Port 5

CHAPTER 5
Introduction to Risk, Return, and

the Historical Record
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
Interest Rate Determinants

• Supply
– Households
• Demand
– Businesses
• Government’s Net Supply and/or
Demand
– Federal Reserve Actions

5-3
Real and Nominal Rates of Interest

Let R = nominal rate,
• Nominal interest
r = real rate and
rate: Growth rate of
i = inflation rate. Then:
your money
r  R i
• Real interest rate:
1 R
Growth rate of your 1 r 
purchasing power 1 i
(how many Big Macs Solve:
R i
can I buy with my r
money?) 1 i
5-4
Equilibrium Real Rate of Interest
• Determined by:
–Supply
–Demand
–Government actions
–Expected rate of inflation

5-5
Figure 5.1 - Real Rate of Interest Equilibrium

5-6
Equilibrium Nominal Rate of Interest
• As the inflation rate increases, investors will

demand higher nominal rates of return
• If E(i) denotes current expectations of
inflation, then we get the Fisher Equation:
• Nominal rate = real rate + expected inflation
R  r  E (i )

5-7
Taxes and the Real Rate of Interest

• Tax liabilities are based on nominal income
– Given a tax rate (t) and nominal interest
rate (R), the real after-tax rate of return is:
R1  t   i  r  i 1  t   i  r 1  t   i  t

 
after tax

inflation -adjusted
• As intuition suggests, the after-tax, real rate

of return falls as the inflation rate rises.
5-8
Rates of Return
for Different Holding Periods
Zero Coupon Bond
Par = $100
T = maturity
P = price
rf(T) = total risk free return
100
rf T  
P 100
1
1  rf T  P
5-9
Example 5.2 Time Does Matter:

Use Annualized Rates of Return

5-10
Equation 5.7 EAR

• Time matters → use EAR to annualize
• Effective Annual Rate definition:
percentage increase in funds invested
over a 1-year horizon
1  rf T   1  EAR 
T

1  EAR  1  rf T   1
T

5-11
Equation 5.8 APR

• Annual Percentage Rate (APR):
annualizing using simple interest
1  APR  T  1  EAR 
T
APR 
1  EAR 
T
1
T

5.00 5-12
End Value with APR=5.0%

4.50
End Value with EAR=5.0%
4.00
Investment End Value
3.50
3.00
2.50
2.00
1.50
1.00
0 5 10 15 INVESTMENTS
20 | BODIE,25KANE, MARCUS
30
(years)
5-13
Table 5.1 APR vs. EAR

5-14
Continuous Compounding
• Frequency of compounding matters

• At the limit to (compounding time)→0:
1  EAR  e rcc

5.00 5-15
End Value with APR=5.0%

4.50
End Value with EAR=5.0%
End Value with Rcc=5.0%
4.00
Investment End Value
3.50
3.00
2.50
2.00
1.50
1.00
0 5 10 15 INVESTMENTS
20 | BODIE,25KANE, MARCUS
30
(years)
How to derive Rcc
Let r=rate and
x=compounding time → T  N * x  N  T / x
End Value  1  r * x     1  r * x   1  r * x 
N

compounding N times
lim1  r * x  S lim e ln 1 r * x N

Make x very N
small. Then Substitute
N=T/x
use A=eln(A) x 0 x 0
T ln 1 r * x   d 
 T ln 1 r * x  
 lim e 
x Looks like 0/0.  dx 
Use de l’Hôpital  d 
x 0  x 
1
 lim e  dx 

T r x 0
1 r * x
 lim e 1
e rT
Q.E.D. Checks: r=0 →End Value=1
x 0 T=0 →End Value=1
5-17
Table 5.2 Statistics for T-Bill Rates, Inflation

Rates and Real Rates, 1926-2009

5-18
Bills and Inflation, 1926-2009

• Moderate inflation can offset most of the
nominal gains on low-risk investments.
• One dollar invested in T-bills from1926–2009

grew to $20.52, but with a real value of only
$1.69.
• Negative correlation between real rate and

inflation rate means the nominal rate
responds less than 1:1 to changes in
expected inflation.
5-19
Figure 5.3 Interest Rates and Inflation,

1926-2009

5-20
Risk and Risk Premiums

Rates of Return: Single Period
HPR 
 P1  P 0   D1
P0
HPR = Holding Period Return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one

5-21
Rates of Return: Single Period Example
Ending Price = 110

Beginning Price = 100
Dividend = 4
HPR = (110 - 100 + 4 )/ (100) = 14%

5-22
Expected Return and Standard

Deviation
Expected (or mean) returns
E (r )   p ( s )r ( s )
s
p(s) = probability of a state

r(s) = return if a state occurs
s = state

5-23
Scenario Returns: Example

State Prob. of State r in State
Excellent 0.25 0.3100
Good 0.45 0.1400
Poor 0.25 -0.0675
Crash 0.05 -0.5200
E(r) = (0.25)(0.31) + (0.45)(0.14) + (0.25)(-0.0675)
+ (0.05)(-0.52)
= 0.0976
= 9.76% (think of a probability-weighted avg)
NOTE: use decimals instead of percentages to be safe
5-24
Variance and Standard Deviation
Variance (VAR):
   p( s)  r ( s)  E (r ) 
2 2
Standard Deviation (STD):
STD   2

