Chapter 1

Returns and risks

of financial securities
H.Nguyen Financial Markets II 2
Facts
Between 2001 and 2006,

n Accor stocks: annual mean return

= 7.8%, min = -28.4% in 2002,
max = 44.7% in 2005.

n Air France-KLM stock: annual

mean return = 9.5% with large
variations, min = -43.7% in 2002,
max = 73.8% in 2006.

n French Treasury Bill: annual

mean return = 2.8%, max = 4.3%
in 2001, min = 2% in 2004

Source: Author’s calculs

H.Nguyen Financial Markets II 3

n Which do large variations of returns imply?
q Measure of return and risks of financial securities
q Arbitrage between return and risks

n Why such gap between stock returns and T-

bill returns?
q Existence of risk premium required by investors
for holding risky assets

H.Nguyen Financial Markets II 4

1. Returns of financial assets

n Rate of Return: RoR, R

n Annual Percentage Return: simple rate
n Effective Annual Return: compound rate

n Nominal interest rate

n Real interest rate = Nominal interest rate – Inflation rate

H.Nguyen Financial Markets II 5

Holding-period Rate of Returns R
n Regular revenues
n Interests/Coupons: obligations, money market instruments Dt-1à t
n Dividends: stocks

n Profit (Loss) on the capital Pt – Pt-1

(Rate of) Return over
a holding period Pt - Pt -1 + Dt é Pt ù Dt
(arithmetic return)
Rt = =ê - 1ú +
Pt -1 ë Pt -1 û Pt -1

Attn: D is supposed to be paid at the end of the holding period. If the

payment is made earlier, the reinvestment is ignored*.

H.Nguyen Financial Markets II 6

Return over one holding period

n Dividend yield
Dt
Pt -1
n Capital gain (or loss)
Pt - Pt -1
Pt -1
n (Arithmetic) return Pt - Pt -1 + Dt
R =
t
a
(for logarithmic return, see further) Pt -1

H.Nguyen Financial Markets II 7

Application

n You bought one stock of EDF on May 2nd 2008 at the

price of 67€ et you resold it on May 30th at 69.58€. A
dividend of 0.7 € was paid on May 28th.

(Arithmetic) Return:

69.58 - 67 + 0.7
R =
a
= 0.049 = 4.9%
67

H.Nguyen Financial Markets II 8

 -0,8
-0,6
-0,4
-0,2
0
0,2
0,4
2/1/2000
8/1/2000

H.Nguyen
2/1/2001
8/1/2001
2/1/2002
8/1/2002
2/1/2003
8/1/2003
2/1/2004
8/1/2004
2/1/2005
8/1/2005
2/1/2006
8/1/2006
2/1/2007
8/1/2007
2/1/2008
8/1/2008
SG 2/1/2009
Danone

8/1/2009
Danone vs. Société Générale

2/1/2010

Financial Markets II
8/1/2010
Monthly arithmetic returns

2/1/2011
8/1/2011
2/1/2012
8/1/2012
2/1/2013
8/1/2013
2/1/2014
8/1/2014
2/1/2015
8/1/2015
2/1/2016
8/1/2016
2/1/2017
9
Holding period return: Logarithmic return

é Pt + Dt ù
R = ln ê
t
l

P
ú = ln 1 + Rt
a
( )
ë t -1 û

q Logarithmic return à return in continuous time* (over a very short

time interval)
q For a small variation of asset prices, the logarithmic return is a
good proxy of the arithmetic return Rlt ≈ Rat

H.Nguyen Financial Markets II 10

Logarithmic return over one period

n You bought one stock of EDF on May 2nd 2008 at the price
of 67€ et you resold it on May 30th at 69.58€. A dividend of
0.7 € was paid on May 28th.

69.58 - 67 + 0.7
R =
a
= 0.049 = 4.9%
67
æ 69.58 + 0.7 ö
R = ln ç
l
÷ = 0.048 = 4.8%
è 67 ø

H.Nguyen Financial Markets II 11

Properties of logarithmic returns (1)
n Being additive: total return over a long period T
(denoted R) = sum of logarithmic returns of its
subperiods.

