglected companies (stocks that are not

followed by analysts or held by institutional investors) may require much longer time

horizons

One factor that will determine the time horizon of an investment philosophy is the

nature of the adjustment that has to occur for you to reap the rewards of a successful

strategy Passive value investors who buy stocks in companies that they believe are under

valued may have to wait years for the market correction to occur, even if they are right

Investors who trade ahead or after earnings reports, because they believe that markets do not

respond correctly to such reports, may hold the stock for only a few days At the extreme,

investors who see the same (or very similar) assets being priced differently in two markets

may buy the cheaper one and sell the more expensive one, locking in “arbitrage” profits in

a few minutes

Coexistence of Contradictory Strategies

One of the most fascinating aspects of investment philosophy is the coexistence of

investment philosophies based upon contradictory views of the markets Thus, you can have

market timers who trade on price momentum (suggesting that investors are slow to learn

from information) and market timers who are contrarians (which is based on the belief that

markets over react) Among security selectors who use fundamentals, you can have value

investors who buy value stocks, because they believe markets overprice growth, and growth

investors who buy growth stocks using exactly the opposite justification The coexistence

of these contradictory impulses for investing may strike some as irrational, but it is healthy

and may actually be responsible for keeping the market in balance In addition, you can

have investors with contradictory philosophies co-existing in the market because of their

different time horizons, views on risk and tax status For instance, tax exempt investors may

find stocks that pay large dividends a bargain, while taxable investors may reject these same

stocks because dividends are taxed at the ordinary tax rate

Investment Philosophies in Context

We can consider the differences between investment philosophies in the context of

the investment process, described in figure 1.1 Market timing strategies primarily affect the

asset allocation decision Thus, investors who believe that stocks are under valued will invest

more of their portfolios in stocks than would be justified given their risk preferences

Security selection strategies in all their forms – technical analysis, fundamentals or private

information – all center on the security selection component of the portfolio management

process You could argue that strategies that are not based upon grand visions of market

efficiency but are designed to take advantage of momentary mispricing of assets in markets

(such as arbitrage) revolve around the execution segment of portfolio management It is not

surprising that the success of such opportunistic strategies depend upon trading quickly to

take advantage of pricing errors, and keeping transactions costs low Figure 1.2 presents

the different investment philosophies

Figure 1.2: Investment Philosophies

Execution

- Trading Costs

- Trading Speed

Developing an Investment Philosophy: The Step

If every investor needs an investment philosophy, what is the process that you go

through to come up with such a philosophy? While this entire book is about the process, we

can lay out the three steps involved in this section

Step 1: Understand the fundamentals of risk and valuation

Before you embark on the journey of finding an investment philosophy, you need to

get your financial toolkit ready At the minimum, you should understand

- how to measure the risk in an investment and relate it to expected returns

- how to value an asset, whether it be a bond, stock or a business

- the ingredients of trading costs, and the trade off between the speed of trading and

the cost of trading

We would hasten to add that you do not need to be a mathematical wizard to do any of these

and we will begin this book with a section dedicated to providing these basic tools

Step 2: Develop a point of view about how markets work and where they might break

down

Every investment philosophy is grounded in a point of view about human behavior

(and irrationality) While personal experience often determines how we view our fellow

human beings, we should expand this to consider broader evidence from markets on how

investors act before we make our final judgments

Over the last few decades, it has become easy to test different investment strategies

as data becomes more accessible There now exists a substantial body of research on the

investment strategies that have beaten the market over time For instance, researchers have

found convincing evidence that stocks with low price to book value ratios have earned

significantly higher returns than stocks of equivalent risk but higher price to book value

ratios It would be foolhardy not to review this evidence in the process of developing your

investment philosophy At the same time, though, you should keep in mind three caveats

about this research:

- Since they are based upon the past, they represent a look in the rearview mirror

Strategies that earned substantial returns in the 1990s may no longer be viable

strategies now In fact, as successful strategies get publicized either directly (in

books and articles) or indirectly (by portfolio managers trading on them), you

should expect to see them become less effective

- Much of the research is based upon constructing hypothetical portfolios, where you

buy and sell stocks at historical prices and little or no attention is paid to

transactions costs To the extent that trading can cause prices to move, the actual

returns on strategies can be very different from the returns on the hypothetical

portfolio

- A test of an investment strategy is almost always a joint test of both the strategy and

a model for risk To see why, consider the evidence that stocks with low price to

book value ratios earn higher returns than stocks with high price to book value

ratios, with similar risk (at least as measured by the models we use) To the extent

that we mismeasure risk or ignore a key component of risk, it is entirely possible

that the higher returns are just a reward for the greater risk associated with low price

to book value stocks

Since understanding whether a strategy beats the market is such a critical component of

investing, we will consider the approaches that are used to test a strategy, some basic rules

that need to be followed in doing these tests and common errors that are made

(unintentionally or intentionally) when running such tests As we look at each investment

philosophy, we will review the evidence that is available on strategies that emerge from that

philosophy

Step 3: Find the philosophy that provides the best fit for you

Once you understand the basics of investing, form your views on human foibles and

behavior and review the evidence accumulated on each of the different investment

philosophies, you are ready to make your choice In our view, there is potential for success

with almost every investment philosophy (yes, even charting) but the prerequisites for

success can vary In particular, success may rest on:

- Your risk aversion: Some strategies are inherently riskier than others For instance,

venture capital or private equity investing, where you invest your funds in small,

private businesses that show promise is inherently more risky than buying value

stocks – equity in large, stable, publicly traded companies The returns are also

likely to be higher However, more risk averse investors should avoid the first

strategy and focus on the second Picking an investment philosophy (and strategy)

that requires you to take on more risk than you feel comfortable taking can be

hazardous to your health and your portfolio

- The size of your portfolio: Some strategies require larger portfolios for success

whereas others work only on a smaller scale For instance, it is very difficult to be an

activist value investor if you have only $ 100,000 in your portfolio, since firms are

unlikely to listen to your complaints On the other hand, a portfolio manager with $

100 billion to invest may not be able to adopt a strategy that requires buying small,

neglected companies With such a large portfolio, she would very quickly end up

becoming the dominant stockholder in each of the companies and affecting the price

every time she trade

- Your time horizon: Some investment philosophies are predicated on a long time

horizon, whereas others require much shorter time horizons If you are investing

your own funds, your time horizon is determined by your personal characteristics –

some of us are more patient than others – and your needs for cash – the greater the

need for liquidity, the shorter your time horizon has to be If you are a professional

