CHAPTER FIVE

RISK, RETURN, AND THE HISTORICAL RECORD

CHAPTER OVERVIEW
This chapter includes two major sections. The first section of the chapter describes the major factors
influencing the level of interest rates and discusses the Fisher Effect. The second part of the chapter
investigates holding period returns for different holding periods and presents information on historical
risk/return data on different types of financial assets and presents statistical calculations of risk and
returns measures, both ex post and ex ante.

LEARNING OBJECTIVES
After covering the chapter, the students should be able to describe the major factors that influence the
level of interest rates and be able to apply the Fisher effect to interest rates and inflation. Students should
be able to understand and calculate risk and return statistical measures, such as holding period returns,
average returns, expected returns, and standard deviations.

PRESENTATION OF MATERIAL
5.1 Measuring Returns over Different Holding Periods
The chapter begins with a discussion on how to compare investment returns over different holding
periods. Starting with the simplest security, a zero-coupon bond, Equation 5.1 illustrates the percentage
increase in value of the investment. This is expressed as the holding period return. Table 5.1 illustrates an
effective annual rate (EAR) through an example of prices and returns on zero-coupon bonds with a face
value of $100 and different maturities.

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5.1 Determinants of the Level of Interest Rates
This next section starts with the list of the major factors that influence interest rates- supply of funds by
savers, demand for funds by businesses, government’s net demand for funds and the expected rate of
inflation. It introduces the important relationship between nominal rates and real rates (Equation 5.7).
Figure 5.1 displays a graph of the supply and demand for loanable funds. The graph shows the impact
that a greater demand for funds would have on rates given no change in the supply of funds. The
equilibrium for the nominal rate of interest is presented by the Fisher hypothesis (Equation 5.8). Please
note that this may be the first time students have seen the expectations operator, so a review of its
meaning and use may be helpful. The impact of taxes on the real rate of interest is presented at the end of
this section (Equation 5.9).
After the holding period returns are calculated, returns can be expressed as Effective Annual Rates and
Annual Percentage Rates. The formulas to calculate EARs and APRs are presented in Table 5.2. It is
advised that instructors discuss the different ways EAR and APR will be presented in the financial world
and their implications.

5.2 Treasury Bills and Inflation, 1926-2018

Historical analysis of real rates of return shows disparity over sub periods from 1926 to 2018, noted in
Table 5.3. While the average real rate of return on T-bills for the entire period was 3.46 percent, real
rates are larger in late periods. Figure 5.2 shows that T-bill rates are much closer to inflation rates in later
periods.

5.3 Risk and Risk Premiums

The formula for calculation of a single holding period rate of return and a sample calculation are
presented at the beginning of this section (Equation 5.10). The formulas used in the calculation of mean
(Equation 5.11) and variance (Equation 5.12) for a scenario along with sample calculations are presented
as well. Spreadsheet 5.1 illustrates a scenario analysis of holding-period return of amutual fund. Scenario
means and variances should be contrasted with historical means and variances to enhance the students
understanding of significant differences in the concepts. While historical returns are used for estimating
future returns, scenario analysis is a different process.

Investors measure reward as the difference between the returns of the investment and the risk-free rate.
This risk premium is also known as excess return when it displays the difference between the actual

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return of the investment and the actual risk-free rate. This section also introduces the idea of risk aversion
as a necessary condition for a risk premium.

5.4 Learning from Historical Returns

When working with historical data each of the observed holding period returns, they are assumed to have
equal probabilities. Average returns can be measured using a simple arithmetic average or a geometric
(time-weighted) average (Equations 5.13 and 5.14). The text contains an excellent discussion of how the
geometric and arithmetic averages differ and issues related to measuring standard deviation of returns
over time. It also presents the difference between variance (Equation 5.15) and estimated variance
(5.16/5.17). Spreadsheet 5.2 illustrates a time series of holding-period returns as an in-class discussion
example.

Investors measure returns in the form of excess returns or risk premiums over the risk-free asset. The
reward-to-volatility or Sharpe Ratio (Equation 5.18) measures the added risk premium or excess return on
a portfolio relative to standard deviation of excess returns. Example 5.7 provides an example of the
Sharpe Ratio.

5.5 The Normal Distribution

The normal distribution is presented in Figure 5.3. When distributions are normal they have a bell shaped
curve that allows complete description of the portfolio by examining the mean and standard deviation.

5.7 Deviations from Normality and Tail Risk

The normal distribution is symmetric and has small probabilities of occurrences in the tails of the
distributions. Two departures from normal distributions that are observed with returns are the existence
of skewed distributions (Equation 5.19) and the existence of fat-tailed distributions (Equation 5.20).
Figure 5.4 and 5.5 demonstrate these concepts.

Variance, while the standard for risk measurement, is not without its shortcomings. This section presents
a series of alternative risk measures. Value at Risk (VaR), Expected Shortfall (ES), Sortino Ratio and
calculating the relative frequency of Large, Negative 3-Sigma returns are four risk measures which can
complement variance.

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5.8 Historical Returns on Risky Portfolios
The historical record on investments is presented in Figure 5.6, Table 5.4 and Figure 5.7. Table 5.5 show
the monthly excess returns on the market index and four “style” portfolios. The material presents results
for large stocks that include portfolios of domestic only and a world portfolio comprised of stocks from
over 40 countries. Returns and standard deviations for selected countries are displayed in Figure 5.9. The
figure shows nominal returns and real returns for equity along with a comparison of nominal equity and
bond rates of return for the various countries.

5.9 Normality and Long-Term Investments

When estimating long-term risk premiums, return distributions can be asymmetric with a significant
positive skew. When compounding returns, the distribution of returns is lognormally distributed and not
normally distributed. Figure 5.10, Example 5.11, and Table 5.6 show risk and return over the long haul;
stocks can be more risky and that terminal values can be less than risk-free securities.

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of McGraw-Hill Education.