æ PT ö æ PT PT -1PT -2 ...P1 ö
R = log ç ÷ = log ç ÷
è P0 ø è PT -1PT -2 ...P1P0 ø
æ PT ö æ PT -1 ö æ P1 ö
= log ç ÷ + log ç ÷ + ... + log ç ÷
è PT -1 ø è PT -2 ø è P0 ø
= R1l + R2l + ... + RTl

H.Nguyen Financial Markets II 12

Properties of logarithmic returns(2)
n Computational convenience in asset pricing
q Statistical properties of a additive process is easier to
determine (explicit solution) than those of a multiplicative
process (arithmetic returns).

q Logarithmic returns are supposed to follow

(approximatively) a gaussian (normal) distribution and to
be identically distributed and serially independently (iid).
Arithmetic returns do not possess this convenient property
(cf. further).

H.Nguyen Financial Markets II 13

Use of arithmetic versus logarithmic returns

n Arithmetic returns
q Calculation of the performance of an investment over a
defined period in the past.
q Prevision of future return over a future finite interval.

n Logarithmic returns
q Econometric studies on time series

n The mean of arithmetic returns depends on the volatility

of the series, an inconvenient property.

H.Nguyen Financial Markets II 14

 Arithmetic versus Logarithmic Returns
0,25
Danone
0,2

0,15

0,1

0,05
ROR log
ROR arith
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73

-0,05

-0,1

-0,15

-0,2
H.Nguyen Financial Markets II 15
Historical returns of Renault
Arithmetic versus Logarithmic

0,8

0,6

0,4

0,2

RoR arith
0
-0,6 -0,4 -0,2 0 0,2 0,4 0,6 0,8
ROR logarithmique = ln(1+RoR arith)
-0,2

-0,4

-0,6

-0,8

H.Nguyen Financial Markets II 16

Return over several periods (1)
n 2 measures:
1 T
q Arithmetic average R = å Ri ,t
a

T t =1

1/T
é T ù
q Geometric average R = êÕ (1 + Ri ,t ) ú
g
-1
ë i =1 û

q If returns come from a normal distribution then:

Geometric Average = Arithmetic Average - 1 .s 2
2
Note: To use this equation, returns must be expressed in decimals,
not percentages.

H.Nguyen Financial Markets II 17

Return over several periods(2)

n Example: one asset whose price varies as follows:

P0 = 100; P1 = 200; P2 = 100

ROR over the total period:

100 - 100
RT = =0
100

H.Nguyen Financial Markets II 18

 200-100
ROR over the 1st subperiod R1 = = 1 = 100%
100
100-200
ROR over the 2nd subperiod R2 = = -0.5 = -50%
200
ROR average
1
R = (1 - 0.5 ) = 0.25
a

2
R = éë(1 + 1) ´ (1 - 0.5 ) ùû
1/2
g
-1 = 0

H.Nguyen Financial Markets II 19

Arithmetic mean or Geometric mean?
n For illustration purpose, variations of stock prices are inflated to
highlight the spread between arithmetic mean and geometric mean.
n Arithmetic mean is always higher than geometric mean*.

n However, in general, when returns over successive periods vary

slightly, arithmetic and geometric means give similar results. The
stronger the price variations, the higher the spread.

n The geometric mean is an appropriate measure of historical return

of financial securities over a given period à indicator usually used to
compare performances between investment funds over 3-year or 5-
year horizons.

n The arithmetic mean is statistically the best estimator of future

expected returns.

H.Nguyen Financial Markets II 20

Expected return
n Future => uncertainty => forward-looking scenario
analysis
q Scenario in function of the state of the economy and the
stock market à Rs
q Each scenario has an occurrence probability ps

à Expected return E(R) = probability-weighted average of

the returns in different scenarios

S
E ( R ) = å Rs ´ ps
s =1

H.Nguyen Financial Markets II 21

Expected return
n Example: A stock of Total is quoted at 43€. A financial
analyste summarizes the uncertainty about the next year’s
return by evoking three possible scenarios:

Scenario State of the Probability Price Dividend Return

economy
1 Stagnation 0.35 47 2.5

2 Expansion 0.30 52 2.7

3 Recession 0.35 33 2.5

1. What is the return in each scenario?

2. What is the expected return?

H.Nguyen Financial Markets II 22

 Expected return
n Example: A stock of Total is quoted at 43€. A financial
analyst summarizes the uncertainty about the next year’s
return by evoking three possible scenarios:

Scenari State of the Probability Price Dividend Return Return * Prob

o economy
1 Normal 0.35 47 2.5 0.15 0.05

2 Good 0.30 52 2.7 0.27 0.08

3 Bad 0.35 33 2.5 -0.17 -0.06

1. Return in each scenario

2. Expected return =
3
E ( R ) = å E ( RS ) ´ ps = 0.05 + 0.08 - 0.06 = 0.07
s =1

H.Nguyen Financial Markets II 23

2. Risks of financial assets

H.Nguyen Financial Markets II 24

Probabilistic distribution of returns
ASSUMPTION

nReturns follow a normal (gaussian) distribution. The density

function is:
R : N (m, s )
È Ê ˆ2˘
1 1 R - m˜ ˙
f (R ) = exp ÍÍ- Á Á ˜˜ ˙
s 2p Á
ÍÎ 2 Ë s ¯ ˜ ˙
˚

nEstimation of expected return = average return μ

nEstimation of expected risk = standard deviation σ

H.Nguyen Financial Markets II 25

Normal distribution of returns

n The rule 68-95-99.7

n 68% of returns fall between μ-σ et μ+σ
n 95% of returns fall between μ-2σ et μ+2σ
n 99.7% of returns fall between μ-3σ et μ+3σ

n Example:

R : N (m = 0.1, s = 0.2 )
fl
P (- 0.1 < R < 0.3 ) = 68%
P (- 0.3 < R < 0.5 ) = 95%
P (- 0.5 < R < 0.7 ) = 99.7%

H.Nguyen Financial Markets II 26

 µ = 10%, σ = 20%

The density function of a normal

(gaussian) distribution

H.Nguyen Financial Markets II 27

Standard deviation of returns
as measure of total risk
n Risk = any deviation from the expected return, whatever the direction

T T
1 2 1 ÈR - R ˘2 (t ime series)
s=
T
 ÈÍÎR t - R ˘˙ fi
˚
s= Â
T - 1 t = 1 ÍÎ t ˙˚
t=1

S
2
s= Â ps ¥ ÈR
Î s - E (R )˘
˚ (probabilist ic analysis)
t=1

n Other kinds of risk

q Insolvency risk

q Liquidity risk

q Interest rate risk

q Exchange risk

H.Nguyen Financial Markets II 28

 Standard deviation of returns
as measure of total risk
n Probabilistic analysis: A stock of Total is quoted at 43€. A financial
analyst summarizes the uncertainty about the next year’s return by evoking
three possible scenarios:

Scenario State of the Probability Price Dividend Return Return * Prob

economy
1 Stagnation 0.35 47 2.5 0.15 0.05
2 Expansion 0.30 52 2.7 0.27 0.08
3 Recession 0.35 33 2.5 -0.17 -0.06

3
E ( R ) = å E ( RS ) ´ ps = 0.05 + 0.08 - 0.06 = 0.07
s =1

å p ´ éë R - E ( R )ùû
2
s= s s
t =1

= é( 0.15 - 0.07 ) ´ 0.35 + ( 0.27 - 0.07 ) ´ 0.3 + ( -0.17 - 0.07 ) ´ 0.35ù == 0.0344 = 0.1855 = 18.55%
2 2 2
ë û

H.Nguyen Financial Markets II 29

Standard deviation of returns
as measure of total risk
n Calculation from historical returns (time series)

Year Ri Ri - μ (Ri - μ)^2

1999 0,200 0,138 0,0190
2000 0,050 -0,012 0,0001
2001 -0,050 -0,112 0,0125
2002 0,020 -0,042 0,0018
2003 0,090 0,028 0,0008
Arithmetic mean μ 0,062
Sum 0,0343
Variance 0,0086
SD 0,0926

H.Nguyen Financial Markets II 30

What if returns are NOT gaussian?
n According to the normal (gaussian) distribution, extreme
events are so rare (with very small probability) that we can
neglect.