(an investment adviser or portfolio manager), managing the funds of others, it is

your clients time horizon and cash needs that will drive your choice of investment

philosophies and strategies

- Your tax status: Since such a significant portion of your money ends up going to

the tax collectors, they have a strong influence on your investment strategies and

perhaps even the investment philosophy you adopt In some cases, you may have to

abandon strategies that you find attractive on a pre-tax basis because of the tax bite

that they expose you to

Thus, the right investment philosophy for you will reflect your particular strengths and

weaknesses It should come as no surprise, then, that investment philosophies that work for

some investors do not work for others Consequently, there can be no one investment

philosophy that can be labeled “best” for all investors

Conclusion

An investment philosophy represents a set of core beliefs about how investors

behave and markets work To be a successful investor, you not only have to consider the

evidence from markets but you also have to examine your own strengths and weaknesses to

come up with an investment philosophy that best fits you Investors without core beliefs

tend to wander from strategy to strategy, drawn by the anecdotal evidence or recent success,

creating transactions costs and incurring losses as a consequence Investors with clearly

defined investment philosophies tend to be more consistent and disciplined in their

investment choices

In this chapter, we considered a broad range of investment philosophies from market

timing to arbitrage and placed each of them in the broad framework of portfolio

management We also examined the three steps in the path to an investment philosophy,

beginning with the understanding of the tools of investing – risk, trading costs and valuation

– continuing with an evaluation of the empirical evidence on whether, when and how

markets break down and concluding with a self-assessment, to find the investment

philosophy that best matches your time horizon, risk preferences and portfolio

characteristics

CHAPTER 2 UPSIDE, DOWNSIDE: UNDERSTANDING RISK

Risk is part of investing and understanding what it is and how it is measured

is essential to developing an investment philosophy In this chapter, we will lay the

foundations for analyzing risk in investments We present alternative models for measuring

risk and converting these risk measures into an expected return We will also consider ways

in an investor can measure his or her risk aversion

We begin with a discussion of risk and present our analysis in three steps In the first step,

we define risk in terms of uncertainty about future returns The greater this uncertainty, the

more risky an investment is perceived to be The next step, which we believe is the central

one, is to decompose this risk into risk that can be diversified away by investors and risk

that cannot In the third step, we look at how different risk and return models in finance

attempt to measure this non-diversifiable risk We compare and contrast the most widely

used model, the capital asset pricing model, with other models, and explain how and why

they diverge in their measures of risk and the implications for the equity risk premium In

the second part of this chapter, we consider default risk and how it is measured by ratings

agencies In addition, we discuss the determinants of the default spread and why it might

change over time

What is risk?

Risk, for most of us, refers to the likelihood that in life’s games of chance, we will

receive an outcome that we will not like For instance, the risk of driving a car too fast is

getting a speeding ticket, or worse still, getting into an accident Webster’s dictionary, in

fact, defines risk as “exposing to danger or hazard” Thus, risk is perceived almost entirely

in negative terms

In finance, our definition of risk is both different and broader Risk, as we see it,

refers to the likelihood that we will receive a return on an investment that is different from

the return we expected to make Thus, risk includes not only the bad outcomes, i.e, returns

that are lower than expected, but also good outcomes, i.e., returns that are higher than

expected In fact, we can refer to the former as downside risk and the latter is upside risk;

but we consider both when measuring risk In fact, the spirit of our definition of risk in

finance is captured best by the Chinese symbols for risk, which are reproduced below:

The first symbol is the symbol for “danger”, while the second is the symbol for

“opportunity”, making risk a mix of danger and opportunity It illustrates very clearly the

tradeoff that every investor and business has to make – between the higher rewards that

come with the opportunity and the higher risk that has to be borne as a consequence of the

danger

Much of this chapter can be viewed as an attempt to come up with a model that best

measures the “danger” in any investment and then attempts to convert this into the

“opportunity” that we would need to compensate for the danger In financial terms, we

term the danger to be “risk” and the opportunity to be “expected return”

Equity Risk and Expected Return

To demonstrate how risk is viewed in finance, we will present risk analysis in three

steps First, we will define risk Second, we will differentiate between risk that is specific to

one or a few investments and risk that affects a much wider cross section of investments

We will argue that in a market where investors are well diversified, it is only the latter risk,

called market risk that will be rewarded Third, we will look at alternative models for

measuring this market risk and the expected returns that go with it

I Defining Risk

Investors who buy assets expect to earn returns over the time horizon that they hold

the asset Their actual returns over this holding period may be very different from the

expected returns and it is this difference between actual and expected returns that is source

of risk For example, assume that you are an investor with a year time horizon buying a

1-year Treasury bill (or any other default-free one-1-year bond) with a 5% expected return At

the end of the 1-year holding period, the actual return on this investment will be 5%, which

is equal to the expected return The return distribution for this investment is shown in

Figure 2.1

Probability = 1

Expected Return

Figure 2.1: Probability Distribution for Riskfree Investment

The actual return is always equal to the expected return

This is a riskless investment

To provide a contrast to the riskless investment, consider an investor who buys stock

in a company like Cisco This investor, having done her research, may conclude that she can

make an expected return of 30% on Cisco over her 1-year holding period The actual return

over this period will almost certainly not be equal to 30%; it might be much greater or much

lower The distribution of returns on this investment is illustrated in Figure 2.2

Expected Return

Figure 2.2: Probability Distribution for Risky Investment

This distribution measures the probabilitythat the actual return will be different fromthe expected return

In addition to the expected return, an investor has to note that the actual returns, in this case,

are different from the expected return The spread of the actual returns around the expected

return is measured by the variance or standard deviation of the distribution; the greater the

deviation of the actual returns from expected returns, the greater the variance

One of the limitations of variance is that it considers all variation from the expected

return to be risk Thus, the potential that you will earn a

60% return on Cisco (30% more than the expected return of

30%) affects the variance exactly as much as the potential

that you will earn 0% (30% less than the expected return)

In other words, you do not distinguish between downside

and upside risk This is justified by arguing that risk is

symmetric – upside risk must inevitably create the potential

you could compute a modified version of the variance, called

the semi-variance, where you consider only the returns that fall below the expected return.

