Missing PDF and a question

[arteja]

Hi David

The pdf document for Foundations.a.ii is missing. The link there is to Foundations.a.i.

And I have a question in Foundation.1.b. In slide 26, where we are looking at how risk management can create value by handling bankruptcy cost, I fail to see where exactly risk management is coming in. There is the forward price of gold, the face value of debt, and so on. So where is the risk management component coming in?

And also in slide 17, I cant understand why the Expected Future Spot (E(S)) keeps increasing with increasing beta. Whats the relationship between the two? It seems to increase in a way so as to keep the present value of S at exactly the same value.

thanks a lot

 

[arteja]

Also David,

In the XLS 1.a.5, where we look at APT, while calculating the APT you do not add the beta*exposure to the APT. Shouldn't that figure in the sum-product? Because the beta is one of the exposures, and this is where the connection between CAPM and APT comes up.

 

[David Harper CFA FRM]

Hi A Ravi,

Re: pdf, it is the *same* 76-page PDF used for both i & ii (the description makes a note of this). The movies can only be 88 min long; so when I am forced, in this case, to break the a into a.i. and a.ii, I thought it would be more convenient to keep the PDF continous. So you only have the one PDF for both videos in this case.

Re: slide 26: you are exactly correct, there is no "risk management" in this slide. Nor in the Stulz discussion on which it is based (p 57). I think that is a smart observation. Stulz here, and this exhibit, is not trying to show how the bankruptcy risk is eliminated (in this simplified example, Stulz may not say because it can be inferred: as the volatility in cash flow is only due to price risk, hedging the price risk here will eliminate the bankruptcy risk). The only point is to illustrate the the "hedging irrelevance" has found an exception: if the firm can elminate bankruptcy risk, then it can increase the firm value by $1.46 MM (the PV of the bankruptcy cost). This is the theme of chapter 3: Chapter 2 is about how risk management cannot create value in a world of many restrictions (no tax, no financial distress); then chapter 3 is about how this assumptions do not apply in the real world and so risk management can create value.

Re slide 17: yes, I should do a better job with this b/c it is giving confusion. It is circular indeed (I am again, merely using Stulz example). The point is that the E(S) is only a function of the systematic risk; i.e., higher beta implies higher E(S). And that's because you, as the investor, expect to be paid only for the systemic risk, so the price you pay today, S0, must be discounted by the beta: S0 = E(S)/[1+rk + beta*ERP]. So, there is no solving here, rather this is more like a medidation on the idea that the spot, S0 and the E(St) are linked by systematic risk only.

Re: APT: again, a smart observation. Aside from this exhibit, you have a good point. The APT (or an explicit factor model version of APT) can include the market beta; this is, in fact, what the three-factor Fama French variation on CAPM is. The excess return is function of beta exposure * market premium + size exposure * size premium + value exposure * value premium. So, generally, you are right.

But the APT does not require market premium to be included, and Grinold does not here. In this (his) version the factors are other factors; please note that industry is the primary factor (exp return = 6%). Arguably, to include both an industry plus an market premium would double-count some exposure. As such, there is no explicit connection is this APT vs. CAPM: they use entirely different factors. The connection is in the idea that the CAPM "substitutes" the 4+1 APT factors with a single factor, where importantly they still share in common the fact they are both linear factor-exposure models. Hope this helps, David

 

[arteja]

thanks David, that was most helpful.

Ravi