25-08-2018

Module 3

Risk and Return

Readings – any one of the below mentioned books,

together with class notes and exercises
• Bodie, Kane and Marcus. 6th Edn.
– Chapters 6,7 and 8 on Portfolio theory
• Reilly and Brown. 7th edn
– Chapter 7
• Farrell 2nd edn
– Chapter 2
• Elton and Grubber 6th Edn
– Chapter 4,5 and 6. Mean variance portfolio theory.

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Holding Period Return (HPR)/

Rate of Return (RoR)/
Periodic return
• RoR are building blocks of security analysis.
• We use them at many places like -
– To estimate value of portfolio at the end of a period of time.
– To benchmark a portfolio against an index.
– To specify the behavior of an asset in order to plug it in a simulation say Monte Carlo
simulation, etc.

Types of Returns

1. Holding Period Return (HPR)

2. Annualized returns
3. Compounded returns/CAGR
4. Continuously Compounded rates and Log-normal returns
5. Arithmetic Mean
6. Geometric Mean
7. Expected return

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HPR (aka simple return/ absolute return)

• HPR = Pi – Po + Dividend = ___%

Po
Example 1: Mr. A purchased 100 shares of ABC Ltd. as on 1.7.2017 when its
price was Rs. 729.25 whereas its current stock market price as on 1.7.2018 is
Rs. 840.25. Dividend received during the same period was Rs. 50 per share.
Calculate HPR.

Example 2: You invested in a mutual fund scheme, when its NAV was Rs. 12
per unit and you sold it for Rs. 15 per unit. How much is your return?
Solution: (15-12+0)/12 * 100 = 25%

Annualized return – simple annualizing,

“no compounding”
• Two investment options have indicated their returns as 5% and 3%
respectively.
• If the first investment was in existence for 6 months and second for 4
months, then -
• The two returns are not comparable.
• Annualizing the return helps us compare the returns of the two different
time periods
• Annualized returns = HPR x 12
Period in HPR (in months)

Investment 1 Investment 2
5% x 12 3% x 12
6 4
`= 10% ` = 9%
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Compounded Annualized Growth Rate

(CAGR)
• If the two investment options mentioned previously were in existence for 6
years and 4 years respectively, then we can calculate annualized returns.
However, the effect of compounding will be missed.
• CAGR is calculated as follows:
• CAGR =((Ending value / Beginning value) ^ (1/n)) - 1 *100
where, n = no. of years

Example 1: Rs. 1,000 grew to Rs. 4,000 in 2 years, the compounded returns would
be:
CAGR =((4,000/1,000) ^ (1/2)) - 1 *100 =100% p.a.

Logically, Rs. 1,000 would become Rs. 2,000 (100% returns) at the end of year 1
and then grow to Rs. 4,000 (100% returns) at the end of year 2.

• OR
 GM=[(1+R1) (1+R2) (1+R3)..(1+Rn)]1/n – 1

Effective Annual Return

• For durations less than 1 year:

EAR = ((1 + HPR)^(12/m)) - 1
where, m = no. of months
Example 1: JM Equity Fund delivered a rate of return from Jan 2018 to June
2018 of 8%. Calculate the EAR.
Solution 1: EAR = ((1+8%)^(12/6)) – 1 = 16.64% p.a.
Minor
• For durations more than 1 year: modification
EAR = (1 + HPR)^(1/n)) - 1 of the CAGR
formula
where n = no. of years
Example 2: Indiabulls Midcap Fund delivered 127.75% from July 2015 to
Dec 2017. Calculate the EAR.
Solution 2: EAR = ((1+127.75%)^(1/2.5)) – 1 = 38.99% p.a.

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Example 2
• Suppose prices of zero-coupon treasuries with $100 face value and various maturities are as follows, find
total return and equivalent returns.
Total return
• Horizon T Price HPR (P1-P0)/P0 HPR %
Half year $97.36 `(100-97.36)/97.36 0.027116 2.71%
1 year $95.52 `(100-95.52)/95.52 0.046901 4.69%
25 year $23.30 `(100-23.30)/23.30 3.291845 329.18%
So how should we compare the
returns on investments with differing Horizon T Effective annual rate (EAR)
horizons? Half year `(1+0.027116)^2 - 1 = 5.49%
This requires that we re-express each compounding- it is half yearly
total return as EAR (effective annual 1 year `(1+0.0469)^(1/1) - 1 = 4.69%
rate) with 1 year horizon for
comparison as a common period. 25 year CAGR `(1+3.291845)^(1/25) - 1 = 6%

a) In first case, Return p.a. (simple annualizing) would be 5.42% p.a. (2.71% x 2). With
compounding effect, it has become 5.49% p.a.
b) In case of 25 year horizon we use the CAGR method.
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Measure of Returns

• Measure of returns of an equity share is simply the HPR. It can be

calculated for any term (i.e. daily, weekly, monthly, annually etc).

• Natural Logarithms of stock return relatives can be useful since they

effectively reduce the impact of extreme values that can distort a
distribution. Logarithms reduce impact of extraordinary deviations from
normality.

Example: Takeover rumours sometimes can cause huge price swings and to
lessen the impact of one big move on the average daily return calculations it is
better to use log-returns.

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In January 2001, Mr. Bhandari purchased the following 5 scrips:

Company No. of shares Purchase price
H ltd. 100 250
C ltd. 100 180
S ltd. 100 80
F ltd. 100 240
M ltd. 100 260
He paid brokerage of Rs. 1500. During the year 2001, Mr. Bhandari received the following:
Company Dividend (Rs) Held:Bonus
H ltd. 300 `1:2
C ltd. 290
S ltd. 450
F ltd. 500
M ltd. 600 `1:5
In January 2002, he sold all his holdings at the following prices:
Company Sale price
H ltd. 275
C ltd. 240
S ltd. 108
F ltd. 200
M ltd. 400
He paid brokerage Rs. 1865. Calculate his HPR. Ignore tax.
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In January 2017, Mr. Bhandari purchased the following 5 scrips:

Company No. of shares Purchase price
(Rs. per share)
H ltd. 100 250
C ltd. 100 180
S ltd. 100 80
F ltd. 100 240
M ltd. 100 260
He paid brokerage of Rs. 1500. During the year 2017, Mr. Bhandari received the following:
Company Dividend (Rs. per Held:Bonus
share)
H ltd. 200 1:2
C ltd. 250 1:4
S ltd. 300 1:6
F ltd. 450
M ltd. 800 1:5
In January 2018, he sold all his holdings at the following prices:
Company Sale price
H ltd. 275
C ltd. 240
S ltd. 108
F ltd. 200
M ltd. 400
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He paid brokerage Rs. 1865. Calculate his HPR. Ignore tax.