It is true that measuring risk with variance or semi-variance can provide too limited a

view of risk, and there are some investors who use simpler stand-ins (proxies) for risk For

instance, you may consider stocks in some sectors (such as technology) to be riskier than

1 In statistical terms, this is the equivalent of assuming that the distribution of returns is close to normal.

The Most and Least

Volatile Stocks: Take a look

at the 50 most and 50 leastvolatile stocks traded in theUnited States, based upon 5years of weekly data

stocks in other sectors (say, food processing) Others prefer ranking or categorization

systems, where you put firms into risk classes, rather than trying to measure its risk in units

Thus, Value Line ranks firms into five classes, based upon risk

There is one final point that needs to be made about how variances and

semi-variances are estimated for most stocks Analysts usually look at the past – stock prices over

the last 2 or 5 years- to make these estimates This may be appropriate for firms that have

not changed their fundamental characteristics – business or leverage – over the period For

firms that have changed significantly over time, variances from the past may provide a very

misleading view of betas in the future

II Diversifiable and Non-diversifiable Risk

Although there are many reasons that actual returns may differ from expected

returns, we can group the reasons into two categories: firm-specific and market-wide The

risks that arise from firm-specific actions affect one or a few investments, while the risk

arising from market-wide reasons affect many or all investments This distinction is critical

to the way we assess risk in finance

The Components of Risk

When an investor buys stock or takes an equity position in a firm, he or she is

exposed to many risks Some risk may affect only one or a few firms and it is this risk that

we categorize as firm-specific risk Within this category, we would consider a wide range of

risks, starting with the risk that a firm may have misjudged the demand for a product from

its customers; we call this project risk For instance, consider an investment by Boeing in a

new larger capacity airplane that we will call the Super Jumbo This investment is based on

the assumption that airlines want a larger airplane and will be willing to pay a higher price

for it If Boeing has misjudged this demand, it will clearly have an impact on Boeing’s

earnings and value, but it should not have a significant effect on other firms in the market

The risk could also arise from competitors proving to be stronger or weaker than

anticipated; we call this competitive risk For instance, assume that Boeing and Airbus are

competing for an order from Qantas, the Australian airline The possibility that Airbus may

win the bid is a potential source of risk to Boeing and perhaps a few of its suppliers But

again, only a handful of firms in the market will be affected by it Similarly, the Home

Depot recently launched an online store to sell its home improvement products Whether it

succeeds or not is clearly important to the Home Depot and its competitors, but it is unlikely

to have an impact on the rest of the market In fact, we would extend our risk measures to

include risks that may affect an entire sector but are restricted to that sector; we call this

sector risk For instance, a cut in the defense budget in the United States will adversely

affect all firms in the defense business, including Boeing, but there should be no significant

impact on other sectors, such as food and apparel What is common across the three risks

described above – project, competitive and sector risk – is that they affect only a small

sub-set of firms

There is other risk that is much more pervasive and affects many if not all

investments For instance, when interest rates increase, all investments are negatively

affected, albeit to different degrees Similarly, when the economy weakens, all firms feel the

effects, though cyclical firms (such as automobiles, steel and housing) may feel it more We

term this risk market risk.

Finally, there are risks that fall in a gray area, depending upon how many assets they

affect For instance, when the dollar strengthens against other currencies, it has a significant

impact on the earnings and values of firms with international operations If most firms in the

market have significant international operations, it could well be categorized as market risk

If only a few do, it would be closer to firm-specific risk Figure 2.3 summarizes the break

down or the spectrum of firm specific and market risks

Actions/Risk that

affect only one

firm

Actions/Risk that affect all

or weaker than anticipated

Entire Sector may be affected

by action

Exchange rate and Political risk

Interest rate, Inflation &

News about Econoomy

Figure 2.3: A Break Down of Risk

Affects few firms

Affects many firms

Why Diversification reduces or eliminates Firm-specific Risk: An Intuitive Explanation

As an investor, you could invest your entire portfolio in one stock, say Boeing If

you do so, you are exposed to both firm specific and market risk If, however, you expand

your portfolio to include other assets or stocks, you are diversifying, and by doing so, you

can reduce your exposure to firm-specific risk There are two reasons why diversification

reduces or, at the limit, eliminates firm specific risk The first is that each investment in a

Highest R-squared

companies: Take a look

at the 50 companies withthe highest proportion ofmarket risk using the last

5 years or weekly data

diversified portfolio is a much smaller percentage of that portfolio than would be the case if

you were not diversified Thus, any action that increases or decreases the value of only that

investment or a small group of investments will have only a small impact on your overall

portfolio, whereas undiversified investors are much more exposed to changes in the values

of the investments in their portfolios The second reason is that the effects of firm-specific

actions on the prices of individual assets in a portfolio can be either positive or negative for

each asset in any period Thus, in very large portfolios, this risk will average out to zero and

will not affect the overall value of the portfolio

In contrast, the effects of market-wide movements are likely to be in the same

direction for most or all investments in a portfolio, though

some assets may be affected more than others For instance,

other things being equal, an increase in interest rates will

lower the values of most assets in a portfolio Being more

diversified does not eliminate this risk

One of the simplest ways of measuring how much

risk in a firm is firm specific is to look at the proportion of

the firm’s price movements that are explained by the

market This is called the R-squared and it should range

between zero and one can be stated as a percentage; it measures the proportion of the firm’s

risk that comes from the market A firm with an R-squared of zero has 100% firm specific

risk whereas a firm with an R-squared of 0% has no firm specific risk

Why is the marginal investor assumed to be diversified?