5-25
Scenario VAR and STD

• Example VAR calculation:
σ2 = 0.25(0.31 - 0.0976)2 +
0.45(0.14 - 0.0976)2 +
0.25(-0.0675 - 0.0976)2 +
0.05(-0.52 - 0.0976)2 =
= 0.038
• Example STD calculation:
  0.038  0.1949
5-26
Time Series Analysis of Past Rates of

Return
The Arithmetic Average of historical rate
of return as an estimator of the expected
rate of return
n
1 n
E (r )   p ( s )r s    r s 
s 1 n s 1

5-27
Geometric Average Return
TVn  (1  r1 )(1  r2 )...(1  rn )

TV = Terminal Value of the Investment
Solve for a rate g that, if compounded n
times, gives you the same TV
TV  1 g   g  TV
n
1
1/ n
g = geometric average rate of return

5-28
Geometric Variance and Standard

Deviation Formulas
Recall the definition of variance
   p( s)  r ( s)  E (r ) 
2 2
s
Estimated Variance = expected value of
squared deviations (from the mean)
n 2
ˆ   r s   r 
2 1
n s 1
5-29
Geometric Variance and Standard

Deviation Formulas
• Using the estimated ravg instead of the real E(r)
introduces a bias:
– we already used the n observations to estimate ravg
– we really have only (n-1) independent observations
– correct by multiplying by n/(n-1)
• When eliminating the bias, Variance and
Standard Deviation become*:
n 2
ˆ 
1
 r s   r 
n  1 j 1
* More at http://en.wikipedia.org/wiki/Unbiased_estimation_of_standard_deviation

5-30
The Reward-to-Volatility (Sharpe)

Ratio
• Sharpe Ratio for Portfolios:
Risk Premium

SD of Excess Returns

5-31
The Normal Distribution

• Investment management math is easier
when returns are normal
– Standard deviation is a good measure of risk
when returns are symmetric
– If security returns are symmetric, portfolio
returns will be, too
– Assuming Normality, future scenarios can be
estimated using just mean and standard
deviation

5-32
Figure 5.4 The Normal Distribution

5-33
Normality and Risk Measures

• What if excess returns are not normally
distributed?
– Standard deviation is no longer a complete
measure of risk
– Sharpe ratio is not a complete measure of
portfolio performance
– Need to consider skew and kurtosis

5-34
Skew and Kurtosis

this is zero for symmetric distributions
 
 R  R  
3
skew  average  
 ˆ
3

 R  R 4 
kurtosis  average   3
 ˆ
4

 
this equals 3 for a Normal distribution

5-35
Figure 5.5A Normal and Skewed

Distributions

5-36
Figure 5.5B Normal and Fat-Tailed

Distributions (mean = 0.1, SD =0.2)

5-37
Value at Risk (VaR)

• A measure of loss most frequently
associated with extreme negative returns
• VaR is the quantile of a distribution below
which lies q% of the possible values of
that distribution
– The 5% VaR, commonly estimated in
practice, is the return at the 5th percentile
when returns are sorted from high to low.
Also referred to as 95%-ile (depends on perspective)

5-38
Normal Distribution and VaR
2.5
2
Percentile
1.5
0.5
VaR
0
-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
5-39
Expected Shortfall (ES)

• a.k.a. Conditional Tail Expectation (CTE)
• More conservative measure of downside
risk than VaR:
– VaR takes the highest return from the worst
cases
– Real life distributions are asymmetric and
have fat tails
– ES takes an average return of the worst cases

5-40
Normal Distribution, VaR, and Expected Shortfall
2.5
2 The area is the

percentile
1.5
0.5 Expected VaR

Shortfall
0
-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
5-41
Lower Partial Standard Deviation (LPSD)

and the Sortino Ratio
• Issues with real life returns:
– Need to look at negative returns separately to
account for asymmetry and fat tails
– Need to consider excess returns: deviations
of returns from the risk-free rate.
• LPSD: similar to usual standard deviation,
but uses only negative deviations from rf
• Sortino Ratio replaces Sharpe Ratio

5-42
A game with a coin

Let’s play a game: flip a (non-fair) coin, and
receive $1 if heads
• Assume Pr[Heads]= p (for example p=50%)
Q. What is the game’s expected outcome?

Q. What is the Variance?
Q. What is the St.Dev?

5-43
A game with two coins

Let’s play a game: flip 2 fair coins, and
receive $1 for each head
Q. What is the portfolio expected return?

