Professional Documents
Culture Documents
2. Financing
Vehicles Factor Models
12. Portfolio
6. CAPM 7. APT
Management
Bonds
3. Trading 13. FinTech
9. Term 10. Duration/
Structure Convexity
2
Overview – Textbook Chapter 5
3
Interest rate determinants
◼ Supply
❑ Savers, primarily households
◼ Demand
❑ Businesses
◼ Government’s Net Supply and/or Demand
❑ Central Bank Actions
◼ The expected rate of inflation.
4
Real vs nominal interest rate
rnom = Nominal Interest Rate
rreal = Real Interest Rate
i = Inflation Rate
𝒓𝒏𝒐𝒎 − 𝒊
𝒓𝒓𝒆𝒂𝒍 =
𝟏 + 𝒊
d
5
T-Bills & inflation 1957-2016
◼ Moderate inflation offsets most nominal gains on
low-risk investments
◼ $1 in T-bills from 1957–2016 grew to $29.14 but
with a real value of only $3.25
6
Taxes and the real interest rate
◼ Tax liabilities are based on nominal income
rnom = Nominal Interest Rate
rreal = Real Interest Rate
i = Inflation Rate
t = Tax Rate
rnom (1 − t ) − i = (r real + i ) (1 − t ) − i = rreal (1 − t ) − i t
7
Measuring Historical Return
◼ What are the 2 components of a stock’s
return?
❑ Dividend Yield
❑ Capital Gains (or Loss)
8
Recall: Holding Period Return (HPR)
Rates of return: Single period:
P1 − P0 + D1
❑ HPR = Holding Period Return
❑
❑
P0 = Beginning price
P1 = Ending price
HPR =
❑ D1 = Dividend during period one P0
Example: Ending Price $110
Beginning Price $100
P1 − P0 + 𝐷1 $110 − $100 + $4
HPR = = Dividend $4
P0 $100
$110 − $100 $4
= +
$100 $100
= 10% Capital Gains yield + 4% Dividend Yield
= 14% Holding Period Return
9
Securities’ total returns
◼ Suppose prices of zero-coupon Treasuries with $100
face value and various maturities are as follows. We
find the total return of each security
Total Return
Horizon, Price,
[100/P(T)] − 1 for Given
T P(T)
Horizon
100/97.36 − 1 = rf (0.5) =
Half-year $97.36
0.0271 2.71%
100/95.52 − 1 = rf (1) =
1 year $95.52
0.0469 4.69%
100/23.30 − 1 = rf (25) =
25 years $23.30
3.2918 329.18%
10
EAR vs APR
Effective Annual Rate (EAR):
1
1 + EAR = 1 + rf (T ) T
(1 + EAR )
T
−1
APR =
T
11
EAR given a 10% APR
Compounding Period # Of Times Effective Annual Rate
Compounded
Year 1 10.00000%
Quarter 4 10.38129%
Month 12 10.47131%
Week 52 10.50648%
Day 365 10.51558%
Hour 8,760 10.51703%
Minute 525,600 10.51709%
Continuous Infinite 10.52%
12
Continuous Compounding
◼ The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
𝐹𝑉 = 𝐶0 𝑒 𝑟𝑇
where:
❑ C0 is cash flow at date 0,
= p( s ) r ( s ) − E (r )
2
Risk → Variance 2
Standard deviation = σ
14
Example
State Prob. of State r in State
Excellent .25 0.3100
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200
= .038
𝝈 = .038
= .1949
15
Time series analysis of past rates of return
16
Mean & Variance of Historical Returns
Return:
𝑛
𝐸(𝑟) = 𝑟 (𝑠)
𝑠=1
Variance:
𝑛
𝑖
𝜎 = [ 𝑟(𝑠) − 𝑟]2
2
𝑛
𝑠=1
17
Geometric vs. Arithmetic Average Returns
1957-2014
Average Return
18
Sharpe Ratio
"A ratio developed by Nobel laureate William F. Sharpe to measure
risk-adjusted performance. The Sharpe ratio is calculated by
subtracting the risk-free rate - such as that of the 10-year U.S. Treasury
bond - from the rate of return for a portfolio and dividing the result by
the standard deviation of the portfolio returns."
19
The Reward-to-Volatility (Sharpe) Ratio
❑ Excess Return
❑ Risk Premium
❑ Sharpe Ratio
𝑹𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
Sharpe Ratio =
𝑺𝒕𝒅.𝑫𝒆𝒗.𝒐𝒇 𝒆𝒙𝒄𝒆𝒔𝒔 𝒓𝒆𝒕𝒖𝒓𝒏𝒔
20
Using Sharpe Ratio
◼ "The Sharpe ratio is a risk-adjusted measure of return that is often
used to evaluate the performance of a portfolio. The ratio helps to
make the performance of one portfolio comparable to that of another
portfolio by making an adjustment for risk.“
21
Sharpe Ratio (cont.)
◼ What were their Sharpe ratios?
𝟏𝟓%−𝟑% 𝟖%−𝟑%
𝑮𝒂𝒎𝒃𝒍𝒆𝒓 𝑺𝑹 = 𝑩𝒓𝒂𝒊𝒏𝒚 𝑺𝑹 =
𝟐𝟒 𝟓
= 0.5 = 1.0
❑ For Sharpe ratios the higher the better.
❑ 1 is a decent Sharpe Ratio, 2 is better, and 3 is almost
unattainable in the long-run in the real world!
𝑹𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
Sharpe Ratio =
𝑺𝒕𝒅.𝑫𝒆𝒗.𝒐𝒇 𝒆𝒙𝒄𝒆𝒔𝒔 𝒓𝒆𝒕𝒖𝒓𝒏𝒔
22
The Normal Distribution
23
The Normal Distribution
◼ Investment management is easier when
returns are normally distributed:
❑ Standard deviation is a good measure of risk
when returns are symmetric
❑ If security returns are symmetric, portfolio returns
will be as well
❑ Only mean and standard deviation needed to
estimate future scenarios
24
Normality & 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
R − Rሜ 3
◼ Skewness: Skew = Average
σ3
ෝ
R − Rሜ 4
◼ Kurtosis: Kurtosis = Average 4 − 3
σ
ෝ
◼ Lower Partial Standard Deviation (LPSD)
◼ Sortino Ratio
25
Normal & Skewed Distributions
26
Normal & Fat-Tailed Distributions
27
❑ The second half of the
20th century offered the
highest average returns
❑ Firm capitalization is
highly skewed to the
right: Many small but a
few gigantic firms
28
Next week – continue Risk & Return
Time Permitting
2. Financing
Vehicles Factor Models
12. Portfolio
6. CAPM 7. APT
Management
Bonds
3. Trading 13. FinTech
9. Term 10. Duration/
Structure Convexity
29
APPENDIX material
30
Arithmetic Average Return Vs. Geometric
Average Returns
◼ The Arithmetic Average Return (“mean”) answers the question:
“What was your return in an average year over a particular period?”
❑ This is how average is “normally” calculated
Note (1): As long as the returns are not all identical in which case the “averages” will be
the same.
31
Arithmetic vs. Geometric Average Example
32
What is the investment worth today?
FV=$100(1+.15)(1-.08)(1+.12)(1+.18)(1-.11)
FV=$124.44
33
Calculating Geometric Average Continued
34
Geometric Average
35