ISM Lecture 2

Introduction to risk and return
Investment & Securities Markets

Lecture 2
Today…
 How to calculate returns
 How to measure risk
 Distribution of returns
 Risk aversion and risk premium
BUST10032 Lecture 2 2
How to calculate returns
Readings
 Key readings
 BKM 12ed: 5.1, 5.3 - 5.6, 5.8 (first part – 1 page); 6.1
BKM 11ed: 5.2, 5.4 - 5.7, 5.9 (first part – 1 page); 6.1
EGBG Chap 4 (pp. 42—47)
 Additional readings
 Fama, Eugene F. "The behavior of stock-market prices." Journal of Business (1965): 34-
105.
Holding period returns
return u receive
over holding period
The holding period return (𝑅𝑡 ):
𝑃𝑡 − 𝑃𝑡−1 + 𝐷𝑡 𝑃𝑡 + 𝐷𝑡
𝑅𝑡 = = −1
𝑃𝑡−1 𝑃𝑡−1
where:
 𝑃𝑡 = price at the end of the period 𝑡
 𝑃𝑡−1 = price at the beginning of the period 𝑡 (end of 𝑡 − 1)
 𝐷𝑡 = cash dividend
The holding period can be day, month, year, and so on.
Example 1
Suppose that you bought some shares of a stock at $20 per share at the end of
February and the prices and dividend payments of the stock at the end of each month
were:
t Month Price Dividend

1 March $30.00 --
2 April $25.00 $2.00
3 May $35.00 --
What is your holding period return at the end of May?
What is your holding period return for each month?
What is your holding period return at the end of May?
You bought the shares at the end of February at $20.
At the end of May, the shares were now worth $35 and, in April, you
received $2 dividend per share.
The holding period return for this 3-month period:
35+2
𝑅0→3 = − 1 = 0.8500 = 85.00%
20
What is your holding period return for each month?
30+0
February — March: 𝑅1 = 𝑅0→1 = − 1 = 50%
20
25+2
March— April: 𝑅2 = 𝑅1→2 = − 1 = −10%
30
35+0
April — May: 𝑅3 = 𝑅2→3 = − 1 = 40%
25
Returns over multiple periods
The holding period return over multiple periods is a product of gross

holding period returns (1 + 𝑅𝑡 ) in all the periods:
𝑅𝑡→𝑡+𝑘 = 1 + 𝑅𝑡 ⋅ 1 + 𝑅𝑡+1 ⋅ … ⋅ 1 + 𝑅𝑡+𝑘 − 1
= ෑ(1 + 𝑅𝑡+𝑗 ) − 1
𝑗=0
Note that this does not work when the stock pays dividends (as this
assumes that the dividends are reinvested).
Example 2
Stock A was $50 per share at the end of February. Using the information
below, calculate the holding period return at the end of May.
t Month Price Return

0 February $50.00 --
1 March $60.00 20%
2 April $45.00 -25%
3 May $51.75 15%
We can simply use prices at the end of February and May to compute the
return of this three-month period:
51.75
𝑅0→3 = − 1 = 3.5%
50
or use monthly returns:
60
𝑅0→1 = − 1 = 20%
50
45
𝑅1→2 = − 1 = −25%
60
51.75
𝑅2→3 = − 1 = 15%
45
then:
𝑅0→3 = 1 + 𝑅0→1 1 + 𝑅1→2 1 + 𝑅2→3 − 1
= 1.20 × 0.75 × 1.15 − 1 = 0.035 = 3.5%
Average returns
Suppose we have monthly data of returns on a stock. Can we sum up how well the
stock is doing in one single number?
This can be done in two ways:
 Arithmetic Average:
𝑘
1
ത
𝑅 = ෍ 𝑅𝑡
𝑘
𝑡=1
 Geometric Average:
𝑘 𝑘
𝑅ത𝑔 = ෑ (1 + 𝑅𝑡 ) − 1
𝑡=1
Example 3
Calculate the arithmetic and geometric mean returns for Stock A in

