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This chapter introduces key financial tools necessary for understanding Fusion for Profit. This chapter shows how different ownership structures (i.e., whether the firm is publicly or privately held) affect the firm's tradeoff between risk and return. It also distinguishes the cases where the firm sells multiple products or has multiple divisions; in particular, it shows how privately and publicly held firms should coordinate their marketing and financial decisions under uncertainty.

This chapter provides a short overview of the main concepts, ideas, and tools that have been produced by more than fifty years of research in the evaluation of risky projects and risky assets. It is devoted to the analysis of the risk premium for risky projects that should be added to the discount rate for safe projects. Here, valuing risky projects introduces a new dimension to the theory of investment. We have shown that this new dimension can be treated by transforming each future cash flow into its certainty equivalent. By doing this, one is back to the problem of evaluating a safe project, and the discount rates discussed in this book can be used.

This chapter discusses essential regulatory principles for controlling systemic risk: Systemic financial intermediaries like large and complex financial institutions (LCFIs), which are thought to be too big to fail, must be charged insurance premiums commensurate with the explicit or implicit government insurance they enjoy on a continuous basis. There should be an additional risk premium tied specifically to the systemic risk of the institutions, for example, if it exceeds a normative level, the institution pays for the additional risk taken on. Some sort of after-the-fact discipline such as “contingent capital” may be necessary; for example, debt that automatically converts into equity when losses seriously deplete equity capital. A form of functional separation or carve-outs needs to be enforced, whether by regulatory fiat or through appropriate capital charges.

This chapter examines the performance of highly indebted countries from the point of view of their links with the international financial market. Although the more analytical parts of the chapter do not refer specifically to Latin America, it considers the regional emergent markets' experiences as examples which provide historical background. The paths followed by some countries in the globalization process led them to situations of segmented integration. Persistently high risk premiums place a country in a sort of financial trap, with a high interest rate and low growth, leaving it highly vulnerable to contagion and other sources of volatility, and imposing narrow limits to the degrees of freedom on economic policy. The chapter suggests that domestic policy implemented during the process of financial integration account for most of the variation in the situations of the different emergent markets in the early 2000s.

This chapter focuses on the evolution of Brazil's credit risk between 1824 and 1889. It determines changes in the government's creditworthiness by reference to the default premium on Brazilian bonds traded in London and Rio de Janeiro. By locating persistent shifts using weekly data on bond yields, the chapter identifies key turning points in the evolution of the Empire's risk premium. It considers and rejects the hypothesis that Brazil's reputation for repayment was the chief determinant of the decline in country risk. In most instances durable changes in the pricing of Brazilian credit risk in the bond markets were related to domestic political events and foreign policy shocks, especially war. These created political and fiscal stresses that altered bondholders' expectations of the government's willingness to pay. Investors faced such episodes with apprehension and viewed their successful resolution with relief, as they repriced sovereign risk accordingly.

Many policies impact on inter-temporal consumption choices, with taxes on capital income being the most obvious example. This chapter examines the welfare effects of linear and non-linear personal income taxes, as well as taxes on corporate income, in a two-period setting. The shadow discount rate obtained by Harberger (1969) and Sandmo and Dre_ze (1971) is personalized in the presence of non-linear income taxes, while the corporate tax is included using the Miller (1977) equilibrium, in which consumers specialize in holding debt or equity, solely on the basis of their tax preferences. A risk premium is included in the social discount rate using the capital asset pricing model (CAPM), and arguments by Arrow and Lind (1970) for using a lower risk premium for public sector projects are also examined.

Explores optimal investment strategies when both riskless interest rates and risk premia change over time in ways that can be described by a vector autoregressive (VAR) model. In this situation, a long‐term investor with constant risk aversion should both exploit and hedge against variations in investment opportunities. As in Ch. 3, a conservative long‐term investor should hedge real interest rate risk by holding long‐term inflation‐indexed bonds, or nominal bonds if inflation risk is low. In addition, the investor should respond to mean‐reverting stock returns by increasing the average allocation to equities. The strategic equity allocation also involves gradual changes in asset allocation over time, since the state variables that predict excess returns are generally slow‐moving.

Equities have historically exhibited high returns relative to bonds and cash (bills). The equity risk premium is a reward for bearing losses during bad times, which are defined by low consumption growth, disasters, or long-run risks. Equities are a surprisingly poor hedge against inflation. While theory suggests that equity risk premiums are predictable, predictability is hard to detect statistically. Equity volatility, however, is much more forecastable.

This chapter models the optimal degree of delegation and centralization of government as the degree of availability of communication between periphery and centre in a hierarchy. Under bounded rationality, delegation is shown to be superior as it uses more information than centralization. Under delegation with risk‐averse agents, it is shown that new transaction costs are introduced since the risk‐averse agent will require a risk premium for incentive compatibility.

The market risk premium (MRP) remains one of the most debated issues in corporate finance. The MRP is a critical input when measuring a company’s cost of equity and weighted cost of capital. Thus, a company’s estimate of the MRP can have major effects on its capital budgeting decisions. This is especially true when estimating the MRP in emerging markets, where expected returns are widely understood to be affected by variables other than those specified by the capital asset pricing model (CAPM). The purpose of this chapter is to investigate the degree of integration or lack thereof (segmentation) between capital markets and to develop a modified CAPM for financial decision-making in emerging markets.

