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A Review
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Overview
Holding period return
Measuring returns over multiple periods
Two approaches to describing returns under
uncertainty:
Scenario analysis and time series analysis
Measuring mean and variance
Risk premiums and risk aversion
Sharpe ratio
Historical record of stock and bond portfolios
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HPR (Holding period return)
[P(t+1)P(t) + D(t)]/P(t)
Depends on
Beginning price and ending price
Dividend, coupons…
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Holding Period Return: Example
No dividends
P(1) =99 and P(0)=100
Return= (99100)/100= 1%
With dividends
P(1) =99, P(0)=100 and D(1)=2
Return=(99100+2)/100=1%
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Measuring Returns over Multiple Periods
Arithmetic Average
Sum of returns in each period divided by number of periods
Geometric Average
• Single perperiod return; gives same cumulative performance as
sequence of actual returns
• Compound periodbyperiod returns; find perperiod rate that
compounds to same final value
• Dollarweighted average return
• Internal rate of return on investment
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Example: Table 5.1 Quarterly Cash Flows and Rates of
Return of a Mutual fund
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1st
Quarter
2nd
Quarter
3rd
Quarter
4th
Quarter
Assets under management at start of
quarter ($ million)
1 1.2 2 0.8
Holdingperiod return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of
quarter ($ million)
1.2 2 0.8 1.56
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Arithmetic Average
r
A
= (10 +25 – 20 + 20) / 4 = 8.75%
Several observations:
Ignores compounding
Does not represent an equivalent, single quarterly rate for the
year.
Is the best forecast of performance for the next quarter
without information beyond the historical sample.
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Geometric Average
(1 + 0.10) * (1 + 0.25) * (1 – 0.20) * (1 + 0.20) = (1 + r
G
)
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Solving for r
G
= 7.19%
Observations:
Also called a timeweighted average return – ignoring the
quartertoquarter variation in funds under management
Mutual funds are required to publish this as a measure of past
performance
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DollarWeighted Return
0 = −1.0 +
−0.1
1+
+
−0.5
1+
2
+
0.8
1+
3
+
(−0.6+1.56)
1+
4
Solving for IRR = 3.38%
Observations:
Similar to a capital budget problem
Accounting for varying amounts of capital under
management form quarter to quarter
Less than timeweighted return of 7.19% (why?)
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Annualizing Rates of Return
Annual Percentage Rates (APR):
APR = Perperiod rate * Periods per year
Effective Annual Rate (EAR):
1 + = 1 +
As n―>∞, we have continuous compounding,
1 + =
= = ln (1 +)
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The Impact of Compounding Frequency
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Compounding
Period
APR EAR
1 year 0.058 0.05800
6 months 0.058 0.05884
1 quarter 0.058 0.05927
1 month 0.058 0.05957
1 week 0.058 0.05968
1 day 0.058 0.05971
continuous 0.058 0.05971
Risk and Risk Premium
Risk free assets: an asset with a certain rate of return
Often taken to be short term Tbills
Investment is risky once we move away from risk free
assets.
Uncertainty about future holdingperiod returns
Sources of uncertainty:
Macroeconomic shocks
Industryspecific shocks
Assetspecific unexpected developments
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Two Approaches to Describing Returns under
Uncertainty
Scenario analysis
Determine a set of relevant scenarios and associated investment
outcomes (rate of return) and assigns probability to each
Compute mean return and variance (the risk)
However, sometimes it is hard to assign probabilities
Time series analysis
Use historical data, treat each observation as equally likely
Compute mean and variance
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Scenario Analysis and Probability Distributions
For each possible scenario s = 1, …, S, let the HPR be r(s)
with probability p(s).
Expected return:
= ()
=1
Variance:
≡
2
= () −()
2
=1
Standard deviation:
≡ = ()
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Spreadsheet 5.1: Scenario Analysis for the Stock
Market
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The Normal Distribution:
Central to the theory and practice of investments
Normal and standard normal distribution:
~
,
=
−(
)
~(0,1)
Two special properties:
The return on a portfolio comprising two or more assets
whose returns are normally distributed also will be
normally distributed.
The normal distribution is completely described by its
mean and standard deviation.
σ is the appropriate measure of risk.
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Figure 5.1 Normal Distribution with Mean Return
10% and Standard Deviation 20%
Measure of Downside
Value at Risk (VaR):
The worst loss that will be suffered with a given probability,
often 5%.
Prob (r <= VaR) = 5%
For normally distributed returns:
A VaR of 5% is 1.64485 standard deviations below the
mean
VaR = E(r) + (1.64485)σ
Useful excel functions:
=NORMSINV(0.05)
=NORMINV(.05, E(r), σ)
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Normality over Time
Compounding will deviate the HPR over multiple periods
from normality.
The longer the time periods, the larger the deviation.
Let the annual continuously compounded rate r
cc
= 12%
EAR = e
0.12
– 1 = 0.1275 ―> meaningful difference (75 bps)
The equivalent monthly r
cc
= 1%
Effective monthly rate = e
0.01
– 1 = 0.01005 ―> negligible
difference
Practical implication: use continuously compounded
rate in all work where normality plays a crucial
role.
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Normality over Time (cont.)
If the continuously compounded rate of return (r
cc
) is
normally distributed at every instant, then the effective rate
of return (HPR) will be lognormally distributed.
For short periods up to 1 month, r
cc
= ln (1 + r) ≈ r
Suppose that, on an annual basis, r
cc
is normally
distributed with an annual geometric mean g and stdev σ
Expected APR: m = g + ½ σ
2
Expected EAR: 1 + E(r) =
+1/2
2
Over T years,
1 + ()
=
+1/2
2
Mean grows at the rate of T
Standard deviation grows at rate of
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Deviation from Normality
When returns are not normal, we need to look beyond
the 2
nd
moment to characterize the distribution.
Two useful statistics:
Skew:
Measuring the asymmetry of a probability distribution
Kurtosis:
Measuring the fatness of the tails of a probability
distribution – indicating likelihood of extreme outcomes
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Skew and Kurtosis
Skew Kurtosis
(
(
(
(
¸
(
¸