Example 2.
1 March $60.00 20%
2 April $45.00 -25%
3 May $51.75 15%
expected return, for eg future prediction
geom avg is less than arithmetic
Arithmetic average: if they are same then no volatility
1
𝑅ത = × 20% − 25% + 15% = 3.33%
3
Geometric average: actual return for eg if asked what the stock produced last year
3
ഥ𝑔 =
R 1 + 20% ⋅ 1 − 25% ⋅ 1 + 15% − 1
= 1.15%
These two numbers tell you two separate stories…
Arithmetic average:
 What rate of return do we expect from this stock in the future?
 Assumes that the return in each month is randomly drawn from a

distribution and that they are independent from each other.
 Each observation is treated as an equally likely scenario.
 𝑅ത = 3.33%: In an average month, stock A yielded a return of 3.33%.
 This is what we use as a proxy for the expected return on an asset.
Geometric average:
 Tells us the actual performance of a portfolio over the past sample

period.
 Takes into account the value of the portfolio when the return is earned.
 e.g. in March, we earned 20% of $50 whereas, in May, we earned 15% of $45.
 𝑅ത𝑔 = 1.15%: Stock A yielded an average return of 1.15% each month.
How to measure risk
Risk
 Using again the example of stock A.
 Stock A’s arithmetic average rate of return is 3.33%

i.e. we expect that next period’s return should be about 3.33%
 However, the actual returns for March, April and May are 20%, -25% and
15% respectively.
 So the average alone is not sufficient in telling us what we can expect in

terms of future returns on Stock A.
 There is a risk that next month’s return will deviate from 3.33%.
Variance and standard deviation
 Variance and standard deviation are measures of dispersion.
 They measure how far away the returns are from the average i.e the
volatility of stock returns.
 These two measures are proxies for risk.
Variance and standard deviation
 Variance:
𝑘
1
𝑠2 = ෍ 𝑅𝑡 − 𝑅ത 2
𝑛−1
𝑡=1
 Standard deviation:
𝑘
1
𝑠= ෍ 𝑅𝑡 − 𝑅ത 2 = 𝑠2
𝑛−1
𝑡=1
Example 4
What is the variance and the standard deviation of returns on Stock A.

1 March $60.00 20%
2 April $45.00 -25%
3 May $51.75 15%
Average Return = 3.33%
Variance:
𝑘
1
2
𝑠 = ෍ 𝑅𝑡 − 𝑅ത 2
𝑛−1
𝑡=1
1
= .20 − .0333 2 + −.25 − .0333 2
+ .15 − .0333 2
2
= 0.0608
Standard deviation:
𝑠= 𝑠2
= 0.0608 = 0.2466
Distribution of returns
The normal distribution
 Investment management is far more tractable when rates of return can

be well approximated by the normal distribution.
 If we assume that the returns for stock A are normally distributed, we

can predict what future returns on stock A will be using only two
parameters:
 the mean (or the average)
 the standard deviation
 The average return (or the sample mean) on Stock A is 3.33%.
 The standard deviation is 24.66%
 If returns on stock A are normally distributed, we expect the monthly

returns on stock A to be as follows.
 68.26% of the time: between -21.33% and 27.99% (3.33% ± 1 × 24.66%)
 The normal distribution is symmetric – we can measure risk using only

the standard deviation.
 It is stable – if we assume that stock returns are normal, then return on a