n If returns are not gaussian, the probability that extreme events

occur is higher à risk is higher than under a gaussian
distribution.
q Testing the normality assumption
q Taking into account other distributional properties of returns to measure
the total risk:
n Asymmetry: SKEWNESS
n Degree of fat tails: KURTOSIS

H.Nguyen Financial Markets II 31

Normal and Skewed distributions
(µ = 6% σ = 17%)

H.Nguyen Financial Markets II 32

Normal and Fat Tails Distributions
(mean = 0.1 σ =0.2)

H.Nguyen Financial Markets II 33

 Returns skewed to the right
0,1 8

0,1 6

0,1 4

0,1 2
Mean
0,1

0,08

0,06

0,04

0,02 0 Return
(Gains)
0

0 2 4 6 8 1 0 1 2 1 4 1 6

Positive asymmetry: investors adore!

H.Nguyen Financial Markets II 34

 Returns skewed to the left

0,1 8

Mean
0,1 6

0,1 4

0,1 2

0,1

0,08

0,06

0,04

0
0,02

Return
(Losses) 0

0 2 4 6 8 1 0 1 2 1 4 1 6

Negative asymmetry: investors dislike !

H.Nguyen Financial Markets II 35
Extreme risk revealed by the skewness
n Skewness (the 3rd moment of a distribtion)
à symmetry (asymmetry) of a distribution

if the distribution is normal )

q Sk = 0: normal distribution
q Sk > 0: skewed to the right à appreciated
n σ overestimates risk
q Sk < 0: skewed to the left
n σ underestimates risk

H.Nguyen Financial Markets II 36

 Extreme risk revealed by the kurtosis

n Kurtosis (the 4th moment of a distribution)

à degree of fat tails of a distribution

if the distribution is normal )

n K = 3: mesokurtic (normal distribution)

n K > 3: leptokurtic (case of many financial assets)
n K < 3: platikurtic (rare in financial asset world)
n σ underestimates the likelihood of extreme events: large
losses and large gains

n Excess of K = K – 3 (used by some softwares)

H.Nguyen Financial Markets II 37

Return distribution of DJIA 1900 - 2000

Source : Analyze Indices

H.Nguyen Financial Markets II 38
 µ=9,8% s=22,7%
H.Nguyen Financial Markets II 39
Annual real returns of US stocks 1900 - 2000

Moyenne : 8,7% Volatilité : 20,2%

H.Nguyen Financial Markets II 40

Histograms of Rates of Return for 1926-2005

H.Nguyen Financial Markets II 41

Return distribution of hedge funds
Indice of Hedge Funds « Merger Arbitrage » (MAR)

35

30

25

20

15

10

0
-3 -2,5 -2 -1,5 -1 -0,5 0 0,5 1 1,5 2 2,5 3 3,5 4 ou
plus...

H.Nguyen Financial Markets II 42

Testing the normality assumption
n Many tests on the normality assumption:
Jarque-Bera, Shapiro-Wilk, Kolmogorov-Smirnov, Chi-
square…
n Jarque-Bera test:
q H0: normality (joint assumption: Sk=0 and K=3)

q H1: non normality

T -2æ 2 1 2ö
JB = ç Sk + ( K - 3) ÷ » c 2
2

6 è 4 ø

Rejection zone W = {JB > Chi-square statistic (df = 2) (table) }

H.Nguyen Financial Markets II 43

 Testing the normality assumption
1000
Series: RIBM
Sample 1/01/1988 31/12/1997
800 Observations 2609

Mean 0.000228
600 Median 0.000000
Maximum 0.121772
Minimum -0.113736
400 Std. Dev. 0.016702
Skew ness 0.236450
Kurtosis 9.449321
200
Jarque-Bera 4545.897
Probability 0.000000
0
-0.10 -0.05 0.00 0.05 0.10
Conclusion: Returns of stock RIBM are not normally distributed
*Probability = probability of rejecting falsely the null hypothesis (normality
assumption)

H.Nguyen Financial Markets II 44

 Historical Returns and Standard Deviations for
Principal Asset Classes (1900–2011)

H.Nguyen Financial Markets II 45

 Risk-Return Tradeoffs for different asset classes
(1900-2011)

