On one half a page review what does our traditional finance framework and the CAPM model, for example, have to say about risk? What is it? How is it approached? The traditional finance framework uses discounted expected future cash flow to determine the NPV of the project. The amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. People are rational and adverse to risk and need incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principle and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. Virtually all investors would buy the government bond the first is less risky while paying the same interest rate as the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays otherwise no investor is likely to buy that bond. If the firm offering to pay an interest rate more than than 5%, it gives investors an incentive to buy a riskier bond. The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus: E(Ri) = Rf + beta * [E(Rm) Rf] The risk of a portfolio comprises systematic risk, also known as un-diversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities - i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities will render the portfolio sufficiently diversified to limit exposure to systematic risk only. In developing markets a larger number is required, due to the higher asset volatilities. A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. 2.
Take half a page to say what you think of the historic capital budgeting model at AES (page 5 of case)? What complications did international operations introduce?
At AES, capital budgeting was historically a straightforward method and was used for all projects being examined, regardless of geographical location. This method entailed 4 rules which were: 1)
all recourse debt was deemed good,
the economics of a given project were...
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