Chapter 5

Risk and Return: Past and Prologue

5-1
5-2
THE PREVIOUS TWO CENTURIES

5-3
 Study: A new historical database for the NYSE 1815
to 1925: Performance and predictability

The previous figure came from a study:

“A new historical database for the NYSE
1815 to 1925: Performance and
predictability.”
JFM 2001 Goetzmann et al.

5-4
INFLATION IMPACT ON PURCHASING POWER

5-5
 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
5-6
Rates of Return: Single Period Example

Ending Price = 48
Beginning Price = 40
Dividend = 2

HPR = (48 - 40 + 2 )/ (40) = 25%

5-7
Measuring Investment Returns Over Multiple Periods

May need to measure how a fund

performed over a preceding five-year
period
Return measurement is more
ambiguous in this case

5-8
Rates of Return of a Mutual Fund: Example

Arithmetic Average
10%  25%  (20%)  20%
 8.75%
4

Geometric Average
1
[(1.1)  (1.25)  (.8)  (1.2)]  1  7.19%
4

5-9
Returns Using Arithmetic and Geometric Averaging

Arithmetic
ra = (r1 + r2 + r3 + ... rn) / n
ra = (.10 + .25 - .20 + .25) / 4
= .10 or 10%
Geometric
rg = {[(1+r1) (1+r2) .... (1+rn)]} 1/n - 1
rg = {[(1.1) (1.25) (.8) (1.25)]} 1/4 - 1
= (1.5150) 1/4 -1 = .0829 = 8.29%

5-10
 Dollar Weighted Returns

Internal Rate of Return (IRR) - the

discount rate that results in present
value of the future cash flows being
equal to the investment amount
Considers changes in investment
Initial Investment is an outflow
Ending value is considered as an inflow
Additional investment is a negative flow
Reduced investment is a positive flow
5-11
 Dollar Weighted Average

Net CFs 1 2 3 4
$ (mil) - 0.1 -0 .5 0.8 1.0

0.1 0.5 0.8 1.0

1.0      4.17%
1  IRR (1  IRR) (1  IRR) (1  IRR)
2 3 4

5-12
 Quoting Conventions

APR = annual percentage rate

(periods in year) X (rate for period)
EAR = effective annual rate
( 1+ rate for period)Periods per yr - 1
Example: monthly return of 1%
APR = 1% X 12 = 12%
EAR = (1.01)12 - 1 = 12.68%

5-13
Rates of Return: EAR vs. APR

For n periods of compounding:

APR n
EAR  (1  ) 1
n
1
APR  [( EAR  1)  1]  n
n

where
n  compounding per period

For Continuous Compounding:

EAR  e APR  1
APR  ln( EAR  1)

5-14
Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1 R
1 r 
1 i
where
r  Real Interest Rate
R  Nominal Interest Rate
i  Inflation Rate

Example : What is the real return on an investment that earns a nominal 10%
return during a period of 5% inflation?
1  .10
1 r   1.048
1  .05
r  .048 or 4.8%

5-15
Inflation and The Real Rates of Interest

• Equilibrium Nominal Rate of Interest

• Fisher Equation
• R = r + E(i)
• E(i): Current expected inflation
• R: Nominal interest rate
• r: Real interest rate

5-16
 Real vs. Nominal Rates
Fisher effect: Approximation
real rate  nominal rate - inflation rate
rreal  rnom - i rreal = real interest rate
Example rnom = 9%, i = 6%
rnom = nominal interest rate
rreal  3%
i = expected inflation rate
Fisher effect: Exact
rreal = [(1 + rnom) / (1 + i)] – 1 or
rreal = (rnom - i) / (1 + i)
r = (9% - 6%) / (1.06) = 2.83%
real

The exact real rate is less than the approximate real rate.

5-17
5-17
 Real vs. Nominal Rates

1 R
1 r  or:
1 i
R i
r 
1 i

With previous data:

2.83% = (9%-6%) / (1.06)

5-18
Interest, Inflation and Real Rates of Return

5-19
RISK AND RISK PREMIUMS

5-20
Characteristics of Probability Distributions
1) Mean: most likely value
2) Variance or standard deviation

3) Higher moments: Skewness and kurtosis.