.

\

÷
=
3
^
3
_
o
R R
average skew
3
4
^
4
_
÷
(
(
(
(
¸
(
¸

.

\

÷
=
o
R R
average kurtosis
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Figure 5.5A Normal and Skewed Distributions
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Figure 5.5B Normal and FatTailed
Distributions (mean = .1, SD =.2)
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Time Series Analysis
Scenario analysis postulates a probability distribution
of future returns.
Where do they come from?
In reality, we observe time series of past realized
returns: dates and associated HPRs.
We must infer from this limited data the probability
distributions from which these returns were drawn.
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Arithmetic Average and Expected Return based on
Time Series Data
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¿ ¿
= =
= =
n
s
n
s
s r
n
s r s p r E
1 1
) (
1
) ( ) ( ) (
When using historical data, we treat each
observation as an equally likely “scenario”
with probability 1/n.
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Geometric Average Return based on Time Series
Data
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1
/ 1
÷ =
TV
g
n
TV = Terminal Value of the
Investment
g= geometric average
rate of return
) 1 )...( 1 )( 1 (
2 1 n n
r r r TV + + + =
Variance and Standard Deviation based on Time
Series Data
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When eliminating the estimating bias,
Variance and Standard Deviation become:
( )
2
1
_ ^
1
1
¿
=
(
¸
(
¸
÷
÷
=
n
j
r s r
n
o
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Example
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Risk Premiums and Risk Aversion
• Riskfree rate: Rate of return that can be earned with
certainty
• Risk premium: Expected return in excess of that on
riskfree securities
• Excess return: Rate of return in excess of riskfree rate
• Risk aversion: Reluctance to accept risk
• Investors will accept a lower risk premium in exchange for
a sufficient reduction in the standard deviation.
• Price of risk: Ratio of risk premium to variance
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The Sharpe (RewardtoVolatility) Ratio
Commonly used to rank portfolios in terms of risk
return tradeoff:
=
=
−
Warning:
A valid statistics only for ranking portfolios
Not valid for ranking individual assets.
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The Historical Record
• World and U.S. Risky Stock and Bond Portfolios
• World Large stocks: 24 developed countries, about
6000 stocks
• U.S. large stocks: Standard & Poor's 500 largest cap
• U.S. small stocks: Smallest 20% on NYSE, NASDAQ,
and Amex
• World bonds: Same countries as World Large stocks
• U.S. Treasury bonds: Barclay's LongTerm Treasury
Bond Index
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Arithmetic vs. Geometric Averages
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Risk Premium and Growth of Wealth
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Performance: Sharpe Ratio
Sharpe ratios for stock portfolios:
0.37 – 0.39 for the overall history
0.34 – 0.46 across all subperiods
0.4% risk premium for every 1% increment in stdev
The differences between the three subperiods and
between the three stock portfolios are not statistically
significant.
Bonds can outperform stocks in periods of falling
interest rates – as in the most recent subperiod.
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Are These Returns Normal?
For stock portfolios, there is excess positive kurtosis
and negative skew.
Extreme gains and, even more so, extreme losses are
significantly more likely than predicted by the normal
distribution.
Consistent with this, the estimated VARs (5%) are
more negative than the normal thresholds.
Potential losses are larger than suggested by the likewise
normal distribution (same mean and stdev).
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