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Companies A, B and C are identical in every respect except for their

dividend payout ratios.
Company A pays 50% of its earnings as dividends, B pays 0% and C pays
100%.

The P/E ratio of each company for the next 3 years remains steady at 10.

Determine the three-year HPR of each stock and compare performances.

Assume the earnings for year1, 2 and 3 are as follows:

Assume earnings p.a. as under:
• For Company A : $10.00 $10.50 $11.25
• For Company B: $10.00 $11.00 $12.10
• For Company C: $10.00 $10.00 $10.00

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Comparison of total returns

Company A Yr 1 Yr 2 Yr 3 Total
Earnings-assume $10.00 $10.50 $11.25
Dividends $5.00 $5.25 $5.63 $15.88
Mkt Price $100.00 $105.00 $112.50
Return ={(112.50-100)+15.88}/100 =28.38%
Company B Yr 1 Yr 2 Yr 3 Total
Earnings-assume $10.00 $11.00 $12.10
Dividends 0.00
Mkt Price $100.00 $110.00 $121.00
Return ={(121-100)+0}/100 =21%
Company C Yr 1 Yr 2 Yr 3 Total
Earnings-assume $10.00 $10.00 $10.00
Dividends $10.00 $10.00 $10.00 $30.00
Mkt Price $100.00 $100.00 $100.00
Return ={(100-100)+30}/100 =30.00%
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Mean Returns

• Return using Arithmetic Mean: Is the most popular statistic. The Arithmetic Mean
(AM) of a series of total returns =
• R = i=1 to n Ri ,
• n R = arithmetic mean, Ri = ith value of total return (i=1,2,3..n) & n=
no. of total returns.

• Ex. Returns from Stock A over a five year period were (in percentage) :
• 22,14,18, -4, and 7 . The AM of the returns is : 11.4%.

• Now consider the stock example given in Return Relative. where price declines from
100 to 80 in the first year and again climbs back to 100 in the second year.
• Assuming that there were no dividends in the two years, the return over the two year
period is NIL (as 100 is still 100)
• Period price HPR
• 1 100
• 2 80 -20%
• 3 100 +25%
• Mean returns = 2.5% (which is a fallacy, therefore many times GM is preferred)
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Return using Geometric Mean

 GM=[(1+R1) (1+R2) (1+R3)..(1+Rn)]1/n – 1,
Where GM is the Geometric Mean return, Ri = total return for period
i (i= 1,2,3……n) and n = number of time periods.
• in the earlier example 100 – 80 – 100: HPRs -0.20 and -0.25
• GM = [(1-0.20)*(1+0.25)]1/2 – 1 = 0% which is more realistic.
• Also check with LN function:

100
80 -0.22
100 0.223144
sum: 0.000000
2 day HPR 0.000

Example - Returns from Stock A over a five year period were (in percentage) were
as 22,14,18, -4, and 7. The AM of the returns is 11.4%. Now calculate GM.

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Calculate the arithmetic and geometric annual average rates of return for
Abbott and Costello mutual funds. Explain differences between the two
results. HPRs are as follows:

Year Abbott fund (%) Costello fund (%)

• 1 10 8
• 2 5 12
• 3 -15 11
• 4 40 9

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Solution
• Arithmetic averages of:
– Abbott = (0.1+0.05-0.15+0.4)/4 = 0.10
– Costello= (0.08+0.12+0.11+0.09)/4=0.10
– Both returns are the same, but variance of Abbott seems to be greater

• Geometric averages of;

– Abbott= [(1+0.1)(1+0.05)(1-0.15)(1+0.4)]1/4 -1= 0.083
– Costello= 0.0999.
– Note the Geometric mean of Abbott is clearly less than its arithmetic
mean. This is because of Abbott’s greater volatility of returns (-15 to
+40).
– The more volatile the returns, the greater is the difference between
arithmetic and geometric returns.

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Continued…
• Situations when arithmetic method is accurate and should be used;
– Estimating average performance across different securities over one period of time only
– Arithmetic average is an unbiased estimate of future expected rates of return

• For averaging over multiple and successive time periods use geometric
average.

• Suppose you want to invest for only one year in Infosys, by taking the
arithmetic average over 10 years, you get a good estimate of the return
required next year.

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Time Weighted (Geometric) Average return

• The CAGR/GM rate g is what practionners call as
TIME WEIGHTED average return, to emphasize each
past return receives an equal weight in the process of
averaging.

• This distinction is important because investment managers

often experience significant changes in funds under
management as investors purchase or redeem shares.

• E(GM) = E(AM) – ½*σ2

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Quantitative Methods –
Money Vs. Time-Weighted Return
Dollar/Money-weighted and time-weighted rates of return are two methods of
measuring performance, or the rate of return on an investment portfolio. Each of
these two approaches has particular instances where it is the preferred method.

Time-Weighted Rate of Return (CAGR)

• The Holy Grail of portfolio performance benchmarking is the time-weighted
rate of return (TWRR). However, it requires daily portfolio valuations
whenever an external cash flow (i.e. a contribution or withdrawal) occurs.

• The time-weighted rate of return is the preferred industry standard as it is not

sensitive to contributions or withdrawals.

• It is defined as the compounded growth rate of $1 over the period being

measured.

• The time-weighted formula is essentially a geometric mean of a number of

holding-period returns that are linked together or compounded over time (thus,
time-weighted).
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Example
• Investor 1 initially invested $250,000 on December 31, 2013. On
September 15, 2014, their portfolio was worth $290,621.

