Include step by step explanations

PART A Search & Identify from the website of MorningStar Bond Center

What is Moody's credit rating for CAT's bonds? What is Moody's credit rating for DE's bonds? Which firm (CAT vs. DE) is rated as with relatively lower credit risk?

PART B What are we expected to understand? ------

1. Just as a bond's price value is inversely affected by its yield-to-maturity (in other names, required/expected return of bond, discount rate of bond, cost of debt capital, etc.), a stock's price value is also inversely affected by its required/expected return of equity (in other names, discount rate of stock, cost of equity capital, etc.).

2. "No pain, no gain; less risk, less return." A stock's required (expected) return depends on its risk, but not ALL types of risk really matter in determining the expected return.

If a stock is considered standing alone, rather than being considered as one component within an "investment basket" portfolio, then investors need to concern its stand-alone risk, which is measured by the standard deviation in its rates of return. The best risk-return bargain stock shall be the stock which has the lowest positive "coefficient of variation" (i.e., the standard deviation divided by the mean rate of return).

However, in the real world, stocks are typically not invested as alone, but instead invested as a portfolio of stocks. Asset portfolio modelers argue that within the stand-alone (total) risk, only the part of "market risk" really matters to effectively determine a stock's required return, while the part of "diversifiable risk" can and shall be effectively minimized (diluted) by portfolio diversification and/or time diversification strategies, therefore, diversifiable risk become rather irrelevant (at least so claimed in theory). The equity market will only reward investors' "market risk" as necessary or required risk taken, but will not reward such "diversifiable risk" since it is instead considered unnecessary, or non-meritorious.

3. Capital Asset Pricing Model (CAPM) and its graphical version, security market line (SML), point out that: a stock's expected return can be linearly estimated based on its specific market risk, whose value is measured by "Beta" (the long-term regression sensitivity coefficient between a stock's historical return and the stock market's historical risk premium over time). The difference between a stock's actual historical return and its CAPM-predicted return is called "Alpha", or "market-risk-adjusted excess return".

4. Rational stock investors do not only look at statistics of return alone or risk alone (because the stock market history may or may not repeat itself), but instead they will look at return in connection with risk. In terms of "risk vs. return" tradeoff bargain:

If each stock is considered standing alone, or if the possibility of building large portfolio diversification is low, then the smaller the positive Coefficient of Variation (CV = standard deviation / mean = risk / return), the more favorable this stock is.

If each stock is considered interacting with the other stocks and the whole stock market, or if the possibility of building large portfolio diversification is high, then CV will become much less relevant, whereas the Alpha will become more informative. The greater the positive Alpha (Alpha = actual performance - market prediction), the more favorable this stock is.

5. In later chapters we can further learn, after estimating the required return (discount rate) for a corporate stock, we can thus compute the stock's fair price value by using the time-value-of-money discount valuation methods.

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What are we expected to practice such learning in HW assignments? ------

Application of "Coefficient of Variation" (CV):

1) Explore Finance Yahoo, get access to the "Historical Data" of rival stocks CAT and DE, respectively, download their historical prices over the past 5 years (e.g.,"Dec 31, 2016 - Dec 31, 2021" ; but in order to save space, select the frequency to be "monthly" only, so the data output will consist of 5 years = 60 months). ------ Dr. Leo has done CAT to show you the basic methods (as attached), and you must do the same analysis for DE (you need to collect DE's data on web).

2) After you define the data range, click "apply" and then click on "Download Data", those data will be downloaded in the file format of "csv". Open these csv files with Excel, copy and paste the "Date" and "adj. close" (which is adjusted for dividend payout and stock split) data columns of two rival companies alongside into the same file, and then save as a new Excel file type "xls" or "xlsx".

3) Use these data columns, calculate the month-by-month rate of return series for each of these two stocks, and then calculate the =AVERAGE(...) and =STDEV(...) for each stock, and then eventually calculate the Coefficient of Variation (CV) of the stock.

4) Compare the CV of these two rivals (CAT vs. DE), which stock seems to be a better "risk vs. return" bargain over the past 5 years?

Part C, Application of the Capital Asset Pricing Model (CAPM).

Calculating CAT stock's CAPM expected return, to similarly calculate DE's CAPM expected return:

1) Quote the stock (historical, 5-year monthly) "beta" value online from Finance Yahoo;

2) Apply the adjusted beta method on the web-quoted historical beta amount, because the beta quoted from web source is "historical beta", which shall better not be directly plugged into the CAPM formula until it is "adjusted" for the long-term future trend factor;

(Notes: However, as for this Step 2, it seems that the 12th ed. textbook gave us a typo "0.35" in the adjusted beta equation on pp. 260. I have double-checked the web source such as Bloomberg Guide, which shows the adjusted beta equation, in the correct form, shall be:

Adjusted beta = (.67) * Historical Raw beta +(.33)* 1.00

So, we shall use 0.33 to replace 0.35 in the adjusted beta equation.)

4) Use the CAPM equation to calculate the expected stock return for a specific firm (e.g., CAT, DE), based on those inputs that you find from Steps 1), 2), 3).

Part D, Application of the Alpha measure.

CAT stock - CV, CAPM, Alpha-1.xlsx Download Ch06 InClass Exercise for CAT stock - CV, CAPM, Alpha-1.xlsx

1) we have calculated the historical average return of a stock over the past 5 years (i.e., 60 months). Because we calculate that average return on "monthly" historical data series (unfortunately, annual historical data series for the stock prices is not available on web), we need to annualized the average monthly return into the average annual return by "multiplying 12 months".

2) In prior, we have used to CAPM to predict the "fair market equilibrium expected return" (already annualized by default) of a stock. Compare this CAPM return against the annualized historical average return from Step (1). Alpha = Annual historical "actual" return - CAPM predicted "fair" return.

3) If a stock's Alpha is positive, it suggests that during the past decade, this stock has been proved to "perform better than market expectation, given its market risk exposure level". The greater the positive Alpha, the more successful this stock has performed.

Please compare and answer: Over the past 5 years, between the rivals "CAT vs. DE", which stock has a more favorable Alpha?