a whole and moving funds from safe investments such as Treasury bills to the stock market when an upturn is anticipated and in the other direction when a downturn is anticipated. Chapter 4 explains other strategies used by hedge funds to try to create positive alpha.
Although the capital asset pricing model is unrealistic in some respects, the alpha and beta parameters that come out of the model are widely used to characterize investments. Beta describes the amount of systematic risk. The higher the value of beta, the greater the systematic risk being taken and the greater the extent to which returns are dependent on the performance of the market. Alpha represents the extra return made from superior portfolio management (or perhaps just good luck). An investor can make a positive alpha only at the expense of other investors who are making a negative alpha. The weighted average alpha of all investors must be zero.
1.4 ARBITRAGE PRICING THEORY
Arbitrage pricing theory can be viewed as an extension of the capital asset pricing model. In the capital asset pricing model, an asset's return depends on just one factor. In arbitrage pricing theory, the return depends on several factors. (These factors might involve variables such as the gross national product, the domestic interest rate, and the inflation rate.) By exploring ways in which investors can form portfolios that eliminate exposure to the factors, arbitrage pricing theory shows that the expected return from an investment is linearly dependent on the factors.
The assumption that the ε variables for different investments are independent in equation (1.3) ensures that there is just one factor driving expected returns (and therefore one source of systematic risk) in the capital asset pricing model. This is the return from the market portfolio. In arbitrage pricing theory there are several factors affecting investment returns. Each factor is a separate source of systematic risk. Unsystematic (i.e., diversifiable) risk in arbitrage pricing theory is the risk that is unrelated to all the factors.
1.5 RISK VS. RETURN FOR COMPANIES
We now move on to consider the trade-offs between risk and return made by a company. How should a company decide whether the expected return on a new investment project is sufficient compensation for its risks?
The ultimate owners of a company are its shareholders and a company should be managed in the best interests of its shareholders. It is therefore natural to argue that a new project undertaken by the company should be viewed as an addition to its shareholder's portfolio. The company should calculate the beta of the investment project and its expected return. If the expected return is greater than that given by the capital asset pricing model, it is a good deal for shareholders and the investment should be accepted. Otherwise it should be rejected.
The argument just given suggests that nonsystematic risks should not be considered when accept/reject decisions on new projects are taken. In practice, companies are concerned about nonsystematic as well as systematic risks. For example, most companies insure themselves against the risk of their buildings being burned down – even though this risk is entirely nonsystematic and can be diversified away by their shareholders. They try to avoid taking high risks and often hedge their exposures to exchange rates, interest rates, commodity prices, and other market variables.
Earnings stability and the survival of the company are often important managerial objectives. Companies do try and ensure that their expected returns on new ventures are consistent with the risk-return trade-offs of their shareholders. But there is an overriding constraint that the total risks taken should not be allowed to get too large.
Many investors are also concerned about the overall risk of the companies they invest in. They do not like surprises and prefer to invest in companies that show solid growth and meet earnings forecasts. They like companies to manage risks carefully and limit the overall amount of risk – both systematic and nonsystematic – they are taking.
The theoretical arguments we presented in Sections 1.1 to 1.4 suggest that investors should not behave in this way. They should hold a well-diversified portfolio and encourage the companies they invest in to make high risk investments when the combination of expected return and systematic risk is favorable. Some of the companies in a shareholder's portfolio will go bankrupt, but others will do very well. The result should be an overall return to the shareholder that is satisfactory.
Are investors behaving suboptimally? Would their interests be better served if companies took more nonsystematic risks? There is an important argument to suggest that this is not necessarily the case. This argument is usually referred to as the “bankruptcy costs” argument. It is often used to explain why a company should restrict the amount of debt it takes on, but it can be extended to apply to a wider range of risk management decisions than this.
Bankruptcy Costs
In a perfect world, bankruptcy would be a fast affair where the company's assets (tangible and intangible) are sold at their fair market value and the proceeds are distributed to the company's creditors using well-defined rules. If we lived in such a perfect world, the bankruptcy process itself would not destroy value for stakeholders. Unfortunately, the real world is far from perfect. By the time a company reaches the point of bankruptcy, it is likely that its assets have lost some value. The bankruptcy process itself invariably reduces the value of its assets further. This further reduction in value is referred to as bankruptcy costs.
What is the nature of bankruptcy costs? Once a bankruptcy has happened, customers and suppliers become less inclined to do business with the company; assets sometimes have to be sold quickly at prices well below those that would be realized in an orderly sale; the value of important intangible assets, such as the company's brand name and its reputation in the market, are often destroyed; the company is no longer run in the best interests of shareholders; large fees are often paid to accountants and lawyers; and so on. The story in Business Snapshot 1.1 is representative of what often happens in practice. It illustrates how, when a high risk decision works out badly, there can be disastrous bankruptcy costs.
BUSINESS SNAPSHOT 1.1
The Hidden Costs of Bankruptcy
Several years ago, a company had a market capitalization of $2 billion and $500 million of debt. The CEO decided to acquire a company in a related industry for $1 billion in cash. The cash was raised using a mixture of bank debt and bond issues. The price paid for the company was justified on the basis of potential synergies, but key threats to the profitability of the company were overlooked.
Many of the anticipated synergies were not realized. Furthermore, the company that was acquired was not profitable and proved to be a cash drain on the parent company. After three years the CEO resigned. The new CEO sold the acquisition for $100 million (10 % of the price paid) and announced that the company would focus on its original core business. However, by then the company was highly leveraged. A temporary economic downturn made it impossible for the company to service its debt and it declared bankruptcy.
The offices of the company were soon filled with accountants and lawyers representing the interests of the various parties (banks, different categories of bondholders, equity holders, the company, and the board of directors). These people directly or indirectly billed the company about $10 million per month in fees. The company lost sales that it would normally have made because nobody wants to do business with a bankrupt company. Key senior executives left. The company experienced a dramatic reduction in its market share.
After two years and three reorganization attempts, an agreement was reached between the various parties and a new company with a market capitalization of $700,000 was incorporated to continue the remaining profitable parts of the business. The shares in the new company were entirely owned by the banks and the bondholders. The shareholders got nothing.
The largest bankruptcy in U.S. history was that of Lehman Brothers on September