Stock returns are sometimes said to be

“leptokurtotic” that is, peaked in the
center with fat tails.

* If a distribution is approximately normal,

the distribution is described by
characteristics 1 and 2.

5-21
Normal Distribution r = 10% and σ = 20%

5-22
Risk and Risk Premiums

5-23
 5.3 Risk and Risk Premiums
• Deviation from Normality and Value at Risk
• Kurtosis: Measure of fatness of tails of probability
distribution; indicates likelihood of extreme outcomes
• Skew: Measure of asymmetry of probability distribution

• Using Time Series of Return

• Scenario analysis derived from sample history of returns
• Variance and standard deviation estimates from time
series of returns:

5-24
Some measures of a distribution

LPSD – lower partial standard deviation.

It is the s.d of the negative side of the
distribution.
VaR normal – 5% point of a normal
distribution = mean minus 1.65 s.d.
VaR actual – 5% point of a distribution

5-25
Skewed Distribution: Large Negative Returns Possible

Median

Negative mean Positive

5-26
Skewed Distribution: Large Positive Returns Possible

Median

mean

5-27
Mean Scenario or Subjective Returns

Subjective returns
s
E (r )   p s r s
1
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states

5-28
Scenario or Subjective Returns: Example

State Prob. of State r in State

1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35

E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)

E(r) = .15

5-29
 Variance or Dispersion of Returns
Subjective or Scenario
2

s
  
   p s  r s  E r   2

SD(r )    Var (r )
Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095

5-30
Risk Premiums and Risk Aversion

Degree to which investors are willing to

commit funds
 P2
Risk aversion
If T-Bill denotes the risk-free rate, rf, and
variance,  P2 , denotes volatility of returns
then:
The risk premium of a portfolio is:

E (rP )  rf
5-31
Risk Premiums and Risk Aversion

To quantify the degree of risk aversion with

parameter A:

1
E (rP )  rf  A P
2

E ( rP )  rf
A
1
 P2
2

5-32
The Sharpe (Reward-to-Volatility) Measure

portfolio risk premium

S
standard deviation of portfolio excess return

E (rP )  rf

P

5-33
Risk and Risk Premiums: Historical Sharpe Ratios

5-34
 5.4 The Historical Record: World Portfolios

• World Large stocks: 24 developed countries,

~6000 stocks
• U.S. large stocks: Standard & Poor's 500 largest
cap
• U.S. small stocks: Smallest 20% on NYSE,
NASDAQ, and Amex
• World bonds: Same countries as World Large
stocks
• U.S. Treasury bonds: Barclay's Long-Term
Treasury Bond Index

5-35
The Historical Return and Risk

5-36
Historic Returns: Treasury Bills

5-37
Historic Returns: Treasury Bonds

5-38
Historic Returns: Equity Markets

5-39
A Note on Continuous Compounding
( APR) of  6% per year compounded semiannually.
The effective annual return ( EAR), accounting for compounding is :
compounding period rate  3% thus FV  (1.03) 2  1.0609
REAR  1.0609  1  .0609 or 6.09% per year

n
 APR 
In general we use REAR  1   1
 n 
where APR is the annual percentage rate and n is the
numberof compounding periods
n
 APR 
as n increases  1   e
APR
w / e  2.71828
 n 
e.06  1.0618365  REAR  0.0618365 or 6.18356% per year
1  REAR  e APR  APR  ln( 1  EAR)

5-40
 .

The optimal point between the risk-free

and the risky portfolio

Risk and Risk Aversion

5-41
 Expected payoffs

In practice, we tend to use historical

averages as proxies for the expected
return and standard deviation.
But one can calculate these things by
assigning probabilities to payoffs in all
different states of the world, and then
estimate expected payoffs.

5-42
 Risk - Uncertain Outcomes

W1 = 150 Profit = 50

W = 100
1-p = .4
W2 = 80 Profit = -20

E(Wealth) = pW1 + (1-p)W2 = 6 (150) + .4(80) = 122

E(R) = (122-100)/100 = 22%
2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 =
.6 (150-122)2 + .4(80-122)2 = 1,176.
  34.293

5-43
 Risky Investments with Risk-Free

W1 = 150 Profit = 50
Risky Inv.

