Professional Documents
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FIN2704/X
Week 4
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Return
Total percentage return =
Nominal rate of return
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Return
Historical return:
• From past data (t‐1, t‐2, t‐3,…, t‐n)
Prospective return:
• Predicting future return
• No crystal ball to predict the future!
• Historical returns are often utilized to predict future
returns
• Some adjustments needed
Image source: https://fortune.com/2013/12/19/the‐fortune‐crystal‐ball/ 4
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Return
Expected returns:
• Returns that take into account uncertainties
that are present in different scenarios
Risk
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Risk
• Uncertainty associated with future possible
outcomes (slide 23).
• How do measure uncertainty?
• Variance:
• Standard deviation: Variance 2
n 2 If we know the future possible
ri r̂ Pi returns and the probability of
each possible return
i 1
2
rt rAvg If we use
Estimated σ t1 historical (past) data
n 1
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Normal Distribution
Mean = 12.4%
Standard deviation = = 20.2%
‐20.2% +20.2%
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Example (slides 34 ‐45)
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Treasury bills (T‐bills)
• Short‐term (less than 1 year lifetime) US govt. debt
instruments (bonds).
• Practically free of default risk
• Short lifetime
• Fully backed by U.S. Government
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What’s the relationship between risk and
return?
(Referring to slide 34)
• No consistent tradeoff between standard deviation and
expected returns.
• However, you can see consistent tradeoff for asset
classes (as shown on slide 41).
• This is related to the fact that standard deviation may
not be the appropriate measure of risk for individual
assets
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Total risk
While market risk affects all firms in the
market, that does not mean that every firm is
affected by the market in the same way
• Depends on the firm’s exposure to the
market
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Portfolio
• A set of assets held by an investor
• Assets i (1, 2, …, n)
n
• Expected portfolio return: r̂ p w i r̂i
i 1
• Portfolio standard deviation (2 assets):
p w12 12 (1 w1 ) 2 22 2w1 (1 w1 )Corr ( R1 , R2 ) 1 2
w12 12 (1 w1 ) 2 22 2w1 (1 w1 ) 12 1 2
• Covariance = Cov1,2 = Corr(R1,R2)*1*2 = 12*1*2
• Correlation = Corr(R1,R2) = 12= cov1,2/1*2
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When assets move together
(ρ = +1)
Value
Investment A
Investment B
Time
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When assets are off‐sync
(ρ = ‐1)
Value
Investment C
Investment D
Time
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Portfolio standard deviation
Any correlation less than 1 would have some
diversification benefit.
• This benefit increases as the correlation is smaller (or
better yet, negative)
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Portfolio standard deviation (cont.)
Asset 1 (w1; 1) Asset 2 (w2; )
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Other notes
Example on slide 61
• Covariance of CGI and DSC is calculated on slide 60
(formula used is from slide 56)
Covi , j Pr(s) * Ri ,s E( Ri ) * R j ,s E( Rj )
S
s 1
• Standard deviation of CGI & standard deviation of DSC
can be calculated using formula in slide 26
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Arithmetic vs. geometric means
• Average return calculated using arithmetic mean
refers to the simple average of the return earned in
an average period over multiple periods.
T
r t
r t 1
T
• Average return calculated using geometric mean
refers to the average compounded return per‐
period over multiple periods.
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Week 4
List of topics
Note:
You are responsible for all materials covered in the pre‐
recorded videos posted on LumiNUS, unless they are marked
“not examinable”. This list only serves to help you in your
revisions.
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Week 4 topics
Returns
• Historical or prospective
• Dollar term or percentage term
• Nominal return or real rate of return
• For stocks or bonds, return comes from:
• Dividend or interest payment, and
• Capital gain/loss
• Expected return
• Arithmetic average return
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Week 4 topics (cont.)
Risk
• Variance and standard deviation
• Coefficient of Variation
• Stand‐alone risk
Risk & Return:
• Risk aversion
• Risk premium
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Week 4 topics (Cont.)
Portfolio
• Portfolio return
• Portfolio risk
• Covariance
• Correlation coefficient
• Total risk = unsystematic risk + systematic risk
• Diversifiable vs. undiversifiable risks
• Arithmetic mean (self study)
• Geometric mean (self study)
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