Lecture 18
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Lecture 18 Capital Markets and Systematic Risk
Fina 110 Spring 2009
Dr. Samuel Xin Liang
1
Is it now a good time for Hutchison to issue debt? (corporate event for speaker)
April 6 (Bloomberg) -- Hutchison Whampoa Ltd., billionaire Li Ka-shing’s biggest company, hired Deutsche Bank AG, HSBC Holdings Plc and JPMorgan Chase & Co. for its first dollar bond sale in more than five years.
Hutchison expects the 10-year notes to be ranked A- by Standard & Poor’s and Fitch Ratings, the seventh-highest investment grade, and a comparable A3 by Moody’s Investors Service, according to an e-mail sent to investors today. The sale will be “benchmark” in size, it said, which typically means at least $500 million. …. Hutchison’s bonds may be priced at about 500 basis points above U.S. Treasuries to yield 8 percent, said three people familiar with the matter, who asked not to be identified as discussions are private. Note: The current Treasuries yield is low, but credit spread is still quite high. What is the purpose of the debt issuance? Retiring existing debt or financing new projects? 2
2
Midterm Statistic Question# 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Accuracy Rate 62.67% 88.00% 66.67% 92.00% 66.67% 93.33% 78.67% 94.67% 96.00% 93.33% 97.33% 81.33% 97.33% 84.00% 58.67%
Summary Max Min Average Std Dev
100 40 83.8 13.1
3
Addressing some confusions
4
“fairly priced” – Misconception: the price is right and cannot generate positive return or will always generate positive return It is the price that reflects all public information about a particular stock at equilibrium. In other word, all public information tells investors or the market about the expected future cash flows.
It is also the price whose required rate of return/market expected return reflects the risk level of this particular stock when the market is efficient. In other word, there should not be any abnormal return or excess return based on all information on fundamentals (future cash flows and probability of cash flows and risks).
The price can generate negative return when there will be new negative information known to the public or the market (example Loss announcement or projections, Citigroup, GM, Bank of America)
4
Clarification of Abnormal Return
5
Abnormal return or excess return: Misconception: Risk premium Risk premium is the expected return of a stock/risky asset minus the risk-free rate Abnormal return is the additional realized return on top of the risk premium that is compensating the risk (volatility) associated with the stock or risky assets The fact that a risky asset/stock can have a abnormal return implies that the stock is either currently or will be underpriced or overpriced Overpriced The stock is overvalued or the price reflects a discount rate less than required rate of return or overestimates of future cash flows Underpriced The stock is oversold or undervalue which means that its price reflects a discount rate or expected return larger than required rate of return or underestimates of futures cash flows.
5
A Positive News Market Reaction Overpriced!
Assuming Fair price
Underpriced! On March 11, Citigroup CEO said in a letter to employees that the bank had operated at a profit for the first two months of this year and was on track, based on historical trends, to make $8.3 billion for the quarter. The correction can take more than days or months ! 6
6
Market Correction Process Overpriced! Assuming Fair Price
Abnormal positive return
Abnormal Negative return
Underpriced!
Assuming Fair Price! 7
7
Graphical Illustration on negative news
Bloomberg (April 1): Obama Said to Find Bankruptcy Likely for GM, Chrysler … This is a negative news for GM as the probability of its bankruptcy increased! Therefore, investors will demand (require) higher return for investing in GM. (will discuss expected return later) The process of finding “fair price” can be viewed as price discovery or market $ price corrections Assuming fair price
Negative News (increasing probability of bankruptcy)
Overpriced!
Overpriced!
Abnormal positive return Assuming fairly priced
Abnormal negative return
8
Underpriced!
Oversold or underpriced!
Time
8
Unexpected Returns
We learn from our previous bond and stock examples that realized returns are generally not equal to expected returns
Realized returns contain the expected component and the unexpected component At any point in time, the unexpected return can be either positive or negative If market is efficient, the average of the unexpected component is zero in a very long time.
