Financial Asset Pricing: Beta, Risk, and OHL Cost of Equity
A) Interpreting the Beta Coefficient of the Stock
Based on the graph, the Capital Market Line (CML) equation is: y = 1.266x + 0.0012. Therefore, the Beta coefficient ($eta$) is 1.266.
Beta measures the degree of volatility relative to the market. Since the calculated Beta (1.266) is greater than 1, it indicates that market fluctuations affect this stock more than proportionally. Consequently, this stock will experience greater variations (both rise and fall) compared to the overall IBEX index.
B) Systematic and Specific Risk Calculation (OHL/DOHLER)
Using the total risk variance in profitability for the stock (DOHLER/OHL), we calculate and discuss the systematic and specific risk components:
- Systematic Risk (Market Risk): 39.32%. This indicates that nearly 40% of the total variation in the stock's returns is explained by variations in the IBEX index.
- Specific Risk (Idiosyncratic Risk): 60.68%. This risk arises when the stock does not perform in compliance with expectations due to reasons specific to the company itself, independent of the broader market.
Discussion of Results: The percentage of specific risk (60.68%) is considered too high. This suggests that a significant portion of the stock's volatility is unique to the company OHL, which exhibits a market-related behavior (systematic risk) similar to 39.32% of the IBEX movements.
C) Estimating the Cost of Equity (Kp) using the SML
We estimate the Cost of Equity (Kp) for OHL using the Security Market Line (SML) formula, given the risk-free rate ($r_f$) is 3.865%:
$$K_p = r_f + [E(r_m) - r_f] \times \beta$$
Calculation:
$$K_p = 3.865\% + (9.865\% - 3.865\%) \times 1.266$$
$$K_p = 3.865\% + (6.000\%) \times 1.266$$
$$K_p = 3.865\% + 7.596\%$$
$$K_p = 11.46\%$$
The required return by shareholders (11.46%) depends on the risk-free rate determined by the market (often based on 10-year Treasury bonds) plus a systematic risk premium.
D) Theoretical Foundations of Systematic Risk
The Systematic Risk Premium and CAPM Theory
This section introduces the concept of systematic risk premium, rooted in the theoretical framework established by figures like Linn, Sharpe, and Merton Miller. Financial professionals increasingly require analytical capacity to apply the concept of systematic risk when discounting monetary amounts of capital across various financial fields.
Sharpe's Contribution: Sharpe utilized the results of Markowitz's portfolio theory as his starting point and developed implications for asset pricing. He introduced the crucial assumption that asset prices would instantaneously adjust to match supply and demand for all risk levels.
The active contributions of Sharpe and Merton Miller, alongside Modigliani (who studied corporate policies regarding dividends and obtaining loans), form the foundation of modern corporate finance theory.
In particular, the conceptual development by Merton Miller (MM) can be summarized in what is known as the Four Propositions.