• They then added $25,000 to the portfolio, bringing the portfolio value up to
$315,621. By the end of 2014, the portfolio had decreased to $298,082.

• Investor 1 would start by calculating their first sub-period return from

December 31, 2013 to September 15, 2014 (using portfolio
values before the cash flow occurred).

• They would then calculate a second sub-period return from September 15,
2014 (using portfolio values after the cash flow occurred) to December 31,
2014.

• After this was done, they would geometrically link the sub-period returns to
obtain their time-weighted rate of return for the year. 22

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Another example
• Investor 2 initially invested $250,000 on December 31, 2013 in the exact
same portfolio as Investor 1. On September 15, 2014, their portfolio was
worth $290,621.

• They then withdrew $25,000 from the portfolio, bringing the portfolio
value down to $265,621. By the end of 2014, the portfolio had decreased
to $250,860. Using the same process, Investor 2 ends up with the exact
same time-weighted rate of return for the year.

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Conclusion
• Regardless of the amounts both investors contributed or withdrew from the
portfolio, they ended up with the exact same return.
• This is precisely the result that should be expected.
• The time-weighted rate of return is not affected by contributions and
withdrawals into and out of the portfolio, making it the ideal choice for
benchmarking portfolio managers or strategies.
• If we compare their return to the returns of the MSCI Canada IMI Index
over the same period (which their portfolio manager was attempting to
track), we also get the same result of 9.79%.

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MSCI Index Performance as of

December 31, 2014

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Dollar/Money-weighted returns (IRR)

• Is a measure of the rate of return for a portfolio that sets the present
value of all cash flows and terminal values equal to the initial investment.

• In other words, the money-weighted rate of return is simply the Internal

Rate of Return (IRR).

• The main difference between time weighted and money weighted returns is
that time weighted returns ignores the effect of cash inflows/outflows,
whereas money-weighted returns incorporate the size and timing of cash
flows.

• The money-weighted rate of return internalizes both the timing and size of
external cash flows (such as deposits and withdrawals), whereas time-
weighted return allows different "sub-periods" to have different returns.

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Time Weighted returns and

Dollar weighted returns
• Time weighted returns is synonymous with Geometric mean
• Dollar weighted return is synonymous with IRR.
• Example of Dollar weighted returns is as under.
• Use XIRR formula in MS Excel.
Time Outlay Using the DCF approach, we can solve for the average return
0 $50 to purchase first share
1 $53 to purchase second share a year later over the 2 years by equating the PV of cash inflows
Proceeds and outflows
1 $2 dividend from initially purchase share
50 + 53 = 2 + 112
2 $4 dividend from the 2 shares held in the second
year, plus $108 received from selling both shares' 1+r 1+r `(1+r)^2
at $54 shares r = 7.117% 29

Investment Return Measurement

Money weighted rate of return

• In Investment management applications, Internal rate of return is called
the money weighted rate of return because it accounts for the timing and
amount of all cash flows into and out of the portfolio
• Example:
• Consider an investment that covers a two year horizon. At time t=0, an
investor buys one share at $200/ At time t=1 (year 1), he purchases an
additional share at $225. At end of year 2, t=2, he sells both shares for
$235 each. During both the years the stock pays a per share dividend of
$5. The t=1 dividend is NOT reinvested. The money weighted portfolio
return for the two years is calculated as follows:

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Investment Return Measurement

PV (outflows) = PV (Inflows)

$200 + 225 = $5 + 480

(1+r)^1 (1+r)^1 (1+r)^2
• r = 9.39%
• The left hand side of this equation details the outflows, $200 at time t=0, $225 at time
t=1. The $225 outflow is discounted back one period because it occurs at t= 1. The right
hand side of the equation shows the present value of the inflows $5 at time t =1
(discounted back one period) and $480 (the $10 dividend plus the $470 sale proceeds) at
time t =2 (discounted back two periods)
• Now have a closer look at what has happened to the portfolio during each of the two
years. In the first year, the portfolio generated a one year holding period return of
[$5+($225-$200) / $200] = 15%.
• At the beginning, of the second year, the amount invested is $450 ($225*2 shares, no
reinvestment of dividend). At the end of second year, the proceeds from the liquidation of
the portfolio are $470 + $5*2 = $480.
• So in the second year the portfolio produced a holding period return of [($470+$10) -
$450 / $450 = $6.67%]

Investment Return Measurement

• The Mean holding period return was [15%+6.67%] / 2 = 10.84% [Arithmetic mean]
• This is Money weighted rate of return, which we calculated as 9.39%, puts a greater
weight on the second years relatively poor performance (6.67%) than the first as more
money is invested in second period
• This is the sense in which returns in this method of calculating performance are
“MONEY-WEIGHTED”
• As a tool for evaluating investment managers, the money weighted rate of return has a
serious drawback. Generally, the investment managers client determine when money is
given to the investment manager and how much money is given.
• As we have seen, those decisions may significantly influence the investment managers
money weighted rate of return.
• A general principle of evaluation, however, is that a personor entity should be judged on
the basis of their own actions and or actions under their control. An evaluation tool should
isolate the effects of the investment managers actions.

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Time weighted returns

• An investment measure that is not sensitive to the additions and withdrawals of funds is the time
weighted rate of return.
• In the investment management industry the time weighted rate of return is the PREFERRED
PERFORMANCE MEASURE .
• It measures the compound rate of growth of $1 initially invested in the portfolio over a stated
measurement period.
• In contrast to the money weighted rate of return, the time weighted rate of return is not affected
by cash withdrawals or additions to the portfolio.
• The term ‘TIME WEIGHTED’ refers to the fact that returns are averaged over time. To compute
an exact time weighted rate of return on a portfolio we use the Geometric Mean/CAGR formula.
• Example:
• As per the first example : the first year t=1 HPR was 15% and second year t=2 HPR was 6.67%,
the time weighted rate of return would be the Geometric mean
• GM = Sqrt √(1+15%)*(1+6.67%) - 1 = 10.76%
• The time weighted return on the portfolio was 10.76%, compared to the money weighted return
of 9.39%, which gave a larger weight to the second years return.