Q. What is the portfolio Variance?
Q. What is the portfolio St.Dev?

5-44
A lot more coins

Let’s play a game: flip 30 fair coins, and
receive $1 for each head.

Q. What is the portfolio St.Dev?

5-45
A Portfolio of 2 stocks
• Portfolio = 0.5 * A + 0.5 * B
• A: rA = 0.08 StDevA = 0.1
• B: rB = 0.10 StDevB = 0.1

Q. What is the portfolio Standard Deviation?

5-46
A Portfolio of 3 stocks
• Portfolio = wA * A + wB * B + wC * C

Q. What is the portfolio Standard Deviation?
Q. What is if you have N stocks?

1926-2009 5-47
S
(A)
(B) (C)
30% (A)
50% (B)
20% (D)
(D) (E)
5-48
Historic Returns on Risky Portfolios

• Returns appear approximately normally
distributed
• Returns are lower over the most recent
half of the period (1986-2009)
• SD for small stocks became smaller;
SD for long-term bonds got bigger
• Better diversified portfolios have higher
Sharpe Ratios
• Negative skew
5-49
Figure 5.7 Nominal and Real Equity

Returns Around the World, 1900-2000

5-50
Figure 5.8 Standard Deviations of Real Equity and

Bond Returns Around the World, 1900-2000

5-51
Figure 5.9 Probability of Investment Outcomes

After 25 Years with a Lognormal Distribution

5-52
Terminal Value with Continuous

Compounding
• When the continuously compounded rate of
return on an asset is normally distributed, the
effective rate of return will be lognormally
distributed. Remember:
E Geom. Avg  E Arithm. Avg  1 / 2 2
so m  g  1 / 2 2
• The Terminal Value will then be:
1  EAR T

 e g 1 / 2 2
 e
T
Tg T / 2 2

5-53
Figure 5.10 Annually Compounded,

25-Year HPRs

5-54
Figure 5.11 Annually Compounded,

25-Year HPRs

5-55
Figure 5.12 Wealth Indices of Selected Outcomes of Large

Stock Portfolios and the Average T-bill Portfolio

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CHAPTER 5

Introduction to Risk, Return, and

INVESTMENTS | BODIE, KANE, MARCUS

Interest Rate Determinants

INVESTMENTS | BODIE, KANE, MARCUS

Real and Nominal Rates of Interest

Equilibrium Real Rate of Interest

INVESTMENTS | BODIE, KANE, MARCUS

Figure 5.1 - Real Rate of Interest Equilibrium

INVESTMENTS | BODIE, KANE, MARCUS

Equilibrium Nominal Rate of Interest

• As the inflation rate increases, investors will

INVESTMENTS | BODIE, KANE, MARCUS

Taxes and the Real Rate of Interest

• As intuition suggests, the after-tax, real rate

Example 5.2 Time Does Matter:

INVESTMENTS | BODIE, KANE, MARCUS

Equation 5.7 EAR

INVESTMENTS | BODIE, KANE, MARCUS

Equation 5.8 APR

INVESTMENTS | BODIE, KANE, MARCUS

End Value with APR=5.0%

Table 5.1 APR vs. EAR

INVESTMENTS | BODIE, KANE, MARCUS

• Frequency of compounding matters

INVESTMENTS | BODIE, KANE, MARCUS

End Value with APR=5.0%

lim1  r * x  S lim e ln 1 r * x N

Table 5.2 Statistics for T-Bill Rates, Inflation

INVESTMENTS | BODIE, KANE, MARCUS

Bills and Inflation, 1926-2009

• One dollar invested in T-bills from1926–2009

• Negative correlation between real rate and

Figure 5.3 Interest Rates and Inflation,

INVESTMENTS | BODIE, KANE, MARCUS

Risk and Risk Premiums

INVESTMENTS | BODIE, KANE, MARCUS

Rates of Return: Single Period Example

Ending Price = 110

HPR = (110 - 100 + 4 )/ (100) = 14%

INVESTMENTS | BODIE, KANE, MARCUS

Expected Return and Standard

p(s) = probability of a state

INVESTMENTS | BODIE, KANE, MARCUS

Scenario Returns: Example

Variance and Standard Deviation

Standard Deviation (STD):

INVESTMENTS | BODIE, KANE, MARCUS

Scenario VAR and STD

Time Series Analysis of Past Rates of

INVESTMENTS | BODIE, KANE, MARCUS

Geometric Average Return

TVn  (1  r1 )(1  r2 )...(1  rn )

g = geometric average rate of return

Geometric Variance and Standard

Geometric Variance and Standard

INVESTMENTS | BODIE, KANE, MARCUS

The Reward-to-Volatility (Sharpe)

• Sharpe Ratio for Portfolios:

INVESTMENTS | BODIE, KANE, MARCUS

The Normal Distribution

INVESTMENTS | BODIE, KANE, MARCUS

Figure 5.4 The Normal Distribution