Risk and Rates of Return

Table of Contents

1. Introduction

2. Questions

3. Appendix
Question 3B: Approximate probability distribution
Question 5: Volatility and Diversification Effect
Question 6C: Characteristics of major mutual fund markets
Question 7A: Return on stocks vs. return on markets
Question 8A: Relationship between the expected and required rate of return.

4. References

1. Introduction

In 1996, Northern Electric and Mid-Continent Gas merged into the North Central Utilities (NCU) since both companies were convinced that future success is dependent on the provision of an entire set of energy sources. Furthermore the merger put both firms in a better position compared to their competitors, especially in view of the fact that in 1996, regulatory changes empowered companies to compete for business in other firm’s territories. Beforehand, competition basically did not exist and the profits were determined easily. Companies knew the amount of capital invested, the cost of capital and the product of those two demonstrated the profits, which had to be generated. In the following case, several questions will be answered to the changing conditions in the utility industry.

2. Questions

1A) Based on the article “downside risk in practice” by Javier Estrada (2006), one may deny this since investor’s associate risk with downturn potential and not with upward movements. This perception of risk is in contrast with the modern portfolio theory, which considers the standard deviation and the beta in evaluating risk. However, both give equal weight to upside and downside fluctuations. One can see from table 1, the higher the range of the returns, the larger the SD. Hence, investors should rather consider the semi-deviation, as it captures the downside volatility which investors want to avoid and not the potential upside volatility, investors are looking for. As a consequence, the company’s risk should be evaluated on downside volatility and not on the spread between high and low returns.

1B) Since a company had to file for service rates with their government, it most closely resembles a T-bill, because as in most cases once the investment was approved the cost of capital was the return with certainty. The only risk involved, was that a company builds too many plants or grossly misestimated the cost of a plant. This was either punished through a penalty or lower returns. Today utility companies have to take NPV, IRR, EVA and other valuation methods into account, since they are faced with increasing competition and entering new market segments. As a result utility stocks and bonds became far more risky than in the past. For example, this is reflected in the current market situation in Germany, because E.ON and RWE have a standard deviation of 27% and 28% respectively, compared to 22% for the Dax (Comdirect, 2012).

1C) Of course the payout rate affects the riskiness of a stock. A bond that pays a high coupon trades at a higher price than the same bond, paying a lower coupon because investors receive more cash flows upfront. In this vein, a stock with a high dividend, often a value stock, might be less volatile under normal circumstances than a growth stock, because shareholders expect to receive a dividend with fairly high certainty in the near future. Companies paying a substantial and continuous dividend yield are perceived as quality stocks. Key characteristics are a solid balance sheet, high capital and sales profitability and the ability to generate ample cash flows. Low P/E ratio and low P/B ratio are further characteristics of stocks paying high dividends.

A possible threat can arise, since the dividend is determined at the general annual meeting, many companies do not pay a dividend if they experience losses. Moreover, a company can change its dividend policy, which increases the risk compared to a bond, because a bond pays a fixed coupon. Furthermore, the higher a company’s payout ratio, the less money it has to reinvest in growth and competitiveness of the company.

1D) T-bills are independent of the state of the economy since the treasury is responsible for redeeming the bills at par value regardless whether the economy undergoes a recession or upturn. Nevertheless, the return is based on two components, the real risk-free rate + an inflation premium. Hence, the real return might deviate from the expected return dependent on the inflation rate. If the inflation rate is higher than expected, the purchasing power will decrease and therefore T-bills cannot be considered as totally risk-free. However, if the treasure raises money by selling inflation-indexed or tax-exempt bonds, they could be considered as riskless whereas all other securities are exposed to some kind of risk.

A cautious note: Recently, many developed economies, including the USA and European countries, have very high debt burdens due to bailouts during the financial crisis. Thereby they lost their AAA rating, which increased the risk of those securities. Nevertheless, those are the safest securities an investor can get in the market.

1E) T-bonds consist basically of two parts: the yield and the coupon rate. The latter is fixed whereas the yield varies over time, because bonds trade in the secondary market and as a result the prices change (eHow, 2012). Furthermore, T-bonds are subject to interest rate risk and their prices can vary over time due to their long maturities. In recessionary times investors often overweight government securities because of their low risk character. A corporate bond is not only subject to interest rate risk, but also to solvency risk of the company. Therefore the returns of those would be correlated to the stock of the company but with a lower strength. A NCU bond would have a higher variability than the T-bond, but lower than NCU stock. In “the good old days” one could have compared it to a T-bond, with the increased competitive environment the bond might be more risky. The bonds yield and coupon payment also depends on the riskiness as measured by the bond rating which large rating agencies, such as Standard & Poor’s, estimate.

1F) Gold is considered as a very safe, non-interest paying investment that can be used to hedge against inflation and against market downturns. Gold returns have an inverse relationship with the broad market index, because gold is not as sensitive to exogenous economic shocks as the computer components. If the economy is in a boom cycle, companies and private households invest in electronic durables whereas they reduce their expenditure on those goods in weak cycles. This amplifies the returns and losses in respective states of the economy.

2) If one bases the analysis on the probabilities and expected return data provided, Computer components have an expected return of 17% with a standard deviation of 18.34% (Appendix B).

3A) The standard deviation is a measure of dispersion. As mentioned above, the standard deviation of Computer Components is 18.34% (Appendix B). It provides the riskiness of a stock, based on the past returns. On the one hand, since a stock can move far away from its fundamental, intrinsic value the standard deviation is a risk measure of total risk in the capital market. On the other hand, as mentioned at question 1A, the semi-deviation might capture the risk in a better way, because it only measures the downside risk, which is of primary interest for the investor. The semi-deviation is even a better concept of risk measurement for a skewed distribution (Estrada, 2006).

3B) Refer to Appendix A.

4A) The expected return is 8.37% (Appendix B).

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