Return, Risk and the Historical Record

8/2022
 • Nominal and real interest rate
• Rates of return for different holding periods
• Estimations of return and risk
• Historical record

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 • Nominal interest rate (rn):
• Growth rate of money
• Real interest rate (rr):
• Growth rate of purchasing power

rn − i
rr = rr  rn − i
1+ i
Where i is the rate of inflation

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 • 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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 • Zero Coupon Bond:
+ Par = $100
+ Maturity = T
+ Price = P
100
rf (T ) = −1
P(T )
Total risk-free return

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 Example 1

How to compare securities with

various maturities?
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 • EAR: Percentage increase in funds invested over a 1-year horizon

1
1 + EAR = 1 + rf (T )  T

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 ▪ 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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 Example 2

Ending Price = $110

Beginning Price = $100
Dividend = $4

$110 − $100 + $4
HPR = = .14, or 14%
$100

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 • 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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 Example 3

State Prob. of State r in State

Excellent 0.25 0.31
Good 0.45 0.14
Poor 0.25 -0.0675
Crash 0.05 -0.52

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

0.52)
E(r) = .0976 or 9.76%

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 Example 4
Considering the following cases. What is the expected
return for a project with initial investment of USD100.
State of Probability Year –end price Cash dividend HPR
economy
Boom 0.3 129.5 4.5
Normal growth 0.5 110 4
Recession 0.2 80.5 3.5

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 • Variance (VAR):

 =  p(s )r (s ) − E (r )
2 2

• Standard Deviation (STD):

STD =  2

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 Example 4
Bear Normal Bull
market market Market
Probability 0.2 0.5 0.3
Stock X -20% 18% 50%
Stock Y -15% 20% 10%

a. Expected rate of return for stocks X and Y.

b. Standard devidation of returns on stocks X and Y
Investors normally don’t buy only 1 stock. They have
a portfolio with many stocks. Assume that of $10,000
portfolio, $9,000 in stock X and $1,000 in stock Y.
What is the expected return and risk of this portfolio?
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 • 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)
• One way: analysing time series of past rates of return

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 ▪ Arithmetic Average
𝑛
1
𝐸 𝑟 = 𝑟ҧ = ෍ 𝑟
𝑛
𝑠=1

▪ Geometric (Time-Weighted) Average

g = TV − 11/ n

TVn = (1 + r1 )(1 + r2 )...(1 + rn )

= Terminal value of the investment
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 • Estimated Variance
• Expected value of squared deviations
𝑛
1
𝜎ො 2 = ෍ 𝑟 − 𝑟lj 2
𝑛
𝑠=1

• Unbiased estimated standard deviation

𝑛 2
1
𝜎ො = ෍ 𝑟 − 𝑟lj
𝑛−1
𝑗=1
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 Example 5
Stock A and B have the historical closing prices as follow:
Date P(A) Div(A) P(B) Div(B)
Q4-2015 50 5 60
Calculate the expected
Q3-2015 55 62
Q2-2105 52 59
return and standard
Q1-2015 54 57 9
deviation of the two stocks.
Q4-2014 56 6 57
Q3-2014 49 60

Again: Investors normally don’t buy only 1 stock. They

have a portfolio with many stocks. Assume that of his
budget, a person invests 30% on A and 70% on B.
5-21 11/12/2017 What is the expected return and risk of this portfolio? 21
 n
E ( R p ) =  wi E ( Ri )
i

Where E(Rp): Expected return of a portfolio

wi: Percentage of asset i in the portfolio
E(Ri): Expected return of asset i
n: numbers of assets in the portfolio

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 𝑛 𝑛 𝑛

𝜎𝑝2 = ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )

𝑖=1 𝑖=1 𝑗=1
𝑗≠𝑖
For a portfolio with 2 assets D and E

▪ Portfolio variance:  p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )

Cov ( rD , rE ) : Covariance of returns for D and E

Cov ( rD , rE ) = DEDE
D,E : Correlation coefficient of returns
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 Cov ( rD , rE ) = ෍ 𝑝(𝑠) [𝑅𝐷(𝑠) − 𝐸(𝑅𝐷 )][(𝑅𝐸(𝑠) − 𝐸(𝑅𝐸 )]
𝑠
or

σ(𝑟𝐴,𝑖 −𝑟ഥ𝐴 )((𝑟𝐵,𝑖 −𝑟ഥ𝐵 )

Cov ( rD , rE ) =
𝑛

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 Cov ( rD , rE ) = DEDE

DE : Correlation coefficient of returns

▪ Range of values for 
−1 ≤ 𝜌 ≤ 1
If  = 1.0, the securities are perfectly positively correlated
If  = - 1.0, the securities are perfectly negatively correlated
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 r

Guessing sign of 𝜌 of pairs of

securities?
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 Now you can come
back Example 4 and 5

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