Source: Smart, Gitman & Joehnk (2014), Fundamentals of Investing, Pearson Education

H.Nguyen Financial Markets II 46

Systematic Risk versus Specific Risk
n Total risk: measured by variations returns relatively to
the expected return (mean return) à standard deviation
of returns
q Expected return = 10%, realized return = 6%
à downside risk
q Expected return = 10%, realized return = 15%
à upside risk

n The total risk contains two types of risk:

q Systematic risk (market risk) (RSy) à non-diversifiable risk

q Specific risk (RSp) à diversifiable risk

H.Nguyen Financial Markets II 47

Specific Risk
n Factors that are speficific to firms
q Management team
q Financial solidity
q Technologic and advertising capacity
q Product specificities and consumer reactions
q …

n Specific risk can be reducted, even eliminated via the

combinaison with other assets in a well diversified
portfolios
q Diversification across sectors
q Diversification across countries / regions
q Diversification across financial asset classes: traditionnal
assets mixed with commodities, real estate, hedge funds…

H.Nguyen Financial Markets II 48

Systematic risk
n Systematic risk is the variability of asset returns caused by
factors that simultanoeusly influence the price of all the assets
à consequence: general upward or downward mouvements
in stock exchange markets.

n Examples: changes in social, economical policies or climates:

interest rate, inflation, political instability

n Systematic risk is common to all financial securities à market

risk, non-diversifiable risk

H.Nguyen Financial Markets II 49

How to measure systematic risk?
n Since the price variations of an individual asset tend to
correlate with variations of financial indices representative of
a market (CAC40, S&P500,…)
à Determine the systematic risk for security i via β

Single-index model
rit = a i + b i rmt + e t (Sharpe (1963), A Simplified
Model of Portfolio Analysis,
Management Science

• rit = Rit – Rft = excess return on asset i at date t

• rmt = Rmt – Rft = excess return on index m (representative of the market) at date t
• Rit, Rmt: return on asset i and index m at date t, respectively
• Rft: risk-free rate at date t (T-bills, sovereign bonds)

H.Nguyen Financial Markets II 50

Risk Premium
n Risk premium (also called excess return): difference between return
on a risky asset and the risk-free rate.

Risk premimum of asset i, RPit = Rit - R ft

Market risk premimum m, RPmt = Rmt - R ft

n Investors are assumed to be risk averse à theoretically, risk

premium needs to be positive to induce risk-averse investors to
invest in risky assets instead of placing all their money in risk-free
assets.
n The market only compensates systematic risk, which is not
diversifiable à the risk premium for a risky investment depends on
the level of the systematic risk incurred. The specific risk is not
valued by the market because it can be eliminated within a well
diversified portfolio.

H.Nguyen Financial Markets II 51

The Modified Single Index Model

n Practionners often use a « modified » single index

model, especially when daily data are used.

Rit = ai + b i Rmt + e t

n In this case, the rate of return on bills is on the order of

only about 0.01% per day, so total and excess returns
are almost indistinguisable.

H.Nguyen Financial Markets II 52

Computing betas
n Econometrically: estimation of the characteristic line with
the OLS method à aˆ i , bˆi

Cov ( ri , rm )
bi =
Var ( rm )
1 T
( )( ) 1 T
( )
2
Þ bi = å
T - 1 t =1
ri ,t - ri rm,t - rm / å
T - 1 t =1
ri ,t - ri

q aˆ i : return on asset i independently of market mouvements

q bˆi : sensitivity of security i to the market

H.Nguyen Financial Markets II 53

Beta: A Popular Measure of Risk
n A measure of systematic risk
n Indicates how the price of a security responds to market
forces
n Compares historical return of an investment to the
market return (the CAC40 Index, S&P 500 Index)
n The beta for the market is 1.0
n Stocks may have positive or negative betas. Nearly all
are positive.
n Stocks with betas greater than 1.0 are more risky than
the overall market.
n Stocks with betas less than 1.0 are less risky than the
overall market.