Factors drive risk premiums. One set of factors describes fundamental, economy-wide variables like growth, inflation, volatility, productivity, and demographic risk. Another set consists of tradeable investment styles like the market portfolio, value-growth investing, and momentum investing. The economic theory behind factors can be either rational, where the factors have high returns over the long run to compensate for their low returns during bad times, or behavioral, where factor risk premiums result from the behavior of agents that is not arbitraged away.

Assets earn risk premiums because they are exposed to underlying factor risks. The capital asset pricing model (CAPM), the first theory of factor risk, states that assets that crash when the market loses money are risky and therefore must reward their holders with high risk premiums. While the CAPM defines bad times as times of low market returns, multifactor models capture multiple definitions of bad times across many factors and states of nature.

There are many factor strategies—value-growth investing, momentum, and short volatility strategies, to name but a few—that beat the market. To determine which factors that we should choose, factor investing asks: how well can a particular investor weather hard times relative to the average investor? Answering this question helps an investor reap long-run factor premiums by embracing risks that lose money during bad times but make up for it the rest of the time with attractive rewards. When factor investing can be done cheaply, it raises the bar for active management.

This chapter focuses on asset allocation, which is an important aspect in the investment decision-making process. Asset allocation has the potential to add the most to longer-term performance, if executed properly, or detract greatly, if done poorly. Strategic asset allocation (SAA) takes a longer-term approach. One approach to SAA, called the historic approach, is to simply extrapolate the risk and return of asset classes experienced over, for example, the last 80 years into the future. Over such a long period, the economy experiences many different economic episodes. An alternative is the scenario approach that forecasts over a shorter, three-to-five-year period and allows for accommodating such episodes. The scenario approach also requires greater skill and analysis to execute than the historic approach. Tactical asset allocation (TAA) is a complementary approach and takes a much shorter-time horizon of, for example, one to three years. TAA has potential to add value by taking advantage of shorter-term opportunities. At the same time, this approach presents greater risk, which the portfolio manager or investor needs to consider. Other topics examined include risk premium valuation, stock-bond correlation, investor expectations, economic and technical indicators, cyclical markets, and secular trends.

Do differences in risk exist across countries? If the answer is yes, judgment is needed in determining how best to reflect those risks in investment analysis. This chapter examines the drivers of country risk, why it varies across countries and across time, and how rating agencies and markets measure country risk. The chapter extends the assessment to estimate equity risk premiums for different countries and looks at how to incorporate this risk into the hurdle rates of companies that may have operations in these countries, even if incorporated elsewhere.

The level factor, which shifts the yields of all bonds, is the crucial factor in fixed income investments. The level factor is affected by risks associated with economic growth, inflation, and monetary policy. Corporate bonds do not just reflect credit risk; as predicted by theory, volatility risk is an important factor and corporate bond returns correlate highly with equity returns. Illiquidity risk is also an important factor in bond returns.

This chapter presents facts and concepts regarding long-run stock market returns. It starts out briefly defining stock returns.The chapter then looks at the historical data, starting with US data and then turning to international data. It decomposes stock returns into a risk-free rate and a risk premium. The chapter also introduces concepts that will be used repeatedly throughout the book, such as different kinds of averages (arithmetic and geometric), standard deviations, variances, and other important concepts in finance.The chapter presents stylized facts about long-run stock returns. It does not try to explain what generates these returns. This is the topic of subsequent chapters.

This chapter focuses on risk neutral valuation (RNV), a method for pricing risky securities. RNV is used for the pricing of options and other derivatives, but can also be applied to determining the profitability of a risky investment or assessing the value of complex securities. The reasons for the popularity of RNV are its simplicity and the fact that it allows determination of risk premiums without any knowledge of economic fundamentals. The RNV relies on assumptions that all risks are traded on active markets and that trade is efficient.

This chapter develops a simple general equilibrium open-economy model in which real exchange rates play a central role in the adjustment process, wages and prices are sticky in terms of domestic currency, liabilities are dollarized, and the country risk premium is endogenously determined by the net worth of domestic entrepreneurs. Hence, all the basic building blocks are there for unexpected real exchange rate movements to be financially dangerous under original sin. In spite of the model's apparent complexity, it obtains an analytic solution for all variables of interest, which can be depicted in terms of three familiar schedules: the IS and the LM, which correspond to equilibrium conditions in the goods and money market, and the BP, along which the international loan market is in equilibrium. This characterization helps to identify exactly how the combination of balance-sheet effects and liability dollarization may lead to departures from the standard framework.

Stocks and bonds? Real estate? Hedge funds? Private equity? The conventional way of allocating across asset classes fails to account for the overlapping risks that they represent. Investors must consider the underlying factor risks behind asset class labels, just as eating a healthy diet requires looking through foods to the nutrients that they contain. Factor risks are the hard times that affect all assets, and investors are rewarded for weathering losses during bad times with long-run risk premiums. Optimally harvesting factor risk premiums—on our own or by hiring others—requires identifying our particular set of bad times and exploiting the difference between them and those of the average investor.