portfolio of stocks is also normal.
 It is very simple to model – we only need the mean and the standard
deviation to obtain the possible future returns and their probabilities.
Returns vs log returns
 We usually assume that returns have a log normal distribution and log
returns have a normal distribution.
 For many financial assets, the most that you can lose is the amount you
have put in – the minimum return is -100%
 But there is no upper limit – the maximum return is +∞
 To take into account limited liability, we usually assume that returns are
log-normally distributed.
 And that the natural logarithm of returns (log returns) are normally
distributed.
incorporate
this with
Log returns explanation
in return
𝑟𝑡 = ln 1 + 𝑅𝑡
𝑃𝑡
= ln 1 + −1
𝑃𝑡−1
𝑃𝑡
= ln = ln 𝑃𝑡 − ln(𝑃𝑡−1 )
𝑃𝑡−1
= 𝑝𝑡 − 𝑝𝑡−1
where 𝑟𝑡 is log return and 𝑝𝑡 is log price.
Log returns
 Assuming that log returns are normal maintains the limited liability
assumption.
 Log returns assume continuous compounding. More here and here.
 The rates of return in log form are generally lower than the usual
percentage returns.
 But the difference is small for short-term returns.
 It is also simpler to compute multi-period compounded returns:

𝑟𝑡→𝑡+𝑘 = 𝑟𝑡 + 𝑟𝑡+1 + 𝑟𝑡+2 + ⋯ + 𝑟𝑡+𝑘 .
Example 5
1 March $60.00 20%
2 April $45.00 -25%
3 May $51.75 15%
The log return for March is:

𝑟1 = ln 1 + 0.20 = 0.1823 = 18.23%
The same result can be obtained using prices:

𝑟1 = ln 60 − ln(50) = 4.0943 − 3.9120
= 0.1823 = 18.23%
Are log returns really normal?
 Short answer: No.
 But in many applications we still assume normality since it greatly

simplifies portfolio selection process.
 It is important to understand how the distribution of actual returns

deviates from normality.
 Let’s try to answer this question using real data.

 Also see Fama (1965) who explored this in great detail.
Data
 Prices of IBM Stock (adjusted for dividends)
 January 1990-June 2015 (306 observations)
Summary statistics
IBM returns Normal Distribution
Mean 0.78%
Standard deviation 7.81%
Skewness -0.173 0
Kurtosis 4.861 3
Returns on IBM are negatively skewed and have fat tails.
Skewness
 Skewness is a measure of symmetry of a distribution:
1 3
𝐸[ 𝑋 − 𝐸 𝑋 3
] 𝑛σ 𝑋 −𝐸 𝑋
𝑆𝑘𝑒𝑤𝑛𝑒𝑠𝑠 = =
𝜎3 𝜎3
 Normal distribution has skewness of zero.
 If asset returns are negatively skewed, the standard deviation

underestimates the probability of large losses.
 the numerator in the formula above is the sample third central moment.
Skewness
Kurtosis
 Kurtosis is a measure of the likelihood of extreme values of a

distribution:
1 4
𝐸[ 𝑋 − 𝐸 𝑋 4
] 𝑛σ 𝑋 −𝐸 𝑋
𝐾𝑢𝑟𝑡𝑜𝑠𝑖𝑠 = =
𝜎4 𝜎4
 Normal distribution has a kurtosis of 3 (excess kurtosis = 0)
 If the distribution of returns has a kurtosis greater than 3, the standard

deviation underestimates the probability of extreme values.
 the numerator in the formula above is the sample forth central moment.
Kurtosis
if not
distributed
normally we
make wrong
calculations/
assumptions/
decisions etc
Here, the illustration is in terms of excess kurtosis (normal is 0)
Measuring extreme negative returns
Value-at-Risk (VaR)
 The loss corresponding to a very low percentile (usually 5%) of the entire
return distribution.
 5% of the time, we can expect a loss equal to or greater than the VaR.
 The best return we can get in the 5% worst scenarios.
 If returns are normally distributed, 5% VaR is 1.65 standard deviations

below the mean.
Example 6
Assume that the value of your portfolio is $100 million. Based on the
information provided below, what is the 5% VaR?
Percentiles Smallest
1% -.2164354 -.3036823
5% -.1131897 -.2567682
10% -.084785 -.2295551 Obs 306
25% -.0393109 -.2164354 Sum of Wgt. 306
50% .0093229 Mean .0078019

