Equity and Default Risk: CAPM and Bond Ratings

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Equity and Default Risk CAPM and Bond Ratings
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Measuring market risk and equity risk premiums

• We concluded that
• Firm-specific (unsystematic) risk can be
  diversified away in a large portfolio
• Market (systematic) risk cannot be diversified
  away
• Thus, the risk of a well-diversified portfolio
  will depend on the market risk of the securities
  (stocks, bonds) of the portfolio

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• Moreover, the expected return (reward) from
  holding a risk-bearing asset (e.g. stock)
• Depends on the market risk of that asset
• Does not depend on firm-specific risk because it
  can be diversified away
• The coefficient beta (?) of a stock (or a
  portfolio) shows how much market risk has the
  particular stock compared to an average stock

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• Alternatively, we say that beta captures the
  sensitivity (reaction) of a particular stock
  (portfolio) to movements in the market
• The beta of a stock i is given by

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Example 1 Total risk vs. beta

• Suppose we know the following about two stocks A
  and B
• St. Deviation Beta
• Stock A 40 0.5
• Stock B 20 1.5
• Which stock has greater total risk? Which stock
  has greater systematic risk? Which stock will
  have a greater risk premium and expected return?

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Beta coefficients for selected companies (2001)
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The Capital Asset Pricing Model (CAPM)

• Why focus on CAPM? Survey by Graham Harvey
  (2001) of 392 CFOs
• How do you always or almost always determine your
  firms cost of equity capital?
• 73 use CAPM
• 39 use historical returns on stock
• 34 use multi-factor CAPM
• 16 back out expected return from discounted
  dividend formula
• 14 use whatever our investors tell us they
  require

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• In the CAPM, all investors hold the market
  portfolio
• Thus, the risk to an investor of an individual
  asset will be the risk that this asset adds on to
  the market portfolio
• Recall that this is given by beta and that
  investors want to be rewarded for holding a
  risk-bearing asset through a risk premium

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• The risk premium for holding the market portfolio
  as opposed to a risk-free security (government
  bond) is
• E(rm) expected return on market portfolio
• rf return on risk-free security

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• The expected risk premium on a stock will be
• This equation shows that the risk premium for
  holding stock i is proportional to the risk that
  this stock adds on to the market portfolio, given
  by the stocks beta

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• Rearranging the above equation, we get
• This shows that the expected return on an asset
  (stock) depends on
• The risk-free rate that shows the time value of
  money
• The market risk premium that shows the reward for
  bearing the systematic risk
• The amount of systematic risk contributed by
  asset i as given by that assets beta

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• The above equation is used to determine the
  minimum required return (hurdle rate) for
  investing in a firms stock (cost of equity)
• Other models to measure market risk and the
  expected return on a stock
• Arbitrage pricing model
• Multi-factor models
• Consumption-based CAPM

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Measuring default risk

• The default risk of a firm depends on
• The firms capacity to generate cash flows from
  operations and the volatility of these cash flows
• The firms existing financial obligations
  (interest and principal payments)
• Models of default risk use financial ratios to
  measure cash flow coverage and control for
  industry factors that affect the volatility of
  cash flows

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• Firms with issued bonds receive periodical
  credit ratings from rating agencies (SP,
  Moodys)
• These ratings depend in large part on
• Ratios that measure the firms ability to meet
  debt obligations (interest coverage ratios,
  debt-capitalization ratios)
• Ratios that measure the firms ability to
  generate stable and predictable cash flows
  (return on permanent capital, operating profit
  margin)

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Financial ratios by bond rating(Standard
Poors, 1996-98)