Time weighted returns

• We can see why investment managers find time weighted returns more meaningful. If a client
gives an investment manager more funds to invest at an Unfavorable time, the managers money
weighted rate of return will tend to be depressed.
• If a client adds funds at a favorable time, the money weighted returns will tend to be elevated.
The time weighted rate of return removes those effects
• We can often obtain a reasonable approximation of the time weighted rate of return by valuing
the portfolios at frequent, regular intervals, particularly if the addition and and withdrawals are
unrelated to the market movements. The more frequent the valuations the more accurate the
approximation.
• Daily valuation is commonplace
• GM = (1+R1)*(1+R2)…(1+Rn) ^N -1 where N = no. of annual RETURNS (not no. of
prices, 1 less)

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Time weighted returns

• Strubeck Corporation sponsors a pension plan for its employees. It manages part of the
equity portfolio in house and delegates management of the balance to Super Trust
Company. As chief investment officer of Strubeck, you want to review the performance of
the in house and Super trust portfolios over the last four quarters.
• You have arranged for outflows and inflows to the portfolios to be made at the very
beginning of the quarter. Below is the inflows and outflows of the two portfolios,
compute the time weighted returns for both of them
Cash Flows for : In-house and Super Trust
Quarter
1 2 3 4
In House Account
Beginning value 40,00,000 60,00,000 57,75,000 67,20,000
Beginning of period inflow / (outflow) 10,00,000 -5,00,000 2,25,000 -6,00,000
Amount Invested 50,00,000 55,00,000 60,00,000 61,20,000
Ending Value 60,00,000 57,75,000 67,20,000 55,08,000

Super Trust Account

Beginning value 1,00,00,000 1,32,00,000 1,22,40,000 56,59,200
Beginning of period inflow / (outflow) 20,00,000 -12,00,000 -70,00,000 -4,00,000
Amount Invested 1,20,00,000 1,20,00,000 52,40,000 52,59,200
Ending Value 1,32,00,000 1,22,40,000 56,59,200 54,69,568

Solution
Quarterly HPR
In House Account
Q1 0.20
2 0.05
3 0.12
4 -0.10

• Since it is a Quarterly CAGR calculation, the TWR is calculated as follows:

• (1+R1)*(1+R2)*(1+R3)*(1+R4) – 1 = (1+0.2)*(1+0.05)*(1+0.12)*(1-0.10) - 1 = 27%. Here
N (annual returns) is 1.
Super trust
Q1 0.10
2 0.02
3 0.08
4 0.04

• Since it is a Quarterly CAGR calculation, the TWR is calculated as follows:

• (1+R1)*(1+R2)*(1+R3)*(1+R4) – 1 = (1+0.10)*(1+0.02)*(1+0.08)*(1-0.04) - 1 = 26%. Here
N (annual returns) is 1.
• The in house portfolios TWR is higher than Super trust portfolio by 100 basis points

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TWR and MWR

• Your task is to compute the investment performance of the Walbright Fund during 2017.
The facts are as follows:
• On 1.1.2017, the walbright Fund has a market value of $100 Million
• During the period 1.1.2017 to 30.4.2017, the stocks in the fund showed a capital gain of
$10 million
• On 1.5.2017, the stocks in the fund paid a total dividend of $2 million. All dividends were
re-invested in additional shares
• Because the funds performance has been exceptional, institutions invested an additional
$20 million in Walbright on 1.5.2017, raising assets under management to $132 million
($100+$10+$2+$20)
• On 31.12.2017, Walbright received total dividends of $2.64 million. The funds market
value on 31.12.2017, not including the $2.64 million in dividends, was $140 million
• The fund made no other interim cash payments during 2017
• Compute:
• A) TWR and b) MWR

Solution : A ) Time weighted Returns

• Because Interim cash flows were made on 1.5.2017, we must compute two interim total
returns and then link them to obtain an annual return. The table below lists the relevant
market values on 1st January, 1St may and 31st December as well as the associated interim four
month (1/1 to 1/5) and eight month (1/5 to 31/12) HPR
• Now we must geometrically link the four and eight month returns to compute an annual
return.
1.1.2017 Beginning portoflio value $100 million
1.5.2017 Dividends received before additional investments $2 million
Ending portfolio Value $110 million

4 month HPR = {$2 + $10} / $ 100 12%

New investment $20 million

Beginning market value of the 8 month period $132 million
31.12.2017 Dividends received $2.64 million
Ending portfolio value $140 million

HPR = {$2.64 + $140 - $132} / $ 132 8.06%

TWR = [(1+0.12)*(1+0.0806)] -1
21.03%
We compute the TWR of 21.03% for one year. The 4m and 8m intervals combine to equal
one year
Taking the square root would be appropriate only is 1.12 and 1.0806 each applied to one full year

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B) MWR
• To compute the MWR, we find the discount rate that sets the PV of the outflows (purchases)
equal to PV of inflows (dividends and future payoffs).
• The Initial market value of the fund and all additions to it are treated as cash outflows (think of
them as expenses), Withdrawals, receipts and ending market values of the fund are counted as
Inflows (ending market value is the amount investors received on liquidating the fund).
• Because, interim cash flows have occurred at 4m intervasl, we must for the 4m IRR. The PV
equation is as follows:
$ 100 + $ 2 = $2 $ 2.64 + $ 140
1 1 3 3
(1+R) (1+R) (1+R) (1+R)

• The Left hand side of the equation shows the Investments in the fund or outflows, a $ 100 million
initial investment followed by the $ 2 million dividend reinvested and an additional $ 20 million
of new investment (both occurring at the END of the first 4m interval which makes the
denominator raised to 1 for compounding
• The right hand side of the equation shows the pay-offs or inflows: the $ 2 million dividend at the
first 4m interval followed by the $ 2.64 million dividend and the terminal market value of $ 140
million (both occurring at the end of the third 4m interval, which makes the denominator raised to
3 for compounding
• The second 4m interval has no cash flow. Using excel or finance calculator or Log we get a 4m
IRR as 6.28%. A quick way to annualize this is to multiply by 3.
• A more accurate way is to show the impact of compounding (1+6.28%)^3 – 1 = 20%

Analysis
• In this example, the TWR (21.03%) is greater than
the MWR (20%). The Walbright Funds performance
was relatively poor during the 8m period, when the
fund owned more shares, than it was overall.