Largest Std. Dev. .07819
75% .0514617 .1799273
90% .0987978 .2141383 Variance .0061137
95% .131865 .2758474 Skewness -.1734523
99% .1799273 .3029146 Kurtosis 4.860732
This can be done in two ways:
If we assume that returns for this portfolio are normally distributed:
5% VaR = mean – 1.65 x (standard deviation)
= 0.0078 – 1.65 x 0.0782
= – 0.1212 = – 12.12%
Thus 5% VaR is 12.12% x $100,000,000 = $12,120,000.
In the 5% worst case scenarios, we can expect a loss equal to or greater than
$12,120,000.
Alternatively, we can use the 5th percentile:
5% VaR = – 11.32%
In monetary value: 11.32% x $100,000,000 = $11,320,000
VaR computed using a percentile does not make any assumption about the distribution
of returns.
Measuring extreme negative returns
 Expected shortfall (ES): the average return we expect to obtain in the

worst case scenarios.
 Lower partial standard deviation (LPSD): the standard deviation of

“bad” returns, usually only negative deviations from the risk-free rate.
 Frequency of large returns: the fraction of observations with returns 3

or more standard deviations below the mean. Requires a large number
of observations.
Risk aversion and risk premium
EXAM
Example 7
Suppose that you have two choices of investment:
1. A bank deposit that offers a return of 5%;
2. A stock that will return 65% with 25% probability and

–15% with 75% probability.
Which one will you choose?
With the bank deposit, it is certain that you will earn 5%.
With the stock, there is an opportunity to earn a lot more, but there is a
change of making a loss.
The expected rate of return on the stock is:
0.25 x 65% + 0.75 x (–15%) = 5%
Both investment opportunities offer the same expected return.
Your investment choice depends on your risk preference.
 Risk averse investors would prefer the bank.
 Risk seeking investors would prefer the stock.
 Risk neutral investors would be indifferent between the two.
Indifference curve
 All assets that lie on the

same indifferent curve are
equally desirable to the
investor.
 The shape of the curve

depends on the investor’s
degree of risk aversion.
Source: https://alphahive.files.wordpress.com/2013/01/r2.jpeg
Source: https://image.slidesharecdn.com/3-130929213433-phpapp01/95/3-risk-and-return-10-638.jpg?cb=1380490524
Risk aversion and utility values
 Most investors are risk averse.

 We need to be compensated for bearing risk – high risk, high return.
 This is commonly accepted but we will look at this a bit more formally
using the concept of utility.
 Basically, we prefer assets/portfolios with higher expected return and

lower risk.
 Therefore, utility increases with expected return and decreases with risk.
Risk aversion and utility values
 We can use a utility function to obtain “utility scores”
1 2
𝑈 = 𝐸 𝑟 − 𝐴𝜎
2
where E(r) = expected return

𝜎2 = variance of returns
A = Degree of risk aversion
Example 8
Consider an investor with a degree of risk aversion A=3.5. Which one of

these following investments would this investor prefer?
Portfolio Expected Return Standard Deviation
L 7% 5%
M 9% 10%
H 13% 20%
1
𝑈 = 𝐸 𝑟 − 𝐴𝜎 2
2
Portfolio L:
1 2
𝑈𝐿 = 0.07 − 3.5 0.05 = 0.0656
2
Portfolio M:
1 2
𝑈𝑀 = 0.09 − 3.5 0.10 = 0.0725
2
Portfolio H:
1 2
𝑈𝐻 = 0.13 − 3.5 0.20 = 0.0600
2
Portfolio M provides this investor with the highest utility.
Risk premium
 Risk averse investors would accept taking risks if they are compensated
with a risk premium.
 If 𝑅𝑓 is the risk-free rate of return and 𝑅𝑖 is the return on asset 𝑖, then

