Chapter Three

Risk, Return, and the Historical

Record

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 Chapter Overview

• Interest rate determinants

• Rates of return for different holding periods
• Risk and risk premiums
• Estimations of return and risk

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 Interest Rate Determinants

• Supply
• Households
• Demand
• Businesses
• Government’s net demand
• Federal Reserve actions

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 Real and Nominal Rates of Interest

• Nominal interest rate (rn):

• Growth rate of your money
• Real interest rate (rr):
• Growth rate of your purchasing power
rn  i
rr  rn  i rr 
1 i
• Where i is the rate of inflation

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 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:

rn  rr  E  i 

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 Taxes and the Real Rate of Interest

• Tax liabilities are based on nominal income

• Given a tax rate (t) and nominal interest rate (rn),
the real after-tax rate is:

rn 1  t   i   rr  i 1  t   i  rr 1  t   it
• The after-tax real rate of return falls as the
inflation rate rises

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 Rates of Return for Different
Holding Periods
• Zero Coupon Bond:
• Par = $100
• Maturity = T
• Price = P
• Total risk free return
100
rf (T )  1
P(T )

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 Example 5.2
Annualized Rates of Return

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 Example 5.2
Annualized Rates of Return

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 Effective Annual Rate (EAR)

• EAR: Percentage increase in funds invested

over a 1-year horizon

1
1  EAR  1  rf T  T

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 Risk and Risk Premiums

• Rates of return: Single period

P1  P 0  D1
HPR 
P0
• HPR = Holding period return
• P0 = Beginning price
• P1 = Ending price
• D1 = Dividend during period one

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 Rates of Return: Single Period
Example
Ending Price = $110
Beginning Price = $100
Dividend = $4

$110  $100  $4
HPR   .14, or 14%
$100

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 Rates of Return: Single Period
Example
Ending Price = $110
Beginning Price = $100
Dividend = $4

$110  $100  $4
HPR   .14, or 14%
$100

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 Expected Return and
Standard Deviation
• Expected returns

E (r )   p( s)r ( s)
s

• p(s) = Probability of a state

• r(s) = Return if a state occurs
• s = State

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 Scenario Returns: Example

State Prob. of State r in State

Excellent .25 0.3100
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200

E(r) = (.25)(.31) + (.45)(.14) + (.25)(−.0675) + (0.05)(− 0.52)

E(r) = .0976 or 9.76%

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 Expected Return and
Standard Deviation
• Variance (VAR):

   ps r s   E r 
2 2

• Standard Deviation (STD):

STD   2

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 Scenario VAR and STD: Example

• Example VAR calculation:

σ2 = .25(.31 − 0.0976)2 + .45(.14 − .0976)2
+ .25(− 0.0675 − 0.0976)2 + .05(−.52 − .0976)2
= .038

• Example STD calculation:

σ  .038
 .1949

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 Time Series Analysis
of Past Rates of Return
• True means and variances are unobservable
because we don’t actually know possible
scenarios like the one in the examples
• So we must estimate them (the means and
variances, not the scenarios)

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 Returns Using Arithmetic and
Geometric Averaging
• Arithmetic Average
n
1 n
E (r )   p( s )r ( s )   r ( s )
s 1 n s 1
• Geometric (Time-Weighted) Average
g  TV 1/ n  1
TVn  (1  r1 )(1  r2 )...(1  rn )

= Terminal value of the investment

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 Estimating
Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations
n
̂   r s   r 
2 1 2

n s 1
• Unbiased estimated standard deviation
n 2

ˆ 
1
 r s   r 
n  1 j 1
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 The Reward-to-Volatility (Sharpe)
Ratio
• Excess Return
• The difference in any particular period between
the actual rate of return on a risky asset and the
actual risk-free rate
• Risk Premium
• The difference between the expected HPR on a
risky asset and the risk-free rate
• Sharpe Ratio Risk premium
SD of excess returns
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 Next Week Requirements
• Read Chapter 4
• Complete exercise 1,2,3,4,5,7(p.165, 166, Hull)
and submit to e-learning.

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