The argument that diversification reduces an investor’s exposure to risk is clear both

intuitively and statistically, but risk and return models in finance go further The models

look at risk through the eyes of the investor most likely to be trading on the investment at

any point in time, i.e the marginal investor They argue that this investor, who sets prices for

investments, is well diversified; thus, the only risk that he or she cares about is the risk

added on to a diversified portfolio or market risk This argument can be justified simply

The risk in an investment will always be perceived to be higher for an undiversified investor

than for a diversified one, since the latter does not shoulder any firm-specific risk and the

former does If both investors have the same expectations about future earnings and cash

flows on an asset, the diversified investor will be willing to pay a higher price for that asset

because of his or her perception of lower risk Consequently, the asset, over time, will end

up being held by diversified investors

This argument is powerful, especially in markets where assets can be traded easily

and at low cost Thus, it works well for a stock traded in the United States, since investors

can become diversified at fairly low cost In addition, a significant proportion of the trading

in US stocks is done by institutional investors, who tend to be well diversified It becomes a

more difficult argument to sustain when assets cannot be easily traded, or the costs of

trading are high In these markets, the marginal investor may well be undiversified and

firm-specific risk may therefore continue to matter when looking at individual investments For

instance, real estate in most countries is still held by investors who are undiversified and

have the bulk of their wealth tied up in these investments

III Models Measuring Market Risk

While most risk and return models in use in finance agree on the first two steps of

the risk analysis process, i.e., that risk comes from the distribution of actual returns around

the expected return and that risk should be measured from the perspective of a marginal

investor who is well diversified, they part ways when it comes to measuring

non-diversifiable or market risk In this section, we will discuss the different models that exist in

finance for measuring market risk and why they differ We will begin with what still is the

standard model for measuring market risk in finance – the capital asset pricing model

(CAPM) – and then discuss the alternatives to this model that have developed over the last

two decades While we will emphasize the differences, we will also look at what they have in

common

A The Capital Asset Pricing Model (CAPM)

The risk and return model that has been in use the longest and is still the standard in

most real world analyses is the capital asset pricing model (CAPM) In this section, we will

examine the assumptions made by the model and the measures of market risk that emerge

from these assumptions

Assumptions

While diversification reduces the exposure of investors to firm specific risk, most

investors limit their diversification to holding only a few assets Even large mutual funds

rarely hold more than a few hundred stocks and many of them hold as few as ten to twenty

There are two reasons why investors stop diversifying One is that an investor or mutual

fund manager can obtain most of the benefits of diversification from a relatively small

portfolio, because the marginal benefits of diversification become smaller as the portfolio

gets more diversified Consequently, these benefits may not cover the marginal costs of

diversification, which include transactions and monitoring costs Another reason for limiting

diversification is that many investors (and funds) believe they can find under valued assets

and thus choose not to hold those assets that they believe to be fairly or over valued

The capital asset pricing model assumes that there are no transactions costs and that

all assets are traded It also assumes that everyone has access to the same information and

that investors therefore cannot find under or over valued assets in the market place Making

these assumptions allows investors to keep diversifying without additional cost At the limit,

each investor’s will include every traded asset in the market held in proportion to its market

value The fact that this diversified portfolio includes all traded assets in the market is the

reason it is called the market portfolio, which should not be a surprising result, given the

benefits of diversification and the absence of transactions costs in the capital asset pricing

model If diversification reduces exposure to firm-specific risk and there are no costs

associated with adding more assets to the portfolio, the logical limit to diversification is to

hold a small proportion of every traded asset in the market If this seems abstract, consider

the market portfolio to be an extremely well diversified mutual fund that holds stocks and

real assets, and treasury bills as the riskless asset In the CAPM, all investors will hold

combinations of treasury bills and the same mutual fund2

Investor Portfolios in the CAPM

If every investor in the market holds the identical market portfolio, how exactly do

investors reflect their risk aversion in their investments? In the capital asset pricing model,

investors adjust for their risk preferences in their allocation decision, where they decide how

much to invest in a riskless asset and how much in the market portfolio Investors who are

risk averse might choose to put much or even all of their wealth in the riskless asset

Investors who want to take more risk will invest the bulk or even all of their wealth in the

market portfolio Investors, who invest all their wealth in the market portfolio and are still

desirous of taking on more risk, would do so by borrowing at the riskless rate and investing

more in the same market portfolio as everyone else

These results are predicated on two additional assumptions First, there exists a

riskless asset, where the expected returns are known with certainty Second, investors can

lend and borrow at the same riskless rate to arrive at their optimal allocations While lending

at the riskless rate can be accomplished fairly simply by buying treasury bills or bonds,

borrowing at the riskless rate might be more difficult to do for individuals There are

variations of the CAPM that allow these assumptions to be relaxed and still arrive at the

conclusions that are consistent with the model

2 The significance of introducing the riskless asset into the choice mix, and the implications for portfolio

choice were first noted in Sharpe (1964) and Lintner (1965) Hence, the model is sometimes called the

Sharpe-Lintner model.

Highest and Lowest

Beta Stocks: Take a look at

the 50 highest beta and 50lowest beta stocks traded

in the United States, basedupon 5 years of weeklydata

Measuring the Market Risk of an Individual Asset

The risk of any asset to an investor is the risk added by that asset to the investor’s

overall portfolio In the CAPM world, where all investors

hold the market portfolio, the risk to an investor of an

individual asset will be the risk that this asset adds on to

that portfolio Intuitively, if an asset moves independently

of the market portfolio, it will not add much risk to the

market portfolio In other words, most of the risk in this

asset is firm-specific and can be diversified away In

contrast, if an asset tends to move up when the market

portfolio moves up and down when it moves down, it will

add risk to the market portfolio This asset has more market risk and less firm-specific risk

Statistically, this added risk is measured by the covariance of the asset with the market

portfolio

The covariance is a percentage value and it is difficult to pass judgment on the

relative risk of an investment by looking at this value In other words, knowing that the

covariance of Boeing with the Market Portfolio is 55% does not provide us a clue as to

whether Boeing is riskier or safer than the average asset We therefore standardize the risk

measure by dividing the covariance of each asset with the market portfolio by the variance of

the market portfolio This yields a risk measure called the beta of the asset:

Variance of the Market PortfolioThe beta of the market portfolio, and by extension, the average asset in it, is one Assets that

are riskier than average (using this measure of risk) will have betas that are greater than 1

and assets that are less risky than average will have betas that are less than 1 The riskless

asset will have a beta of 0

Getting Expected Returns

Once you accept the assumptions that lead to all investors holding the market

portfolio and measure the risk of an asset with beta, the return you can expect to make can

be written as a function of the risk-free rate and the beta of that asset

Expected Return on an investment = Riskfree Rate + Beta (Risk Premium for

buying the average risk investment)

Consider the three components that go into the expected return

a Riskless Rate: The return you can make on a riskfree investment becomes the base from

which you build expected returns Essentially, you are assuming that if you can make 5%

investing in treasury bills or bonds, you would not settle for less than this as an expected

return for investing in a riskier asset Generally speaking, we use the interest rate on

government securities to estimate the riskfree rate, assuming that such securities have no

default risk While this may be a safe assumption in the United States and other developed

markets, it may be inappropriate in many emerging markets, where governments themselves

are viewed as capable of defaulting In such cases, the government bond rate will include a

premium for default risk and this premium will have to be removed to arrive at a riskfree

b The beta of the investment: The beta is the only component in this model which varies

from investment to investment, with investments that add more risk to the market portfolio

having higher betas But where do betas come from? Since the beta measures the risk added

to a market portfolio by an individual stock, it is usually estimated by running a regression

of past returns on the stock against returns on a market index

Figure 2.4: Beta Estimate for Cisco: S&P 500

Slope of the line is beta

R squared measures how far points fall from regression line.

