Risk and Return 81Their model also captures firm specific default risk. They use bond ratings, Altman’s Z score and duration
to measure default risk and maturity risk. Credit risk refers to the chance that the expectation will not be met.
One approach to estimating default risk is to compute a composite risk measure based on a firm’s financial
ratios advocated by Altman (1968).^10 His Z-score model combines select financial ratios to arrive at a score
as follows:
Z = 0.012 × Net working capital/Total assets
+ 0.014 × Retained earnings/Total assets
+ 0.033 × EBIT/Total assets
+ 0.006 × Market value of equity/Book value of liabilities
+ 0.999 × Sales/Total assetsA high Z score represents a low probability of default and a low Z score represents a high probability
of default. The model’s classification accuracy was 95 percent one year before bankruptcy and 72 percent
two years before. Accuracy of the model decreases as the time period is extended (it may also be unreliable
in its predictive ability). Based on the study, it was concluded that firms with a Z score less than 1.81 are all
bankrupt, while those with Z scores greater than 2.99 fall into the non-bankrupt group. Those falling into
the area between 1.81 and 2.99 require more analysis to determine their solvency status. The non-liquid asset
ratios like total debt to total assets and cash flow to total debt are, in general, better predictors of bankruptcy
than the liquid assets ratios like quick ratio or net working capital to total assets.
In sum, a model containing default beta, term beta, ratings and duration could be used to calculate cost
of debt.
BACK TO ING
What should ING do? I mean how should the fund manager choose stocks? That depends not only on the
returns from a stock but also its systematic risk. That is, the risk it adds to the portfolio. If the fund manager
wants to construct an aggressive portfolio, a portfolio that is more volatile than the market as a whole, he
may choose high beta stocks. Such a portfolio would do well in a bull market. If the manager is not interested
in active management, he may simply replicate the index and sit tight. His portfolio will do as well or as bad
as the index.
The fund manager would also want to measure the performance of a stock. To do the same he will have to
compare the stock’s performance with what is expected out of it. Assume that a stock’s one-year return
is 12 percent. Is this good or bad? We can answer this question only by comparing with the return on
a benchmark index. Assume that the stock has a beta of 1.2 and the index return for the same period is
10 percent. Although the raw return is more than that from the index, the beta adjusted return (1.2 *index
return) exactly equals the index return. In other words, the stock did as well as the index.
Another measure of security performance is the Jensen’s Alpha. The standard procedure for estimating
beta is to regress stock returns against market returns.
Rj= a + bRm (A)(^10) Financial ratios and bankruptcy prediction is discussed in greater detail in the chapter on Financial Statements.