• This fact is reflected in a lower money weighted rate

of return compared with TWR, as the MWR is
sensitive to the timing and amount of withdrawal
and additions to the portfolio

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Money Market Yields

• The money market is the market for short term debt instruments (one year or less). Some
instruments require the issuer to repay the lender the amount borrowed plus interest/
• Others are PURE DISCOUNT instruments that pay interest as the difference between amount
borrowed and the amount paid back.
• In the US money market, T-bill is considered as a classic example of pure discount instrument
issued by the Federal Government.
• The face value of a T-bill is the amount the US government promises to pay back to a T-bill
investor. In buying a T-bill, investors pay the face value amount less the DISCOUNT, and
receive the face amount at MATURITY. The discount becomes the INTEREST that accumulates,
because the investor received the face value amount on Maturity.
• PURE DISCOUNT instruments such as T-bills are quoted differently from US government
bonds.
• T-bills are quoted on a BANK DISCOUNT YIELD (BDY) basis, rather than on PRICE basis.
The Bank discount basis is a quoting convention that annualizes , based on a 360 day year, the
discount as a percentage of face value.

Money Market Yields

• The BDY is calculated as follows: Rbd (FV – Po) x 360
FV n
Where, Rbd = ANNUALISED YILED on a BANK DISCOUNT BASIS
FV-Po = Dollar Discount which is Face value less Purchase price
n = the actual no. of days remaining to maturity
360 = bank convention of the number of days in a year
BDY is often called simply as the DISCOUNT YILED, takes the dollar discount from PAR (FV) and
expresses it as a fraction of the face value (NOT PRICE) of the T-bill.
This fraction is then multiplied by the number of periods of length ‘n’ in one year (360/n) where the
year is assumed to have 360 days.
Annualizing in this manner assumes SIMPLE INTEREST (no compounding)

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Money market instruments

• Suppose a T-bill with a face value (par value) of $100,000 and 150 days until maturity is
selling for $98,000, What is the BDY ?
• BDY = ($100,000 - $98,000) * 360 = 4.8%
• $100,000 150
• The BDY takes the T-bills dollar discount from FV as a fraction of the face value, 2
percent and then annualizes it by the factor 360/150 = 2.4.
• Alternatively, the price of discount instruments such as T-bills is quoted using
DISCOUNT YIELDS so we typically translate discount yield into PRICE
• Discount (FV-Po) = Rbd*FV*(n / 360)
• With 4.8%, the dollar discount is D = 0.048*$100,000*150/360 = $2,000
• So if discount is $2000 , it means that the PURCHASE price for the T-bill is its
FV-discount = $ 100000- $ 2000 = $98000

Money market instruments

• Yield on a bank discount basis is not a meaningful measure of investors return, but is used as a
CONVENTION
• Its limitations include a 360 days basis in lieu of 365, Returns based on FV in lieu of
Investment value (Po) and discounting with Simple Interest in lieu of compound interest
• We extend the above example to three often used alternative yield measures.
• A) Holding Period Yield = [P1 – P0 +D1] / P0
• Where:
• P1 = price received on maturity
• P0 = initial purchase price of the instrument
• D1 = cash distribution paid by the instrument at its maturity (i.e. Interest)
• Important point: the purchase price and sale price will include any accrued interest.
• For Pure discount securities, the HPY is the annualized yield/return
• HPY = $100,000 - $98,000 + 0 / $98,000 = 2.0408 %

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Money market instruments

• The second measure of yield is the Effective Annual Yield (EAY).
• EAY takes 1 + HPY and compounds it forward to one year, then Subtracts 1 to recover an
annualized return that accounts for the effect of Interest-on-interest
• EAY = (1+HPY)365/n – 1
• In our given example:
• EAY = (1+2.0408%)365/150 – 1 = 5.0388%

Money Market Yield (MMY)

• The Third alternative measure of yield is the money market yield (also known as CD
equivalent yield)
• This convention makes the quoted yield on a T-bill comparable to yield quotations on
Interest bearing money market instruments that pay interest on a 360 day basis.
• In general the MMY is equal to the annualized holding period yield; assuming a 360day,
Rmm = HPY*(360/n).
• Compared to the bank discount yield, the money market yield is computed on the
purchase price, so Rmm = Rbd*(F/Po)
• The equation shows that the MM yield > BDY (due to denominator effect)
• Rmm = 360*Rbd
• 360 – n*Rbd
• For the T-bill the MMY = 360*4.8%/(360-(150*4.8%) = 4.898%

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Example
• You need to find the PV of a cash flow of $1,000 that is to be received in 150 days. You decide
to look at a T-bill maturing in 150 days to determine the relevant Interest rate for calculating the
PV. You have found a variety of yields for the 150-day yield.
• HPY = 2.0408% BDY = 4.8% MMY = 4.898% EAY = 5.0388%
• Which yield or yields are appropriate for finding the PV of the $1,000 to be received in 150
days?
• Solution: The HPY is appropriate, and we can also use MMY and EAR after converting them
to a holding period yield
• HPY (2.0408%). This yield is exactly what we want. Because it applies to a 150-day period
return, we can use it in a straight forward fashion to find the PV of the $1000 to be received in
150 days.
• PV = 1000 / 1.020408 = $980
• BDY – should not be used to calculate the PV of cash flow as it is based on FV and not price
• MMY – to use the MMY we need to convert it to the 150 day holding period yield by dividing it
by 360/15. After obtaining the HPY 0.04898/(360/150) = 0.020408 we use it to discount $ 1000
as above
• EAY – This yield has also been annualized, so it must be adjusted to be compatible with the
timing of the cash flow. We can obtain the Holding period Yield from the EAY as follows:
(1+0.05388)^(150/365) -1 = 0.020408
• Recall that when we found the effective annual yield, the exponent was 365/150 or the number
of 150-day periods in a 365-day year
• To shrink the EAY to a 150-day yield, we use the reciprocal of the exponent that we use to
annualize