3 Consider, for example, a government bond issued by the Brazilian government Denominated in Brazilian

Real, this bond has an interest rate of 17% The Brazilian government is viewed as having default risk on

this bond and is rated BB by Standard and Poor’s If we subtract the typical default spread earned by BB rated

country bonds (about 5%) from 17%, we end up with a riskless rate in Brazilian Real of 12%.

Risk Premium for the

United States: Take a look at

the equity risk premiumimplied in the U.S stockmarket from 1960 throughthe most recent year

The slope of the regression captures how sensitive a stock is to market movements and is

the beta of the stock In the regression above, for instance, the beta of Cisco would be 1.39

There are, however, two problems with regression betas One is that the beta comes with

estimation error – the standard error in the estimate is 0.27 Thus, the true beta for Cisco

could be anywhere from 85 to 1.93 – this range is estimated by adding and subtracting two

standard errors to the beta estimate The other is that

firms change over time and we are looking backwards

rather than looking forwards A better way to estimate

betas is to look at the average beta for publicly traded

firms in the business or businesses Cisco operates in

While these betas come from regressions as well, the

average beta is always more precise than any one firm’s

beta estimate

c The risk premium for buying the average risk

investment: You can view this as the premium you would demand for investing in equities as

a class as opposed to the riskless investment Thus, if you require a return of 9% for

investing in equities and the treasury bond rate is 5%, your risk premium is 4% There are

again two ways in which you can estimate this risk premium One is to look at the past and

look at the typical premium you would have earned investing in stocks as opposed to a

riskless investment This number is called a historical premium and yields about 5-7% for

the United States The other is to look at how stocks are priced today and to estimate the

premium that investors must be demanding This is called an implied premium and yields a

value of about 4% for U.S stocks in early 2002

Bringing it all together, you could use the capital asset pricing model to estimate the

expected return on a stock for Cisco for the future (assuming a treasury bond rate of 5%,

the regression beta of 1.39 and a risk premium of 4%):

Expected return on Cisco = T Bond Rate + Beta * Risk Premium

= 5% + 1.39 (4%) = 10.56%

What does this number imply? It does not mean that you will earn 10.56% every year from

risk, but it does provide a benchmark that you will have to meet and beat if you are

considering Cisco as an investment For Cisco to be a good investment, you would have to

expect it to make more than 10.56% as an annual return in the future

In summary, in the capital asset pricing model, all the market risk is captured in the beta,

measured relative to a market portfolio, which at least in theory should include all traded

assets in the market place held in proportion to their market value

Betas for Other Investments

Most services report betas for publicly traded stocks, but there is no reason why the

concept cannot be extended to other investments You could compute the beta of real estate,

gold or even fine art as an investment, just as you computed the beta for Cisco While

analysts have done this and concluded that both real estate and gold are low beta

investments (though not necessarily low variance investments), we would add a few

cautionary notes The first is that it is difficult to get traded prices on some alternative

stock index as their measure of the market portfolio Since the market portfolio in the capital

asset pricing model is supposed to include all traded assets, this likely to give you betas that

are biased downwards for non-equity investments

If you modify the market portfolio to include other traded asset classes and compute

betas for alternative investments, you may even find some that have negative betas While,

on the face of it, this may seem absurd, you can get negative betas for investments that

reduce the risk (rather than add on to risk) of the market portfolio Essentially, these

investments act as insurance against some large component of market risk, going up as

other investments in the portfolio go down This is the reason why some analysts claim that

gold as an investment should have a negative beta, because it tends to do well when inflation

increases whereas financial investments are hurt

B Alternatives to the Capital Asset Pricing Model

The restrictive assumptions on transactions costs and private information in the

capital asset pricing model and the model’s dependence on the market portfolio have long

been viewed with skepticism by both academics and practitioners There are three

alternatives to the CAPM that have been developed over time:

1 Arbitrage Pricing Model: To understand the arbitrage pricing model, we need to begin

with a definition of arbitrage The basic idea is a simple one Two portfolios or assets with

the same exposure to market risk should be priced to earn exactly the same expected

returns If they are not, you could buy the less expensive portfolio, sell the more expensive

portfolio, have no risk exposure and earn a return that exceeds the riskless rate This is

arbitrage If you assume that arbitrage is not possible and that investors are diversified, you

can show that the expected return on an investment should be a function of its exposure to

market risk While this statement mirrors what was stated in the capital asset pricing model,

4 Analysts have tried to get around this problem by using the prices of real estate investment trusts which

are traded, but they represent a small fraction of all real estate investments.

the arbitrage pricing model does not make the restrictive assumptions about transactions

costs and private information that lead to the conclusion that one beta can capture an

investment’s entire exposure to market risk Instead, in the arbitrage pricing model, you can

have multiples sources of market risk and different exposures to each (betas) and your

expected return on an investment can be written as:

Expected return = Riskfree rate + Beta for factor 1 (Risk premium for factor 1) +

Beta for factor 2 (Risk premium for factor 2)….+ Beta for factor n (Risk premium

for factor n)

The practical questions then become knowing how many factors there are that determine

expected returns and what the betas for each investment are against these factors The

arbitrage model estimates both by examining historical data on stock returns for common

patterns (since market risk affects most stocks) and estimating each stock’s exposure to

these patterns in a process called factor analysis A factor analysis provides two output

measures:

1 It specifies the number of common factors that affected the historical return data

2 It measures the beta of each investment relative to each of the common factors and

provides an estimate of the actual risk premium earned by each factor

The factor analysis does not, however, identify the factors in economic terms – the factors

remain factor 1, factor etc In summary, in the arbitrage pricing model, the market risk is

measured relative to multiple unspecified macroeconomic variables, with the sensitivity of

the investment relative to each factor being measured by a beta The number of factors, the

factor betas and factor risk premiums can all be estimated using the factor analysis

