Chapter 4

Risk and Return

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1. Determinants of the Level of Interest Rate.
2. The Fundamental Factors that Determine the
Level of Interest Rates.
3. Real and Nominal Rates of Interest.
4. Capital Gains and Dividend
5. Expected Rate of Return of Individual Asset
6. Risk of Individual Asset
 Variance
 Standard Deviation.
7. Coefficient of Variation
8. Expected Rate of Return of Portfolio of Risky
Assets
9. Risk of Portfolio
 Variance
 Standard Deviation.
10. Correlation Coefficient.

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Determinants of the Level of Interest Rate:
Interest rates and forecasts of their future values are among the
most important inputs into an investment decision. For example,
suppose you have $10,000 in a savings account. The bank pays you a
variable interest rate tied to some short-term reference rate such as the
30-day Treasury bill rate. You have the option of moving some or all
of your money into a longer-term certificate of deposit that offers a
fixed rate over the term of the deposit.

Your decision depends critically on your outlook for interest

rates. If you think rates will fall, you will want to lock in the current
higher rates by investing in a relatively long-term CD. If you expect
rates to rise, you will want to postpone committing any funds to long-
term CDs. Forecasting interest rates is one of the most notoriously
difficult parts of applied macroeconomics.

The Fundamental Factors that Determine the Level of

Interest Rates:

1. The supply of funds from savers, primarily households.

2. The demand for funds from businesses to be used to finance
investments in plant, equipment, and inventories (real assets or
capital formation).

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 3. The government’s net demand for funds as modified by actions
of the Federal Reserve Bank.

Real and Nominal Rates of Interest:

An interest rate is a promised rate of return denominated in some

unit of account (dollars, or yen) over some time period (a month, a
year, or longer). Thus, when we say the interest rate is 5%, we must
specify both the unit of account and the time period.

Assuming there is no default risk, we can refer to the promised

rate of interest as a risk-free rate for that particular unit of account and
time period.

To illustrate, consider a 1-year dollar (nominal) risk-free interest

rate. Suppose exactly 1 year ago you deposited $1,000 in a 1-year time
deposit guaranteeing a rate of interest of 10%. You are about to collect
$1,100 in cash. What is the real return on your investment? That
depends on what money can buy these days, relative to what you
could buy a year ago.

The consumer price index (CPI) measures purchasing power by

averaging the prices of goods and services in the consumption basket
of an average urban family of four.

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 Suppose the rate of inflation (the percent change in the CPI,
denoted by i ) for the last year amounted to i = 6%. This tells you that
the purchasing power of money is reduced by 6% a year. The value of
each dollar depreciates by 6% a year in terms of the goods it can buy.

Ex: If the nominal interest rate on a 1-year CD is 8%, and

inflation =5% using the approximation formula,

𝒓=𝑹−𝒊
𝒓 = 𝟖% − 𝟓% = 𝟑%
Using the exact formula,

𝑹−𝒊
𝒓=
𝟏+𝒊
𝟎. 𝟎𝟓 − 𝟎. 𝟎𝟖
𝒓= =. 𝟎𝟐𝟖 = 𝟐. 𝟖𝟔
𝟏 + 𝟎. 𝟎𝟓
Therefore, the approximation rule overstates the expected real
rate by .14% (14 basis points).

Capital Gains and Dividend:

Goal of the firm is to maximize the wealth of the stockholders

(which is the stock price), the financial managers should know how to
assess 2 key determinants: (what affects our decision) risk and return.

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  Return: Represents the total gain or loss on an investment over
a given period of time. Returns for stakeholders are dividend or
capital gains.
 Capital Gain: Increase in the share price.
 Dividends: Distribution of income among stockholders.

Ex: X stock has a dividends of 7 $ & its buying price is 100 $ &now
its price is 110 $. What is its return (in value), & rate of return?

Capital gain Dividend

𝒑𝒕 − 𝒑𝒕−𝟏 𝑫𝑻 +( 𝒑𝒕 − 𝒑𝒕−𝟏)
𝑹𝑻 = 𝑹𝑻 =
𝒑𝒕−𝟏 𝒑𝒕−𝟏

110−100 7+(110−100)
𝑅𝑇 = = 10% 𝑅𝑇 = = 17%
100 100

Expected Rate of Return of Individual Asset:

(Probability Theory)

𝑬(𝑹𝒊 ) = ∑ 𝒑𝒊 ∗ 𝑬(𝑹)
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Risk of Individual Asset (Variance and SD):

Standard Deviation (б): the difference between the actual and the
expected return. It measures the dispersion around the expected
values.