Bond Equivalent Yield

• We frequently need to convert periodic rates to annual rates. The issue can arise both in
money markets and in long term debt markets
• As an example, many Bonds (long term debt instruments) pay Interest semi annually. Bond
investors compute IRRs for bonds, known as YTM
• If the semiannual YTM is 4%, we annualize it by compounding it as (1+0.04)^2 – 1 =
0.0816 or 8.16%.
• This is what we have been calling as EAY.
• An approach used in US Bond markets, however, is to double the Semi-annual YTM 4%*2
= 8%. The YTM calculated this way, by ignoring compounding has been called as BOND
EQUIVALENT YIELD
• Annualizing a semiannual yield by doubling is putting the yield on a Bond equivalent basis
• In practice the result 8% would be simply referred to as Bonds YTM.
• In MM, if we annualized a six month period yield by doubling it, in order to make the result
comparable to Bonds YTM we would also say that the result was a BEY

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Future returns and Estimated risk

• Based on the past, future can be estimated under normal business
environment.

• Expected returns are estimates and have carry a probability based on past
again.

• Expected return is given by E(r)

• E(r) = Σ (Pi x ri) where i is number of years or securities.

• Note: sum of probabilities will always be equal to 1.

49

Calculate E(r)
• Company A Company B
returns probability returns Prob.
ri (in %) pi ri (in %) pi
6 0.1 4 0.1
7 0.25 6 0.2
8 0.3 8 0.4
9 0.25 10 0.2
10 0.1 12 0.1

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Answer
• Company A Company B
returns probability returns probability
ri pi pi x ri ri pi pi x ri
6 0.1 0.6 4 0.1 0.4
7 0.25 1.75 6 0.2 1.2
8 0.3 2.4 8 0.4 3.2
9 0.25 2.25 10 0.2 2
10 0.1 1 12 0.1 1.2
Σr= 8 per cent 8
51

Rolling Returns
• Rolling returns are the returns taken for a specified period on every
day/week/month and taken till the last day of the duration.
• Rolling returns consider performance on every day or week (or any
specified frequency) of a defined period and hence, tell you how you
would have fared regardless of when you chose to invest.
• For example, if you want to look at returns of an equity mutual fund in the
last one year, instead of just looking at returns from say 31 January 2013 to
31 January 2014 you can look at one year returns on every day of the last
year. Or in other words, returns from 31 January 2013 to 31 January 2014,
from 30 January 2013 to 30 January 2014 and then 29 January 2013 to 29
January 2014 and so on till one year returns from 31 January 2012 to 31
January 2013.
• Looking at all these returns will tell you how the fund performed on a one-
year basis had you invested on any day in the last one year. And an average
of this will give you a better sense of the funds performance in the year
rather than just looking at returns from one point to another.
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Risk
• Based on the above example we can see that returns for both the companies
is 8%

• So the next question is which to select for investment ?

• To probe further we need to identify which one is less riskier

• Standard deviation of the rate of return is a measure of risk. It is the square

root of variance.

53

Risk
• Variance (v) = Std. deviation2
• σ = √ ∑ {pi [(ri – E(r) ]2 }
where p = probability

• ri is rate of return
• E(r) – mean return

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2 2
ri pi Ri - E(R) {Ri - E(r ) } Pi*{Ri - E(r ) }
6 0.1 -2 4 0.4
7 0.25 -1 1 0.25
8 0.3 0 0 0
9 0.25 1 1 0.25
10 0.1 2 4 0.4
8 E(R) 1.3
SD = sqrt (1.3) 1.140175425
Company B
returns probability
2 2
ri pi Ri - E(R) {Ri - E(r ) } Pi*{Ri - E(r ) }
4 0.1 -4 16 1.6
6 0.2 -2 4 0.8
8 0.4 0 0 0
10 0.2 2 4 0.8
12 0.1 4 16 1.6
8 E(R) total 4.8
SD = sqrt (4.8) 2.19089023

55

Conclusion
• Based on the above information, we can see that, even though the returns
are the same, company B has higher risk (2.1908) as compared to company
A (1.14)

• Therefore it is better to invest in company A.

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Additional questions

Q1) The returns on securities A and B are given below:

Probability Security A Security B
0.5 4 0
0.4 2 3
0.1 0 2
Give your security preference based on risk and return

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Q2) An investor has a choice of four stocks for investment. Their rates of return and
probabilites are as below:
ICICI bank Axis bank Yes bank HDFC bank
r p (in %) r p (in %) r p (in %) r p (in %)
-30 20 -20 15 -20 20 -10 10
0 40 0 35 10 40 0 25
30 30 20 45 40 30 10 40
70 10 40 5 80 10 20 25
a) Are all these stocks attractive investment?
b) How should the investor choose one to buy
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Additional problems..
• see Xerox..

59

Risk
• You cannot talk about investment returns without talking about risk
because investment decisions invariably involve a trade-off between the
two.

• What is RISK ?
• Risk refers to the possibility that the actual outcome of an investment will
differ from its expected outcome.

• Why is knowledge of RISK important?

• Knowledge of risk helps in planning a portfolio and to minimize risk.

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Risk aversion
• Two themes in portfolio theory that are centered on risk, viz.;
a) Investors will avoid risk unless they can anticipate a reward for
engaging in risky investments.
b) Investors want to quantify personal trade-offs between portfolio risk
and expected return.

• To do this we introduce the utility function.

61

Sources of Risk
Modern portfolio theory analyses risk from a different perspective. It
divides total risk as follows:

• Total risk = Unique risk + Market risk. OR

• Total risk = Unsystematic risk + Systematic risk OR
• Total risk = Diversifiable risk + Non-diversifiable risk.

• The unique risk of security represents that portion of its total risk which
stems from firm specific factors like the development of a new product, a
labor strike, or the emergence of a new competitor.

• Events of this nature primarily affect the specific firm and not all firms in
general. Hence, unique risk is also referred to as diversifiable risk or
unsystematic risk.