1-p = .4
100 W2 = 80 Profit = -20

Risk Free T-bills Profit = 5

Risk premium = R – rf
RP = 50(0.6) – 20(0.4) – 5
RP = 30 – 8 – 5
Risk Premium = 17
5-44
 Risk Aversion & Utility
We use the concept of investor utility to map investor
preferences to their optimal portfolio
Where an “optimal” portfolio is some {E(r), }
combination (which is just a vector of weights of the
component assets).

Investor’s view of risk

Risk Averse
Risk Neutral
Risk Seeking

Which type are YOU?

Utility

Typical utility function

U = E ( r ) - .005 A  2
A measures the degree of risk aversion

5-45
 Risk Aversion and Value:

Assume E(r) = 22%,   34%

Utility = E ( r ) - .005 A  2
= 22 - .005 A (34) 2
Risk Aversion A Utility
High 5 -6.90
3 4.66 T-bill = 5%
Low 1 16.22

5-46
 Dominance Principle

Expected Return

4
2 3
1

Variance or Standard Deviation

• 2 dominates 1; has a higher return
• 2 dominates 3; has a lower risk
• 4 dominates 3; has a higher return
Does 3 dominate 1? How do we decide?
Lets do an example…
5-47
 Utility and Indifference Curves

Represent an investor’s willingness to trade-

off return and risk.
Example (A=4)
Exp Ret St Deviation U=E ( r ) - .005A2
10 20.0 2
15 25.5 2
20 30.0 2
25 33.9 2

Concept of “indifference” – same utility, so you are

indifferent between Exp Ret/St Deviation pairs.

5-48
 Indifference Curves

Expected Return

Increasing Utility

Standard Deviation
5-49
 Expected Return

Rule 1 : The return for an asset is the

probability weighted average return in
all scenarios.

E (r )   P ( s )r ( s )
s

5-50
 Variance of Return

Rule 2: The variance of an asset’s return

is the expected value of the squared
deviations from the expected return.

  s P ( s )[ r ( s )  E ( r )]
2
2

5-51
 Return on a 2-asset Portfolio

Rule 3: The rate of return on a portfolio is a weighted

average of the rates of return of each asset
comprising the portfolio, with the portfolio proportions
as weights.

rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2

5-52
 Portfolio Risk with one risky and one risk-free asset

Rule 4: When a risky asset is combined with a risk-free

asset, the portfolio standard deviation equals the
risky asset’s standard deviation multiplied by the
portfolio proportion invested in the risky asset.

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

If r2=risk free asset, then 2 = 0,
and Cov(r1r2) = ?

Thus,
 p  wriskyasset   riskyasset

5-53
 Portfolio risk with two risky assets

Rule 5: When two risky assets with variances 12 and 22,
respectively, are combined into a portfolio with portfolio weights
w1 and w2, respectively, the portfolio variance is given by:

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

Cov(r1r2) = 1*2*correlation(r1r2)

Correlation is between -1 to 1, but covariance is unbounded.

5-54
 Portfolio Risk

I know what you are thinking…were the heck

did this portfolio standard deviation formula
come from?

Lets derive it!

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

5-55
Next few chapters; baby portfolio, teenage, adult, and geriatric
portfolios.

5-56
5-57
 .

Capital Allocation Between The

Risky And The Risk-Free Asset

5-58
Allocating Capital: Risky & Risk Free Assets

It’s possible to split investment funds

between safe and risky assets.
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)

5-59
Allocating Capital: Risky & Risk Free Assets

Issues
Examine risk/return tradeoff.
Demonstrate how different degrees
of risk aversion will affect
allocations between risky and risk
free assets.