Announcements and news contain both an expected component and a surprise component
It is the surprise component that affects a stock’s price and generates its unexpected return
9
9
Implication for Efficient Markets
10
We learn from Citigroup example that stock prices move when an unexpected announcement is made, or earnings are different from anticipated (unexpected profit in first two months.
Efficient markets are a result of investors trading on the unexpected portion of announcements. Investors will trade whenever they find mispricing (overpriced or underpriced)
If the markets are more efficient, the stock prices will take shorter time to convert a fair price.
Efficient markets assumes the price changes are random because we cannot predict surprises
We learn from the history that there are still abnormal returns on top of returns generated by earning surprise! 10
Implication for non-financial markets
Strong efficient markets implies that stock prices reflect past, public and private information (inside information) The hypothesis of strong efficient market has weak empirical support
Semi-strong efficient markets implies that stock prices reflect past and public information.
Weak efficient markets implies that stock prices reflect past information.
We know that financial markets are more efficient than non-financial markets eg. Real estate and physical goods
11
11
How do investors generate expected returns on risky assets?
12
We learn that a corporation can go bankruptcy even though it might be very large and had been successful. (eg. Nortel, Lehman).
Why GM is not trading at zero? There is still probability that it will not be bankrupt even though its probability of bankruptcy increase substantially.
We now is ready to investigate how investors and market obtain expected returns.
12
Consider a simple scenario
We assume that there are two possible outcomes regarding GM’s bankruptcy: Case 1) the probability of GM’s bankruptcy is 100%, Its expected returns should be -100% Case 2) the probability of GM’s bankruptcy is 70%, and we can assume that GM will have a 400% return if it does not go bankrupt. What is its expected return?
We now obtain GM’s expected return. 0.7* -100% + 0.3 * 400% = 50%. Therefore, in this case, GM’s expected return is 50% and its fair price should be trading at a price that reflects its future cash flow with 50% discount rate. Market will require 50% rate of return from investing in GM’s stock when market is efficient. This discount rate reflects the reward or compensation that investors are willing to pay for bearing the risk of holding GM’s stock.
13
13
We will cover the following
14
Expected Returns and Variances
Portfolios
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital
14
Fina 110 Spring 2009
Dr. Samuel Xin Liang
1
Is it now a good time for Hutchison to issue debt? (corporate event for speaker)
April 6 (Bloomberg) -- Hutchison Whampoa Ltd., billionaire Li Ka-shing’s biggest company, hired Deutsche Bank AG, HSBC Holdings Plc and JPMorgan Chase & Co. for its first dollar bond sale in more than five years.
Hutchison expects the 10-year notes to be ranked A- by Standard & Poor’s and Fitch Ratings, the seventh-highest investment grade, and a comparable A3 by Moody’s Investors Service, according to an e-mail sent to investors today. The sale will be “benchmark” in size, it said, which typically means at least $500 million. …. Hutchison’s bonds may be priced at about 500 basis points above U.S. Treasuries to yield 8 percent, said three people familiar with the matter, who asked not to be identified as discussions are private. Note: The current Treasuries yield is low, but credit spread is still quite high. What is the purpose of the debt issuance? Retiring existing debt or financing new projects? 2
2
Midterm Statistic Question# 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Accuracy Rate 62.67% 88.00% 66.67% 92.00% 66.67% 93.33% 78.67% 94.67% 96.00% 93.33% 97.33% 81.33% 97.33% 84.00% 58.67%
Summary Max Min Average Std Dev
100 40 83.8 13.1
3
Addressing some confusions
4
“fairly priced” – Misconception: the price is right and cannot generate positive return or will always generate positive return It is the price that reflects all public information about a particular stock at equilibrium. In other word, all public information tells investors or the market about the expected future cash flows.
It is also the price whose required rate of return/market expected return reflects the risk level of this particular stock when the market is efficient. In other word, there should not be any abnormal return or excess return based on all information on fundamentals (future cash flows and probability of cash flows and risks).