• The market risk of a stock represents that portion of its risk which is
attributable to economy wide factors like the growth rate of GDP, the level
of government spending, money supply, interest rate structure, and inflation
rate.
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Systematic risk
• Systematic risk affects the entire market.
• Mainly consists of: market risk, interest rate risk and purchasing power
risk
• Market risk: tangible factors - changes in macro economic factors due to
economic factors and natural factors like earthquake, war, political
uncertainty, etc.
• Intangible factors - market psychology, negative sentiments, impacts of
economic changes like recession, etc.

63

Interest rate risk

• Corporates borrow massively from banks.

• RBI regulates interest rates for controlling money supply
• It impacts financial instruments like bonds, treasury bills, debentures and
stocks.
• It drives the monetary policy.
• Impacts the debt leverages of borrowings based Corporates.

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Purchasing power risk

• Inflation is the key reason for the decrease in the purchasing power of
money.
• Inflation also increases the buying cost leading to decline in profits.
• When analyzing returns on instruments, one should look at the real rate of
return rather than the nominal rate of return (actual return).

65

Unsystematic risk
• Unsystematic risk is unique and peculiar to a firm or to an industry.
• Stems from managerial inefficiency, technological change in production
process, raw material availability, changes in consumer preference, labour
problems, etc.
• The magnitude of this risk varies form industry to industry. Example:
changes in consumer preference affects products like TV, Mobiles, etc.
• Technological changes affect IT industry, etc.

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Unsystematic risk
Are of 2 types:

• Business risk

• Financial risk

67

Business Risk
• Business risk is that portion of the unsystematic risk caused by the
operating environment of the business.

• Arises from the inability of a firm to maintain its competitive edge and
growth.

Example: A Ltd.’s earnings vary from a high of 20% to a low of 6%,

whereas B ltd. Earnings vary from 12% to 15%. A Ltd. has higher business
risk due to higher volatility in earnings.

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Business Risk
• Can be divided into external business risk and internal business risk.

• Internal business risk: Fluctuations in sales, R&D expenditure, Quality of

management, high fixed cost and single product.

• External business risk: Social and regulatory factors, Political risk,

Business cycle, etc.

69

Financial Risk
• Major sources of financial risk – rising cost of capital and capital
structure of company.

• Easy access to credit/borrowings

• Financial risk is avoidable and can be eliminated or diversified through

internal policies and actions.

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Systematic Risk an Unsystematic Risk

BASIS FOR UNSYSTEMATIC
SYSTEMATIC RISK
COMPARISON RISK
Meaning Systematic risk refers to Unsystematic risk refers
the hazard which is to the risk associated
associated with the with a particular security,
market or market company or industry.
segment as a whole.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of Only particular company.
securities in the market.
Types Interest risk, market risk Business risk and
and purchasing power financial risk
risk.
Protection Asset allocation Portfolio diversification

• Risk free assets: T-bills, Money Market Instruments or Bank Deposits,

Bonds, Government securities, etc. They are in nature of sovereign
debt/securities.
• The rate you can earn by leaving money in risk free assets is called risk free
rate.
• The difference between the Expected HPR and Risk free rate is called as
RISK PREMIUM.
• Example: If the risk free rate is 6% and E(r) is 10%, the risk premium is
4%.
• The excess return/risk premium is the additional return receivable due to
additional Risk undertaken.
• Rm = Returns from market; Rf = Risk free rate of return
• σm = Risk of market; σi/p = Risk of security/portfolio

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How to measure Risk?

Historical Data

The statistical measure of dispersion – “Standard Deviation” measures risk

of a security/ portfolio of securities. It is given by the following formula:

A rational investor will invest in a security that gives him the highest average
return and lowest SD.
In case 2 securities, give the same average return and SD, we use Co-
efficient of Variation for comparison between the 2 securities. It measures the
risk per unit of return.

73

Behaviour between 2 securities

The statistical measure – “Covariance” measures the relationship between 2
securities.

If the value of covariance is positive – the 2 securities behave similarly

negative – the 2 securities behave oppositely
zero – no predictable behaviour exists between
the 2 securities

Covariance only tells us about the direction of the behaviour and not the
extent of the behaviour.

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Behaviour between 2 securities

Correlation coefficient tells us about the direction and also the extent of the
behaviour between 2 securities.

If the value of r is -1 – the 2 securities behave exactly oppositely

+1 – the 2 securities behave exactly similar
0 – no behaviour can be predicted

75

How to measure Risk?

Uncertain situations – probabilities are given

In formulas for E(R), SD and Covariance, replace “1/(n-1)” by “pi”

(probability).

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Portfolio Return and Risk

General formula for Return of a Portfolio is as under:

General formula for Risk of a Portfolio (2 asset portfolio) is as under:

77

Point of Minimum Risk

Point of Minimum Risk is nothing but the optimal weights of individual
investments in the portfolio such that the variance of the portfolio is
minimum.

These optimal weights are obtained by differentiating the equation of portfolio

variance and equating it to zero.

The point of minimum risk is given as under:

W1 = σ22 - Cov12
σ12 + σ22 - 2Cov12

W2 = 1 - W 1

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Beta
• Beta is a measure of the volatility, or systematic risk, of a security or a
portfolio in comparison to the market as a whole.
• Measure of performance of a particular share or class of shares in relation
to the general movement of the market.
• Beta describes the relationship between the stocks return and index returns.
• Beta represents the tendency of a security's returns to respond to swings in
the market.

79

Beta measures
• Beta = +1.0
Indicates 1% change in market index causes exactly 1% change in stock
return. It indicates that the stock moves in tandem with the market.
• Beta = +0.5
Indicates 1% change in market index causes exactly 0.5% change in stock
returns. It indicates that stock is less volatile compared to market.
• Beta = + 2.0
Indicates 1% change in market index causes exactly 2% change in stock
return. Stock is more volatile. Also, when markets go down by 10%, stock
will go down by 20%.
• Stocks with more than 1 BETA value is considered to be risky.