2 Multi-factor Models for risk and return: The arbitrage pricing model's failure to

identify the factors specifically in the model may be a statistical strength, but it is an intuitive

weakness The solution seems simple: Replace the unidentified statistical factors with

specific economic factors and the resultant model should have an economic basis while still

retaining much of the strength of the arbitrage pricing model That is precisely what

multi-factor models try to do Multi-multi-factor models generally are determined by historical data,

rather than economic modeling Once the number of factors has been identified in the

arbitrage pricing model, their behavior over time can be extracted from the data The

behavior of the unnamed factors over time can then be compared to the behavior of

macroeconomic variables over that same period to see whether any of the variables is

correlated, over time, with the identified factors

For instance, Chen, Roll, and Ross (1986) suggest that the following

macroeconomic variables are highly correlated with the factors that come out of factor

analysis: industrial production, changes in default premium, shifts in the term structure,

unanticipated inflation, and changes in the real rate of return These variables can then be

correlated with returns to come up with a model of expected returns, with firm-specific betas

calculated relative to each variable

where

βGNP = Beta relative to changes in industrial production

E(RGNP) = Expected return on a portfolio with a beta of one on the industrial

production factor and zero on all other factors

βI = Beta relative to changes in inflation

E(RI) = Expected return on a portfolio with a beta of one on the inflation factor

and zero on all other factorsThe costs of going from the arbitrage pricing model to a macroeconomic multi-

factor model can be traced directly to the errors that can be made in identifying the factors

The economic factors in the model can change over time, as will the risk premia associated

with each one For instance, oil price changes were a significant economic factor driving

expected returns in the 1970s but are not as significant in other time periods Using the

wrong factor or missing a significant factor in a multi-factor model can lead to inferior

estimates of expected return

In summary, multi-factor models, like the arbitrage pricing model, assume that

market risk can be captured best using multiple macro economic factors and betas relative to

each Unlike the arbitrage pricing model, multi factor models do attempt to identify the

macro economic factors that drive market risk

3 Regression or Proxy Models: All the models described so far begin by defining market

risk in broad terms and then developing models that might best measure this market risk

All of them, however, extract their measures of market risk (betas) by looking at historical

data There is a final class of risk and return models that start with the returns and try to

explain differences in returns across stocks over long time periods using characteristics

such as a firm’s market value or price multiples5 Proponents of these models argue that if

some investments earn consistently higher returns than other investments, they must be

riskier Consequently, we could look at the characteristics that these high-return investments

5 A price multiple is obtained by dividing the market price by its earnings or its book value Studies

indicate that stocks that have low price to earnings multiples or low price to book value multiples earn

higher returns than other stocks.

have in common and consider these characteristics to be indirect measures or proxies for

market risk

Fama and French, in a highly influential study of the capital asset pricing model in

the early 1990s, noted that actual returns between 1963 and 1990 have been highly

correlated with book to price ratios6 and size High return investments, over this period,

tended to be investments in companies with low market capitalization and high book to price

ratios Fama and French suggested that these measures be used as proxies for risk and

report the following regression for monthly returns on stocks on the NYSE:

MV = Market Value of Equity

BV/MV = Book Value of Equity / Market Value of Equity

The values for market value of equity and book-price ratios for individual firms, when

plugged into this regression, should yield expected monthly returns

A Composite of the CAPM and Proxy Models: Three Factor Models

The capital asset pricing model relates the expected return on an investment to its

beta against a market portfolio The proxy models find that there are other variables such as

market capitalization and price to book ratios explain returns better than betas There are

composite models that attempt to blend the two and estimated expected returns as a function

of betas, market capitalization and price to book ratios These are also called factor models

Will these composite models work better than the CAPM? Of course! Should we

therefore use them instead of the CAPM? The answer is that it depends on what you are

trying to do If you are trying to explain the past performance of portfolio managers, it may

make sense to use composite models, since failing to do so will make portfolio managers

who invest in small cap stocks look much better than portfolio managers who invest in large

cap stocks If you are trying to estimate expected returns for the future, to make judgments

on where to invest your money, you should be careful about going down this road, since it

seems designed to lead the conclusion that everything is fairly priced Consider why If

there are pockets of the market which are systematically mispriced – say small cap stocks

with low price to book ratios – you want to buy these stocks and you will using a

conventional risk and return model If you use a composite model and include market

capitalization and price to book ratios as factors, these same stocks will look fairly valued

6 The book to price ratio is the ratio of the book value of equity to the market value of equity.

A Comparative Analysis of Risk and Return Models

Figure 2.5 summarizes all the risk and return models in finance, noting their

similarities in the first two steps and the differences in the way they define market risk

Figure 2.5: Risk and Return Models in Finance

The risk in an investment can be measured by the variance in actual returns around an

expected return

E(R)

Riskless Investment Low Risk Investment High Risk Investment

Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)

Can be diversified away in a diversified portfolio Cannot be diversified away since most assets

1 each investment is a small proportion of portfolio are affected by it.

2 risk averages out across investments in portfolio

The marginal investor is assumed to hold a “diversified” portfolio Thus, only market risk will

be rewarded and priced.

If there is

1 no private information

2 no transactions cost

the optimal diversified

portfolio includes every

traded asset Everyone

will hold this market portfolio

Market Risk = Risk

added by any investment

to the market portfolio:

If there are no arbitrage opportunities then the market risk of any asset must be captured by betas relative to factors that affect all investments.

Market Risk = Risk exposures of any asset to market factors

Beta of asset relative to

Market portfolio (from

a regression)

Betas of asset relative

to unspecified market factors (from a factor analysis)

Since market risk affects most or all investments,

it must come from macro economic factors.

Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relative

to specified macro economic factors (from

a regression)

In an efficient market, differences in returns across long periods must

be due to market risk differences Looking for variables correlated with returns should then give

us proxies for this risk.

Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from a regression)

Step 1: Defining Risk

Step 2: Differentiating between Rewarded and Unrewarded Risk

Step 3: Measuring Market Risk

As noted in Figure 2.5, all the risk and return models developed in this chapter make

some assumptions in common They all assume that only market risk is rewarded and they

derive the expected return as a function of measures of this risk The capital asset pricing

model makes the most restrictive assumptions about how markets work but arrives at the

simplest model, with only one factor driving risk and requiring estimation The arbitrage

pricing model makes fewer assumptions but arrives at a more complicated model, at least in

terms of the parameters that require estimation The capital asset pricing model can be

considered a specialized case of the arbitrage pricing model, where there is only one

underlying factor and it is completely measured by the market index In general, the CAPM

has the advantage of being a simpler model to estimate and to use, but it will underperform

the richer multi-factor models when an investment is sensitive to economic factors not well

represented in the market index For instance, oil company stocks, which derive most of

their risk from oil price movements, tend to have low CAPM betas and low expected

returns An arbitrage pricing model, where one of the factors may measure oil and other

commodity price movements, will yield a better estimate of risk and higher expected return

for these firms7

Which of these models works the best? Is beta a good proxy for risk and is it

correlated with expected returns? The answers to these questions have been debated widely

in the last two decades The first tests of the CAPM suggested that betas and returns were

positively related, though other measures of risk (such as variance) continued to explain

differences in actual returns This discrepancy was attributed to limitations in the testing

techniques In 1977, Roll, in a seminal critique of the model's tests, suggested that since the

market portfolio could never be observed, the CAPM could never be tested, and all tests of

the CAPM were therefore joint tests of both the model and the market portfolio used in the

tests In other words, all that any test of the CAPM could show was that the model worked

(or did not) given the proxy used for the market portfolio It could therefore be argued that

in any empirical test that claimed to reject the CAPM, the rejection could be of the proxy

used for the market portfolio rather than of the model itself Roll noted that there was no

way to ever prove that the CAPM worked and thus no empirical basis for using the model

Fama and French (1992) examined the relationship between betas and returns

between 1963 and 1990 and concluded that there is no relationship These results have been

contested on three fronts First, Amihud, Christensen, and Mendelson (1992), used the same

data, performed different statistical tests and showed that differences in betas did, in fact,

explain differences in returns during the time period Second, Kothari and Shanken (1995)

estimated betas using annual data, instead of the shorter intervals used in many tests, and

concluded that betas do explain a significant proportion of the differences in returns across

investments Third, Chan and Lakonishok (1993) looked at a much longer time series of

returns from 1926 to 1991 and found that the positive relationship between betas and

returns broke down only in the period after 1982 They also find that betas are a useful

guide to risk in extreme market conditions, with the riskiest firms (the 10% with highest

betas) performing far worse than the market as a whole, in the ten worst months for the

market between 1926 and 1991 (See Figure 2.6)

7 Weston and Copeland used both approaches to estimate the cost of equity for oil companies in 1989 and

came up with 14.4% with the CAPM and 19.1% using the arbitrage pricing model.

FIGURE 2.6: Returns and Betas: Ten Worst Months between 1926 and 1991

Mar 1988 Oct 1987 May 1940 May 1932 Apr 1932 Sep 1937 Feb 1933 Oct 1932 Mar 1980 Nov 1973

High-beta stocks Whole Market Low-beta stocks

While the initial tests of the APM suggested that they might provide more promise

in terms of explaining differences in returns, a distinction has to be drawn between the use

of these models to explain differences in past returns and their use to predict expected

returns in the future The competitors to the CAPM clearly do a much better job at

explaining past returns since they do not constrain themselves to one factor, as the CAPM

does This extension to multiple factors does become more of a problem when we try to

project expected returns into the future, since the betas and premiums of each of these

factors now have to be estimated Because the factor premiums and betas are themselves

volatile, the estimation error may eliminate the benefits that could be gained by moving from

the CAPM to more complex models The regression models that were offered as an

alternative also have an estimation problem, since the variables that work best as proxies for

market risk in one period (such as market capitalization) may not be the ones that work in

the next period

Ultimately, the survival of the capital asset pricing model as the default model for

risk in real world applications is a testament to both its intuitive appeal and the failure of

more complex models to deliver significant improvement in terms of estimating expected

returns We would argue that a judicious use of the capital asset pricing model, without an

over reliance on historical data, is still the most effective way of dealing with risk in modern

corporate finance

Models of Default Risk

The risk that we have discussed hitherto in this chapter relates to cash flows on

investments being different from expected cash flows There are some investments, however,

in which the cash flows are promised when the investment is made This is the case, for

instance, when you lend to a business or buy a corporate bond However, the borrower may

default on interest and principal payments on the borrowing Generally speaking, borrowers

with higher default risk should pay higher interest rates on their borrowing than those with

lower default risk This section examines the measurement of default risk and the

relationship of default risk to interest rates on borrowing

In contrast to the general risk and return models for equity, which evaluate the

effects of market risk on expected returns, models of default risk measure the consequences

of firm-specific default risk on promised returns While diversification can be used to

explain why firm-specific risk will not be priced into expected returns for equities, the same

rationale cannot be applied to securities that have limited upside potential and much greater

downside potential from firm-specific events To see what we mean by limited upside

potential, consider investing in the bond issued by a company The coupons are fixed at the

time of the issue and these coupons represent the promised cash flow on the bond The best

case scenario for you as an investor is that you receive the promised cash flows; you are not

entitled to more than these cash flows even if the company is wildly successful All other

scenarios contain only bad news, though in varying degrees, with the delivered cash flows

being less than the promised cash flows Consequently, the expected return on a corporate

bond is likely to reflect the firm-specific default risk of the firm issuing the bond

The Determinants of Default Risk

The default risk of a firm is a function of two variables The first is the firm’s

capacity to generate cash flows from operations and the second is its financial obligations –

their financial obligations should have lower default risk than firms that generate low cash

flows relative to their financial obligations Thus, firms with significant existing investments,

which generate relatively high cash flows, will have lower default risk than firms that do not

In addition to the magnitude of a firm’s cash flows, the default risk is also affected by

the volatility in these cash flows The more stability there is in cash flows the lower the

8 Financial obligation refers to any payment that the firm has legally obligated itself to make, such as

interest and principal payments It does not include discretionary cash flows, such as dividend payments or

new capital expenditures, which can be deferred or delayed, without legal consequences, though there may

be economic consequences.

default risk in the firm Firms that operate in predictable and stable businesses will have

lower default risk than will other similar firms that operate in cyclical or volatile businesses

Most models of default risk use financial ratios to measure the cash flow coverage (i.e.,

the magnitude of cash flows relative to obligations) and control for industry effects to

evaluate the variability in cash flows

Bond Ratings and Interest rates

The most widely used measure of a firm's default risk is its bond rating, which is

generally assigned by an independent ratings agency The two best known are Standard and

