5. Risk and Return

12. Some Lessons from Capital Market History

1. Risky assets, on average, earn a risk premium. There is a reward for bearing risk

2. The greater the potential reward from a risky investment, the greater is the risk

3. the concept of market efficiency

  - In an efficient market, prices adjust quickly and correctly to new information

        - EHM: All investments in the market are 0 NPV  

  - Consequently, asset prices in efficient markets are rarely too high or too low

 

The form of market efficiency
- Weak form efficient
    - current price of stock reflects the stock's own past prices
    - Do not searching for patterns in historical prices to identifying mispriced stocks
- Semistrong form efficient
    - All public information is reflected in the stock price
    - There is inside information not reflected in the price of the stock
- Strong form efficient
    - all information of every kind is reflected in stock prices

13. Return, Risk, and the Security Market Line

Risk premium = Expected Return - Risk free rate

Total return = Expected return + Unexpected return

    +) Expected return: the information that shareholders' understanding of market today

    +) Unexpected Return: news, government figures(GDP)....

            Announcement = Expected part + Surprise

 

 Why SML?
- compare (the expected return on that new investment) to (what the financial market offers on an investment with the same beta) whether or not an investment has a positive NPV

 

 

 

14. Options and Corporate Finance

 Options are contracts giving the right, but not the obligation, to buy and sell underlying assets at a fixed price during a specified time period.

 

• These options give the holder the right, but not the obligation, to sell (the put option) or buy (the call option) shares of common stock at a given price
  • 5 factors of option:
    • price of the underlying asset (S): 기초자산
    • exercise price (E): 행사가
    • expiration date (t): 만기일
    • interest rate on risk-free bonds (Rf): 무위험이자율
    • volatility of the underlying asset’s value(sigma^2): 기초자산가치의 변동성 -> 위험
    

  • 

• employee stock options (ESO) 
  •  similar to call options and serve to motivate employees to boost stock prices
    • simply substitute for ordinary wages
  • compensation for many workers, particularly at more senior management levels
    • aligining shareholder and management interest
  • always "at the money" when they issued (intrinsic value = 0)
  • Not be sold during 'vesting' period
  • ESO Repricing
    • Underwater: the granted ESO option's stock falls significantly
    • Restruck (Reprice): decide to lower strike price on underwater options
      • Sadly, in that case employee may leave the company
      • But a lowered strike price is a reward for failing
• Almost all capital budgeting proposals can be viewed as real options
  •  Also, projects and operations contain implicit options
    • real option: 부동산 월세집 알아볼 때 미리 내는 계약금. 이는 마치 콜옵션을 구매하는 것.
      • Even if NPV is negative on today, perpetual cash flow is considered to valuable
    • managerial option: Opportunities that managers can exploit if certain things happen in the future
      • Contigency Planning: option to expand, the option to abandon, and the option to suspend or contract operations
      • Strategic options: options for future, related business products or strategies
        • The information gained for the actions are all valuable, but not reliable dollar figure 
          • Using the sales experience gained from the pilot, the firm can then evaluate whether or not to open more outlets
•  A warrant(신주인수권부사채) gives the holder the right to buy shares of common stock directly from the company at a fixed exercise price for a given period of time. 
  • Typically, warrants are issued in a package with bonds
    •  unique feature: the number of shares of stock that the holder can buy
  • Afterwards, they often can be detached and traded separately
  •  Difference between Warrants and Call options
    • Call options are issued by individuals, Warrent are issued by firms
      • In Call option, investor buys stock from another investor.
      • In Warrents, firm must issue new shares of stock
        • If warrant is exercised, the firm receives some cash and the nubmer of shares outstanding increrase
    • Earnings Dilution
      • Warrent and Convertible bonds cause the number of shares to increase, so earning per prices decrease (diluted EPS < basic EPS)
• A convertible bond: combination of a straight bond and a call option
  • The holder can give up the bond in exchange for a fixed number of shares of stock
    • unique feature
      • (conversion ratio) The number of shares per bond received for conversion into stock
      • (conversion premium) The difference between the conversion price and the current stock price, divided by the current stock price
  • The minimum value of a convertible bond is given by its straight bond value or its conversion value, whichever is greater 

 

• Many other corporate securities have option features
  • Bonds with call provisions, bonds with put provisions, and bonds backed by a loan guarantee ...