The price can generate negative return when there will be new negative information known to the public or the market (example Loss announcement or projections, Citigroup, GM, Bank of America)
4
Clarification of Abnormal Return
5
Abnormal return or excess return: Misconception: Risk premium Risk premium is the expected return of a stock/risky asset minus the risk-free rate Abnormal return is the additional realized return on top of the risk premium that is compensating the risk (volatility) associated with the stock or risky assets The fact that a risky asset/stock can have a abnormal return implies that the stock is either currently or will be underpriced or overpriced Overpriced The stock is overvalued or the price reflects a discount rate less than required rate of return or overestimates of future cash flows Underpriced The stock is oversold or undervalue which means that its price reflects a discount rate or expected return larger than required rate of return or underestimates of futures cash flows.
5
A Positive News Market Reaction Overpriced!
Assuming Fair price
Underpriced! On March 11, Citigroup CEO said in a letter to employees that the bank had operated at a profit for the first two months of this year and was on track, based on historical trends, to make $8.3 billion for the quarter. The correction can take more than days or months ! 6
6
Market Correction Process Overpriced! Assuming Fair Price
Abnormal positive return
Abnormal Negative return
Underpriced!
Assuming Fair Price! 7
7
Graphical Illustration on negative news
Bloomberg (April 1): Obama Said to Find Bankruptcy Likely for GM, Chrysler … This is a negative news for GM as the probability of its bankruptcy increased! Therefore, investors will demand (require) higher return for investing in GM. (will discuss expected return later) The process of finding “fair price” can be viewed as price discovery or market $ price corrections Assuming fair price
Negative News (increasing probability of bankruptcy)
Overpriced!
Overpriced!
Abnormal positive return Assuming fairly priced
Abnormal negative return
8
Underpriced!
Oversold or underpriced!
Time
8
Unexpected Returns
We learn from our previous bond and stock examples that realized returns are generally not equal to expected returns
Realized returns contain the expected component and the unexpected component At any point in time, the unexpected return can be either positive or negative If market is efficient, the average of the unexpected component is zero in a very long time.
Announcements and news contain both an expected component and a surprise component
It is the surprise component that affects a stock’s price and generates its unexpected return
9
9
Implication for Efficient Markets
10
We learn from Citigroup example that stock prices move when an unexpected announcement is made, or earnings are different from anticipated (unexpected profit in first two months.
Efficient markets are a result of investors trading on the unexpected portion of announcements. Investors will trade whenever they find mispricing (overpriced or underpriced)
If the markets are more efficient, the stock prices will take shorter time to convert a fair price.
Efficient markets assumes the price changes are random because we cannot predict surprises
We learn from the history that there are still abnormal returns on top of returns generated by earning surprise! 10
Implication for non-financial markets
Strong efficient markets implies that stock prices reflect past, public and private information (inside information) The hypothesis of strong efficient market has weak empirical support
Semi-strong efficient markets implies that stock prices reflect past and public information.
Weak efficient markets implies that stock prices reflect past information.
We know that financial markets are more efficient than non-financial markets eg. Real estate and physical goods
11
11
How do investors generate expected returns on risky assets?
12
We learn that a corporation can go bankruptcy even though it might be very large and had been successful. (eg. Nortel, Lehman).
Why GM is not trading at zero? There is still probability that it will not be bankrupt even though its probability of bankruptcy increase substantially.
We now is ready to investigate how investors and market obtain expected returns.
12
Consider a simple scenario
We assume that there are two possible outcomes regarding GM’s bankruptcy: Case 1) the probability of GM’s bankruptcy is 100%, Its expected returns should be -100% Case 2) the probability of GM’s bankruptcy is 70%, and we can assume that GM will have a 400% return if it does not go bankrupt. What is its expected return?
We now obtain GM’s expected return. 0.7* -100% + 0.3 * 400% = 50%. Therefore, in this case, GM’s expected return is 50% and its fair price should be trading at a price that reflects its future cash flow with 50% discount rate. Market will require 50% rate of return from investing in GM’s stock when market is efficient. This discount rate reflects the reward or compensation that investors are willing to pay for bearing the risk of holding GM’s stock.
13
13
We will cover the following
14
Expected Returns and Variances
Portfolios
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital
14
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