Welcome to Finance in EXCEL video number 108.
Hey, if you want to download this workbook for Chapter 11,
or the PowerPoints for Chapter 11,
click on the link directly below the video
and scroll all the way down to the Excel Finance Class
section.
In the last video, we talked about beta.
Beta is a proxy for systematic risk,
and since the only risks in the market that are rewarded
are systematic risks, that was a very important step
at getting towards what is a reward for risk.
Now, earlier last chapter, we saw that--
from historical data, we saw that the return
minus the risk-free rate or some proxy for T-bill, which we
used as a proxy for the risk-free rate, that's
our reward for bearing risk.
So now here, we just have been talking
about in this chapter about the risks,
and the risks come from new, unexpected information.
And amongst all that different information,
the one that is rewarded is systematic risk,
and so we have our beta.
That's our measure.
So look at this.
Isn't this clever?
The Treynor index, named after the guy who created this--
expected return on the asset minus our risk-free,
that is our reward for bearing risk, divided by our beta.
And beta is a proxy for systematic risk.
Well, what happens?
Remember all the way back in, I think
it was chapter two or three we did financial statement
analysis, and we talked about the beauty of ratios.
Because whenever you do a ratio like this,
you end up with whatever the answer is over 1.
And so when we do this calculation,
it's going to give us our reward for risk
for every one unit of beta, and so that is the meaning of this.
And what's so awesome about it is
that the market has a beta of 1, so now
we'll be able to do this calculation--
compare our answer to what the market, the financial markets
out there, are giving out for risk.
All right, so percentage return per one unit
of systematic risk.
And this will allow us, or this can
be used to see if a stock return seen in the market--
stock returns are too high or too low.
Or more specifically, are expected returns--
are they too high or low?
And then that can help us decide whether we want--
whether a stock is priced correctly.
Let's go over to Excel.
Here's our situation-- risk-free 2%--
and the market-risk premium is 9%.
So this is the reward that the market is giving.
And our goal is to see if these stocks are priced correctly.
So stock A, beta is 1.2.
The expected return, that's expected
return that we've calculated at 12.5.
And down here, we have B with a beta of 0.6
and an expected return of 9%.
So we want to calculate our reward-to-risk ratio.
According to our calculations here,
what is the reward for one unit of systematic risk?
So I'm simply going to say equals this.
That is our expected return for asset A minus the risk-free
divided by the beta.
The result is about a reward of 8.75% for every one
unit of beta, which is our proxy for systematic risk.
And then you can immediately see, if you compare this,
the market out there is offering 9%.
This is 8.75%.
Are we going to buy this stock?
No way.
So through this measure here, reward-to-risk measure,
we can see we're not going to buy this stock.
Now in a competitive market, if this situation--
shouldn't last too long, right?
Other people will be doing the same calculations
and seeing that this price is too high,
and that it should be a bit down.
Now wait a second.
8.75% means the price is too high?
Yeah, because if everyone's discounting,
right-- when you discount at a higher rate,
you get a smaller number.
If you discount at a lower rate, you get a higher number.
Remember rates and prices are inversely related,
so as soon as we see this, we know that the stock
price is too high.
Let's do this one down here.
Equals.
And we'll do our--
this is our estimated.
So we've estimated expected returns should
be that minus our risk-free divided
by the proxy for systematic risk.
Remember it's only systematic risk that is rewarded,
so by dividing by this, we get for one
unit of systematic risk--
what should the return be?
It should be that.
We can then compare it to the market,
which always has a systematic risk of 1,
because it's the market.
Market's offering 9%.
This one's offering 11.67%.
You betcha we will buy, because why?
This rate is really high, so when
you discount it down back at a high rate,
it's going to be very low.
This one, if we've discounted it back,
it would be higher than this.
So we would expect in a competitive market
for this stock to--
people like us, right?
We see this, and so we buy.
The more people buy, price goes bid up.
All right, that's the risk-reward ratio--
expected return minus our risk-free divided by the beta.
When we come back in our next video,
we'll look at an extension of this security market line
and then capital asset priced mark--
Capital Asset Pricing Model, CAPM.
All right, see you next video.