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Presenter

Venue

Date

RETURN ON FINANCIAL ASSETS

Total Return

Income or Loss

HOLDING PERIOD RETURN

A holding period return is the return from

holding an asset for a single specified period of

time.

Pt Pt 1 Dt Pt Pt 1 Dt

R

Pt 1 Pt 1 Pt 1

Capital gain Dividend yield

105 100 2

R 5% 2% 7%

100 100

HOLDING PERIOD RETURNS

annual returns are 7%, 9%, and –5%?

R 1 R1 1 R2 1 R3 1

1 .07 (1 .09)(1 .05) 1 .1080 10.80%

AVERAGE RETURNS

Average

returns

or mean mean weighted

return return return

ARITHMETIC OR MEAN RETURN

average of all holding period returns.

Ri Rit

T T t 1

Ri 4%

3

GEOMETRIC MEAN RETURN

compounding of returns.

T

T 1 Rit 1

t 1

MONEY-WEIGHTED RETURN

0

(1 IRR) (1 IRR) (1 IRR) (1 IRR)

0 1 2 3

0

1 (1 IRR) (1 IRR) (1 IRR)

1 2 3

IRR 26.11%

ANNUALIZED RETURN

rannual 1 rperiod 1

c

Weekly return of 0.20%:

52

2

rannual (1 0.20) 3 1 0.1292 12.92%

GROSS AND NET RETURNS

PRE-TAX AND AFTER-TAX NOMINAL

RETURN

After-tax

Pre-tax nominal

Taxes nominal

return

return

NOMINAL RETURNS AND REAL RETURNS

r 10.313%

1 rreal 1 rrF (1 RP) (1 0.03) (1 0.05)

rreal 8.15%

1 rreal (1 r ) (1 ) (1 0.10313) (1 0.02)

rreal 8.15%

VARIANCE AND STANDARD DEVIATION OF A

SINGLE ASSET

Population Sample

R R

T T

R

2 2

t t

2 t 1

s2 t 1

T T 1

2 s s2

VARIANCE OF A PORTFOLIO OF ASSETS

Variance can be determined for N securities in a portfolio

using the formulas below. Cov(Ri, Rj) is the covariance of

returns between security i and security j and can be

expressed as the product of the correlation between the

two returns (ρi,j) and the standard deviations of the two

assets, Cov(Ri, Rj) = ρi,j σiσj.

N

P Var RP Var wi Ri

2

i 1

w w Cov R , R

N

i j i j

i , j 1

w w Cov R , R

N N

w Var Ri

2

i i j i j

i 1 i , j 1, i j

EXAMPLE 5-4 RETURN AND RISK OF A TWO-

ASSET PORTFOLIO

portfolio with 80 percent invested in the S&P 500 U.S.

stock index and the remaining 20 percent in the MSCI

Emerging Markets index. The expected return is 9.93

percent for the S&P 500 and 18.20 percent for the

Emerging Markets index. The risk (standard deviation) is

16.21 percent for the S&P 500 and 33.11 percent for the

Emerging Markets index. What will be the portfolio’s

expected return and risk given that the covariance

between the S&P 500 and the Emerging Markets index is

0.0050?

EXAMPLE 5-4 RETURN AND RISK OF A TWO-

ASSET PORTFOLIO (CONTINUED)

0.1158 11 .58%

0.80 2 0.16212 0.20 2 0.33112 (2 0.80 0.20 0.0050)

0.02281

0.02281 0.1510 15.10%

EXAMPLE 5-4 RETURN AND RISK OF A TWO-

ASSET PORTFOLIO (CONTINUED)

EXHIBIT 5-5 RISK AND RETURN FOR U.S. ASSET

CLASSES BY DECADE (%)

EXHIBIT 5-7 NOMINAL RETURNS, REAL RETURNS, AND

RISK PREMIUMS FOR ASSET CLASSES (1900–2008)

IMPORTANT ASSUMPTIONS OF MEAN-

VARIANCE ANALYSIS

Mean-variance

analysis

Markets are

Returns are informationally and

normally distributed operationally

efficient

EXHIBIT 5-9 HISTOGRAM OF U.S. LARGE

COMPANY STOCK RETURNS, 1926-2008

Violations of the

normality assumption:

skewness and

kurtosis.

UTILITY THEORY

Expected

Variance or

return

risk

1

U E (r ) A 2

Utility of an Measure of

investment risk

tolerance or

risk aversion

INDIFFERENCE CURVES

An indifference

curve plots the

combination of

risk-return pairs

that an investor

would accept to

maintain a given

level of utility.

PORTFOLIO EXPECTED RETURN AND

RISK ASSUMING A RISK-FREE ASSET

Assume a portfolio of two assets, a risk-free asset

and a risky asset. Expected return and risk for that

portfolio can be determined using the following

formulas:

E RP w1 R f 1 w1 E Ri

w 1 w1 2w1 1 w1 fi f i

2 2 2 2 2

P 1 f i

1 w1 i2

2

P 1 w1 1 w1 i

2 2

i

THE CAPITAL ALLOCATION LINE (CAL)

E(Rp)

CAL

E(Ri)

Equation of the CAL :

E Ri R f

E RP R f P

i

Rf

σp

σi

EXHIBIT 5-15 PORTFOLIO SELECTION FOR TWO

INVESTORS WITH VARIOUS LEVELS OF RISK AVERSION

CORRELATION AND PORTFOLIO RISK

Correlation

between assets

in the portfolio

Portfolio risk

EXHIBIT 5-16 RELATIONSHIP BETWEEN

RISK AND RETURN

EXHIBIT 5-17 RELATIONSHIP BETWEEN

RISK AND RETURN

AVENUES FOR DIVERSIFICATION

Diversify

with asset

classes

Diversify

Buy

with index

insurance

funds

Diversify

Evaluate

among

assets

countries

EXHIBIT 5-22 MINIMUM-VARIANCE

FRONTIER

EXHIBIT 5-23 CAPITAL ALLOCATION LINE

AND OPTIMAL RISKY PORTFOLIO

CAL(P) is

the optimal

capital

allocation

line and

portfolio P

is the

optimal

risky

portfolio.

THE TWO-FUND SEPARATION THEOREM

Investment

Decision

Optimal

Investor

Portfolio

Financing

Decision

EXHIBIT 5-25 OPTIMAL INVESTOR

PORTFOLIO

Given the

investor’s

indifference

curve,

portfolio C on

CAL(P) is the

optimal

portfolio.

SUMMARY

• Risk measures for individual assets and portfolios

• Market evidence on the risk-return tradeoff

• Correlation and portfolio risk

• The risk-free asset and the optimal risky portfolio

• Utility theory and the optimal investor portfolio

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