Poor’s and Moody’s Thousands of companies are rated by these two agencies and their

views carry significant weight with financial markets

The Ratings Process

The process of rating a bond usually starts when the issuing company requests a

rating from a bond ratings agency The ratings agency then collects information from both

publicly available sources, such as financial statements, and the company itself and makes a

decision on the rating If the company disagrees with the rating, it is given the opportunity to

present additional information This process is presented schematically for one ratings

agency, Standard and Poors (S&P), in Figure 2.7

Figure 2.7: The Ratings Process

entered into S&P's administrative and control systems

S&P assigns analytical team to issue

Analysts research S&P library, internal files and data bases

Issuer meeting: presentation to S&P personnel or

S&P personnel tour issuer facilities

Final Analyticalreview and preparation

of rating committeepresentation

to issuer or its authorized representative

Does issuer wish to appeal

by furnishing additional information?

Presentation of additional information to S&P rating committee:

Discussion and vote to confirm

or modify rating

Format notification to issuer or its authorized representative: Rating is releasedYes

No

THE RATINGS PROCESS

The ratings assigned by these agencies are letter ratings A rating of AAA from Standard

and Poor’s and Aaa from Moody’s represents the highest rating granted to firms that are

viewed as having the lowest default risk As the default risk increases, the ratings decrease

toward D for firms in default (Standard and Poor’s) A rating at or above BBB by Standard

and Poor’s is categorized as investment grade, reflecting the view of the ratings agency that

there is relatively little default risk in investing in bonds issued by these firms

Determinants of Bond Ratings

The bond ratings assigned by ratings agencies are primarily based upon publicly

available information, though private information conveyed by the firm to the rating agency

does play a role The rating assigned to a company's bonds will depend in large part on

financial ratios that measure the capacity of the company to meet debt payments and

generate stable and predictable cash flows While a multitude of financial ratios exist, table

2.1 summarizes some of the key ratios used to measure default risk

Table 2.1: Financial Ratios used to measure Default Risk

Cashflow/ Total Debt

Funds from Operations - Capital Expenditures-Change in Working Capital

Average of Beginning of the year and End of the year of long andshort term debt, minority interest and Shareholders Equity

Companies with AAA

ratings: Take a look at the

companies that commandedtriple AAA ratings fromStandard and Poor’s in themost recent period

Long Term Debt/

Capital

Long Term Debt

Total

Debt/Capitalization

Total Debt

Source: Standard and Poors

There is a strong relationship between the bond rating a company receives and its

performance on these financial ratios Table 2.2 provides a summary of the median ratios9

from 1998 to 2000 for different S&P ratings classes for manufacturing firms

Table 2.2: Financial Ratios by Bond Rating: 1998-2000

Free oper cash

Source: Standard and Poors

Note that the pre-tax interest coverage ratio (EBIT) and the EBITDA interest coverage ratio

are stated in terms of times interest earned, whereas the rest of the ratios are stated in

percentage terms

Not surprisingly, firms that generate income and

cash flows significantly higher than debt payments, that

are profitable and that have low debt ratios are more likely

9 See the Standard and Poor’s online site: http://www.standardandpoors.com/ratings/criteria/index.htm

to be highly rated than are firms that do not have these characteristics There will be

individual firms whose ratings are not consistent with their financial ratios, however, because

the ratings agency does add subjective judgments into the final mix Thus, a firm that

performs poorly on financial ratios but is expected to improve its performance dramatically

over the next period may receive a higher rating than is justified by its current financials

For most firms, however, the financial ratios should provide a reasonable basis for guessing

at the bond rating

Synthetic Ratings and Default Risk

Not all firms that borrow money have bond ratings available on them How do you

go about estimating the cost of debt for these firms? There are two choices

• One is to look at recent borrowing history Many firms that are not rated still borrow

money from banks and other financial institutions By looking at the most recent

borrowings made by a firm, you can get a sense of the types of default spreads being

charged the firm and use these spreads to come up with a cost of debt

• The other is to estimate a synthetic rating for the firm, i.e, use the financial ratios used

by the bond ratings agencies to estimate a rating for the firm To do this you would need

to begin with the rated firms and examine the financial characteristics shared by firms

within each ratings class As an example, assume that you have an unrated firm with

operating earnings of $ 100 million and interest expenses of $ 20 million You could

use the interest coverage ratio of 5.00 (100/20) to estimate a bond rating of A- for this

firm.10

Bond Ratings and Interest Rates

The interest rate on a corporate bond should be a function of its default risk, which

is measured by its rating If the rating is a good measure of the default risk, higher rated

bonds should be priced to yield lower interest rates than would lower rated bonds The

difference between the interest rate on a bond with default risk and a default-free

government bond is defined to be the default spread Table 2.3 summarizes default spreads

for 10-year bonds in S&P’s different rating classes as of December 31, 2001:

Table 2.3: Default Spreads and Bond Ratings

10 This rating was based upon a table that was developed in 1999 and 2000, by listing out all rated firms,

with market capitalization lower than $ 2 billion, and their interest coverage ratios, and then sorting firms

based upon their bond ratings The ranges were adjusted to eliminate outliers and to prevent overlapping

ranges.

These default spreads, when added to the riskless rate, yield the interest rates for

bonds with the specified ratings For instance, a D rated bond has an interest rate about 14%

higher than the riskless rate This default spread will vary by maturity of the bond and can

also change from period to period, depending on economic conditions, widening during

economic slowdowns and narrowing when the economy is strong

Summary

Risk, as we define it in finance, is measured based upon deviations of actual returns

on an investment from its' expected returns There are two types of risk The first, which we

call equity risk, arises in investments where there are no promised cash flows, but there are

expected cash flows The second, default risk, arises on investments with promised cash

flows

On investments with equity risk, the risk is best measured by looking at the variance

of actual returns around the expected returns, with greater variance indicating greater risk

This risk can be broken down into risk that affects one or a few investments, which we call

firm specific risk, and risk that affects many investments, which we refer to as market risk

When investors diversify, they can reduce their exposure to firm specific risk By assuming

that the investors who trade at the margin are well diversified, we conclude that the risk we

should be looking at with equity investments is the market risk The different models of

equity risk introduced in this chapter share this objective of measuring market risk, but they