𝟐
𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆(б𝟐 ) = ∑ [𝑹𝒊 − 𝑬 (𝑹𝒊 )] 𝒑𝒊

𝟐
SD (б) = √[𝑹𝒊 − 𝑬( 𝑹𝒊 )] 𝒑𝒊

Coefficient of Variation:

CV is a measure of relative dispersion that is useful in comparing

the risks of assets with differing expected return.

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 𝑺𝑫
𝑪𝑽 =
𝑬(𝑹𝒊 )

𝟐.𝟏𝟎%
CV =𝟏𝟎.𝟑% = 0.20

So, this asset has 0.20 unit of risk for each unit of return.

Expected Rate of Return of Portfolio of Risky Assets:

𝑬(𝑹𝒑𝒐𝒓𝒕 ) = ∑ 𝑾𝒊 𝑹𝒊

Risk of Portfolio (Variance and SD):

𝝈𝟐𝒑𝒐𝒓𝒕= 𝒘𝟐𝝈𝟐 +𝒘𝟐 𝝈𝟐+𝟐𝒘 𝒘 𝝈

𝒊 𝒊 𝒋 𝒋 𝒊 𝒋 𝒊 𝝈𝒋 𝒓𝒊𝒋

SD (𝝈) = √𝒘𝟐𝒊 𝝈𝟐𝒊 + 𝒘𝟐𝒋 𝝈𝟐𝒋 + 𝟐𝒘𝒊𝒘𝒋𝝈𝒊 𝝈𝒋𝒓𝒊𝒋

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 𝒄𝒐𝒗𝒊𝒋
𝒓𝒊𝒋 =
𝝈𝒊 𝝈𝒋

Therefore, 𝒄𝒐𝒗𝒊𝒋 = 𝒓𝒊𝒋 𝝈𝒊 𝝈𝒋

𝟏
𝒄𝒐𝒗𝒊𝒋 = ∑ [𝑹𝒊 − 𝑬(Ṝ𝒊 )] [𝑹𝒋 − 𝑬(Ṝ𝒋 )]
𝒏−𝟏

Correlation Coefficient:

𝒄𝒐𝒗𝒊𝒋
𝒓𝒊𝒋 =
𝝈𝒊 𝝈𝒋

Correlation Coefficient 𝒓𝒊𝒋 , which can vary only in the range −1 to +1.

• A value of +1 indicates a perfect positive linear relationship

between 𝑅𝑖 and 𝑅𝑗 , meaning the returns for the two assets move
together in a completely linear manner.
• A value of −1 indicates a perfect negative relationship between the
two return indexes, So that when one asset’s rate of return is
above its mean, the other asset’s rate of return will be below its
mean by a comparable amount.

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Time Patterns of Returns for Two Assets with Perfect
Negative Correlation:

Example:

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Return:

𝑬(𝑹𝒑𝒐𝒓𝒕 ) = ∑ 𝑾𝒊 𝑹𝒊

𝑬(𝑹𝒑𝒐𝒓𝒕 ) = (𝟎. 𝟓𝟎)(𝟎. 𝟏𝟎) +(0.50) (0.20) =0.15

𝝈𝟐𝒑𝒐𝒓𝒕= 𝒘𝟐𝝈𝟐 +𝒘𝟐 𝝈𝟐 +𝟐𝒘 𝒘

𝒊 𝒊 𝒋 𝒋 𝒊 𝒋 𝒄𝒐𝒗𝒊𝒋

Covariance:

• Covariance is a measure of the degree to which two variables

move together relative to their individual mean values over time.
• A positive covariance means that the rates of return for two
investments tend to move in the same direction relative to their
individual means during the same time period.
• A negative covariance indicates that the rates of return for two
investments tend to move in different directions relative to their
means during specified time intervals over time.

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Appendix:

Calculation of covariance

𝟏
𝒄𝒐𝒗𝒊𝒋 = ∑ [𝑹𝒊 − 𝑬(Ṝ𝒊 )] [𝑹𝒋 − 𝑬(Ṝ𝒋 )]
𝒏−𝟏

[𝑹𝒊 − 𝑬(Ṝ𝒊 )]= -3.60 – 1.32= -4.92

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