the risk premium of this asset is
𝜋𝑖 = 𝑅𝑖 − 𝑅𝑓
 If most investors are risk averse, stocks (which are risky investments)
should offer a return higher than the risk-free interest rate.
 Risker assets have to compensate risk averse investors with higher risk
premiums. For instance if stock A is risker than stock B, then 𝜋𝐴 > 𝜋𝐵 .
Summary
 In this lecture we look at how return and risk can be calculated.
 We look at the distribution of returns and look at the shortcomings of

assumption that stock returns are normally distributed.
 We also formally look at why risk-averse investors should be

compensated for bearing risk.

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Introduction to risk and return

Investment & Securities Markets

 How to calculate returns

 How to measure risk

 Risk aversion and risk premium

The holding period return (𝑅𝑡 ):

t Month Price Dividend

What is your holding period return at the end of May?

What is your holding period return for each month?

You bought the shares at the end of February at $20.

The holding period return for this 3-month period:

The holding period return over multiple periods is a product of gross

𝑅𝑡→𝑡+𝑘 = 1 + 𝑅𝑡 ⋅ 1 + 𝑅𝑡+1 ⋅ … ⋅ 1 + 𝑅𝑡+𝑘 − 1

t Month Price Return

This can be done in two ways:

Calculate the arithmetic and geometric mean returns for Stock A in

These two numbers tell you two separate stories…

 What rate of return do we expect from this stock in the future?

 Assumes that the return in each month is randomly drawn from a

 Each observation is treated as an equally likely scenario.

 𝑅ത = 3.33%: In an average month, stock A yielded a return of 3.33%.

 This is what we use as a proxy for the expected return on an asset.

 Tells us the actual performance of a portfolio over the past sample

 𝑅ത𝑔 = 1.15%: Stock A yielded an average return of 1.15% each month.

 Using again the example of stock A.

 Stock A’s arithmetic average rate of return is 3.33%

 So the average alone is not sufficient in telling us what we can expect in

 Variance and standard deviation are measures of dispersion.

 These two measures are proxies for risk.

What is the variance and the standard deviation of returns on Stock A.

t Month Price Return

 Investment management is far more tractable when rates of return can

 If we assume that the returns for stock A are normally distributed, we

 the standard deviation

 The average return (or the sample mean) on Stock A is 3.33%.

 The standard deviation is 24.66%

 If returns on stock A are normally distributed, we expect the monthly

 95.44% of the time: between -45.99% and 52.65% (3.33% ± 2 × 24.66%)

 99.75% of the time: between -70.65% and 77.31% (3.33% ± 3 × 24.66%)

 The normal distribution is symmetric – we can measure risk using only

 It is stable – if we assume that stock returns are normal, then return on a

 But there is no upper limit – the maximum return is +∞

where 𝑟𝑡 is log return and 𝑝𝑡 is log price.

 Log returns assume continuous compounding. More here and here.

 But the difference is small for short-term returns.

 It is also simpler to compute multi-period compounded returns:

The log return for March is:

The same result can be obtained using prices:

 Short answer: No.

 But in many applications we still assume normality since it greatly

 It is important to understand how the distribution of actual returns

 Let’s try to answer this question using real data.

 Prices of IBM Stock (adjusted for dividends)

 January 1990-June 2015 (306 observations)

Returns on IBM are negatively skewed and have fat tails.

 Skewness is a measure of symmetry of a distribution:

 Normal distribution has skewness of zero.

 If asset returns are negatively skewed, the standard deviation

 Kurtosis is a measure of the likelihood of extreme values of a

 Normal distribution has a kurtosis of 3 (excess kurtosis = 0)

 If the distribution of returns has a kurtosis greater than 3, the standard

Here, the illustration is in terms of excess kurtosis (normal is 0)

 If returns are normally distributed, 5% VaR is 1.65 standard deviations

50% .0093229 Mean .0078019