• Beta = Negative value. Indicates that the stock return moves in the
opposite direction to the market return. A stock with negative beta – 1
would provide a return of 10%, if market declines by 10% and vice versa.
• Stocks with negative beta are very rare.
βi = Cov (Ri, Rm) / varm
• Normally for Beta calculation we use WEEKLY data, 3 years is optimal
enough
• Download RIL and SENSEX last 3 years weekly closing price in excel
from yahoofinance.com/bseindia 80

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Beta calculation
Beta calculation can be done in 2 ways through excel
• Regression method
• Slope tool
• See your data of ICICI Bank Ltd. and Sensex – weekly closing for last 3
years
• Basically we want to know what is the relationship between returns of
stock and index.
• In Excel we have a function = slope (y,x)
• Where y is the dependent variable (stock) & x is the independent variable
(index)
• See excel working.

81

Utility
• Risk averse investors are willing to consider only risk free or speculative
prospects with positive risk premiums. In order words, a risk averse
investor ‘penalizes’ the expected rate of return of a risky portfolio by a
certain percentage to account for the risk involved.
• The greater the risk the larger is the penalty.
• Let us take an example: Suppose the risk free rate is 5% and an investor has
3 alternatives as below:
Portfolio Risk premium Expected return Risk
L (low risk) 2% 7% 5%
M (medium risk) 4% 9% 10%
H(high risk) 8% 13% 20%

• Accordingly to these portfolios offer progressively higher risk premiums to

compensate for greater risk. How might investors choose among them?

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Utility
• We will assume that each investor can assign a welfare or utility score to
competing investment portfolios based on E(R) and Risk of those portfolios.
• An ordinary investor is assumed to receive greater utility from HIGHER
returns and vice-versa.
• Utility is the satisfaction an investor enjoys from the portfolio return.
• One reasonable function that has been employed by financial theorists and
CFA Institute assigns a portfolio with E(R) and Variance of returns the
following utility score:

U = E (r) – ½*A*2
Consistent with view that there is a penalty imposed on return based on level of risk aversion and
variance of investment.
– The factor ½ is a scaling convention
– A is index of investor’s risk aversion.
– to use the equation, E(r) must be expressed as decimals rather than percentages
A risk free portfolio will receive utility equal to its known rate of return, as
they have no risk and therefore variance is zero.
In general, portfolios receive higher utility scores for higher expected
returns and lower scores for higher volatility/lower returns. 83

Utility
Example:
• A portfolio has an expected rate of return of 20% and Standard deviation of
30%. T-bills offer a safe rate of return of 7%. Would an investor with risk
aversion parameter A =4 prefer to invest in T-bills or Risky portfolio? What
if A = 2
• For A = 4, U = 0.20 – ½*4*0.30*0.30 = 0.02
• While the utility of T-bills is U = 0.07 – ½*0*0 = 0.07
• The more risk averse investor will prefer T-bills to the risky portfolio.

• Now try with A = 2

• Risky p/f U = 0.11, RF p/f = U = 0.07
• The less risk-averse investor prefers the risky portfolio.

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Mean Variance (M-V) criterion

• We can depict the individuals trade-off between risk and return by plotting the characteristics
of potential investment portfolios that the individual would view as equally attractive on a
graph with axes measuring the expected value and standard deviation of portfolio returns.
The figure below plots characteristics of one portfolio denoted P
• Portfolio P which has Erp and SDp is preferred by risk averse investors to any portfolio in
Quadrant 4 because it has ER equal to or greater than any portfolio in that quadrant and a
standard deviation equal to or smaller than any portfolio in that quadrant.
• Conversely , any portfolio in Quadrant 1 is preferable to Portfolio P because its ERp is equal
to or greater than P and its SD is equal to or smaller than P`s.
• This is the mean-sd or MEAN-VARIANCE criterion. It can be stated as follows: portfolio A
dominates portfolio B if, E(Ra) >= E(Rb) or Sda <= SDb and atleast one inequality exists.

ERp

SDp

85

Indifference Curves
• In the expected return-SD plane, the preferred direction is Northwest, because in
this direction we simultaneously increase the expected return and decrease the
variance of the rate of return. This means that any portfolio that lies northwest of P
is superior to it.
• What can be said about quadrant II and III? Their desirability, compared with P,
depends on the exact nature of the investor`s risk aversion. Suppose an investor
identifies all portfolios that are equally attractive as portfolio P. Starting at P, an
increase in SD lowers utility; it must be compensated for by an increase in ER.
Thus, point Q in the below figure is equally desirable to this investor as P.
• Investors will equally be attracted to portfolios with high risk and high expected
returns compared with other portfolios with lower risk but lower expected returns.
This equally preferred portfolios will lie in the Mean-SD plane on a Curve called
the INDIFFERENCE curve that connects all portfolios with the same utility.

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Example
Erp SD Utility (A = 4) U
0.10 0.20 0.10-1/2*4*0.04 0.02
0.15 0.26 0.15-1/2*4*0.065 0.02
0.20 0.30 0.20-1/2*4*0.09 0.02
0.25 0.34 0.25-1/2*4*0.115 0.02

• To determine some of the points that appear on the indifference

curve, examine the utility values of several possible portfolios for
an investor A=4, presented above. Note that each portfolio offers
identical utility, because the portfolios with higher expected returns
also have higher risk (SD)
• If we plot this, it will lie on the same indifference curve. We can
plot different indifference curves for different values of A.

87

Indifference curves
• Represent a set of risk and expected rate of return combinations that give
the same utility or satisfaction

• Utility curve connects all equally preferred portfolios. They lie on the
mean-variance deviation plane on a curve called as UTILITY curve.

• Investor is indifferent between any two points that lie on the same curve.
See diagram next slide.

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 Return
 I2

 D
 Indifference curves
for a risk averse
investor  I1
 B
 C

 A Mean-Variance criterion –Certain types of

portfolios or investments dominate others.
Portfolio C will dominate portfolio A.
•However, he would find a portfolio lying on the L2 line more desirable than the
combinations to North-west of L1 as they give higher risk adjusted returns. Risk  Risk
is same for B and D but returns higher in D than B 89

Indifference curves and Markowitz Efficient

portfolio
• Each investor has a series of indifference curves. His final choice out of the
efficient set depends on his attitude for risk. The point at which the
Efficient frontier tangentially touches the highest indifference curve
determines the most attractive portfolio for the investor as seen below:

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Question
• Class exercise on Utility problems.
• Questions
• Please see PPT and Word document for
questions and solutions.
• Module 3

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