H.Nguyen Financial Markets II 54

 Interpreting Betas

H.Nguyen Financial Markets II 55

Interpreting Betas (cont.)

n Higher stock betas should result in higher expected

returns due to greater risk
n If the market is expected to increase 10%, a stock with a
beta of 1.50 is expected to increase 15%
n If the market went down 8%, then a stock with a beta of
0.50 should only decrease by about 4%
n Beta values for specific stocks can be obtained from
websites such as yahoo.com, yahoo.fr

H.Nguyen Financial Markets II 56

Beta of French stocks

Stock Beta Stock Beta

Danone 0.89 Sanofi 0.74
Total 0.86 Orange 0.46
Bnp Paribas 0.93 Carrefour 0.86
Air France - KLM 0.61 Vinci 0.44
Peugeot 1.57 Vivendi 0.48

Source: finance.yahoo.fr au 7/3/2017

H.Nguyen Financial Markets II 57

Beta of US Stocks

H.Nguyen Financial Markets II 58

 Beta of US Sectors

H.Nguyen Financial Markets II 59

 Graphical Derivation of Betas for Stock C and D

H.Nguyen Financial Markets II 60

 Sensitivity of RENAULT to the market
(1/1998-12/2003, monthly returns)

Beta = .992

Characteristic line of
RENAULT stock

H.Nguyen Financial Markets II 61

Beta = sensitivity coefficient to the market
..
Ri
Ri

RM RM

Ri

RM

H. Nguyen Financial Markets II 62

Decomposition of total risk into systematic
and specific risks
rit = a i + bi rmt + e it
Þ Var ( rit ) = Var (a i ) + Var ( bi rmt ) + Var ( e it )
+ 2 ´ Cov (a i , rmt ) + 2 ´ Cov (a i , e it ) + 2 ´ Cov ( rmt , e it )
Since Var (a i ) = 0 because a i is a constant
Cov (a i , rmt ) = Cov (a i , e it ) = Cov ( rmt , e it ) = 0 by construction
Þ Var ( rit ) = bi2 ´Var ( rmt ) + Var ( e it )
Þ s i2 = bi2 ´ s m2 + s 2 (e i )
Þ Total Risk = Systematic Risk + Specific Risk

H.Nguyen Financial Markets II 63

 Single-Index Model in Brief
n Total risk = Systematic risk + Firm-specific risk
s = bi s
i
2 2 2
M + s ( ei )
2

q For individual stocks, firm-specific risk is as large as systematic risk*.

n Covariance = product of betas x market index risk

( )
Cov( Ri , R j ) = Cov (a i + bi rM + ei , a j + b j rM + e j ) = Cov bi b j rM2 = bi b js M2
since by construction a i , bi rM and ei are independant
Û their covariances are equal to zerobi b js M2

n Correlation = product of correlations with the market index

b i b js M2 b is M2 b js M2
Corr ( R i , R j ) = = = Corr ( R i , R M ) ´ Corr ( R j , R M )
s is j s i s M s js M
H.Nguyen Financial Markets II 64
Application
n The following describes a three-stock market that satisfies the
single-index model

Stock Capitalization Beta Mean excess Standard

return deviation
A $3,000 1.0 10% 40%
B $1,940 0.2 2% 30%
C $1,360 1.7 17% 50%

n The standard deviation of the market index portfolio is 25%

a) What is the mean excess return of the index portfolio?
b) What is the covariance between A and B?
c) What is the covariance between B and the index?
d) Break down the variance of B into systematic and specific
components

H.Nguyen Financial Markets II 65

 Scatter Diagram of HP, the S&P 500, and the Security
Characteristic Line (SCL) for HP from monthly data

• 1/2001-3/2006
• Monthly data
• 60 observations
• Rf: US T-bills

• SCL: graphic
representation
of a security’s
single-index
model
H.Nguyen Financial Markets II 66
 Regression Statistics for the SCL of HP

H.Nguyen Financial Markets II 67

Annexes
H.Nguyen Financial Markets II 69
Source: Bodie, Kane & Marcus (2003)

H.Nguyen Financial Markets II 70

Required Return

n The rate of return an investor must earn on an

investment to be fully compensated for its risk

Required return Real rate Expected inflation Risk premium

= + +
on investment j of return premium for investment j

Required return Risk-free Risk premium

= +
on investment j rate for investment j

H.Nguyen Financial Markets II 71