5-60
 Example

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf

5-61
 Expected Returns for Combinations

E(rc) = yE(rp) + (1 - y)rf

rc = complete or combined portfolio

For example, y = .75

E(rc) = .75(.15) + .25(.07)
= .13 or 13%
E (rc )  r f  y [ E (rp  r f )]

5-62
 Possible Combinations

E(r)

E(rp) = 15%
P
E(rc) = 13%
C

rf = 7%
F


0 c 22%
5-63
Variance For Possible Combined Portfolios

Since  r = 0, then
f

 c = y  p*

5-64
 Combinations Without Leverage

If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
5-65
Using Leverage with Capital Allocation Line

Borrow at the Risk-Free Rate and

invest in stock

Using 50% Leverage

rc = (-.5) (.07) + (1.5) (.15) = .19

sc = (1.5) (.22) = .33

5-66
Invest Opportunity Set with a Risk-Free Invest.

5-67
Capital allocation line – refer to Fig 5.5

Remember the equation of a line?

Y=mx + b
Y = E(r)
M = slope of line = rise/run
= (15-7)/22=8/22 = the Sharpe ratio
b= intercept = 7
E(r) = 7 +8/22 p

5-68
Capital Allocation Line with Leverage

Borrow at the Risk-Free Rate and invest in

stock.
Using 40% Leverage,
E(Rc) = (-.4) (.07) + (1.4) (.15) = .182 or
18.2%

Weights sum to 1: -.4 + 1.4 = 1

Stdev.c = (1.4) (.22) = .308 or 30.8%

(18.2-7)/30.8=0.36 (15-9)/22=.27
5-69
 CAL with Higher Borrowing Rate

E(r)
Lower Sharpe ratio for the
borrower

P
SR = .27

9%
SR = .36
7%


p = 22%

5-70
 Risk Aversion and Allocation

Greater levels of risk aversion lead to larger

proportions of the risk free rate.
Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets.
Willingness to accept high levels of risk for
high levels of returns would result in
leveraged combinations.

5-71
Costs and Benefits of Passive Investing

Active strategy entails costs

Free-rider benefit
Involves investment in two passive
portfolios
Short-term T-bills
Fund of common stocks that mimics a
broad market index

5-72
 The Optimal weights

If Passive Investing is the “right way”

we still need to tailor (optimize) the
proportions
of the risk-free and risky assets
according to the risk profile (represented in
her utility function) of the investor.
Optimal weights = weights that maximize the
investor’s utility

5-73
 Utility Function

U = E ( r ) - .005 A 2
Where
U = utility
E ( r ) = expected return on the asset or
portfolio
A = coefficient of risk aversion (A=4 in the ex)
2 = variance of returns

5-74
 Derive the optimal y
max y U  E (rc )  0.005 A c 

 max y rf  y[ E (rp  rf )]  0.005 Ay 2 p2 
E (rp )  rf
y 
*
 0.41
0.01A 2
p

with rf  7%; E (rp )  15% and  p  22%, A  4

Resulting optimal portfolio

Expected Return= 7+0.41(15-7)=10.28%
Stdev=0.41*.2=9.02%

5-75
 CAL with Risk Preferences
The lender has a larger A when
compared to the borrower
E(r)

Borrower

7%
Lender


p = 22%
5-76
Optimal Portfolio Mean=10.28 and Standard Dev =9.02

5-77
 Example

U  E (r )  0.005  A   2
5  E (r )  0.005  4  12
the necessary exp ected return is
Necessary E (r )  5  0.005  4 12  5.02%
changing  2 and calculatin g the necessary E (r ), For a given level of
utility , yield all the possible combinations of exp ected return
and volatility used to draw the indifference curve ( for U  5).

REPEATING the process for different levels of U leads to

Figure 7.6 in the previous slide .

5-78
 A Passive Strategy

Investing in a broad stock index and a risk

free investment is an example of a passive
strategy.

The investor makes no attempt to actively find

undervalued strategies nor actively switch
their asset allocations.

The CAL that employs the market (or an index

that mimics overall market performance) is
called the Capital Market Line or CML.

5-79
5-79
Active versus Passive Strategies

Active strategies entail more trading costs than

passive strategies.
Passive investor “free-rides” in a competitive
investment environment.
Passive involves investment in two passive
portfolios
Short-term T-bills
Fund of common stocks that mimics a broad
market index
Vary combinations according to investor’s
risk aversion.

5-80
5-80
Selected Problems

5-81
5-81
 Problem 1

V(12/31/2004) = V (1/1/1998) x (1 + GAR)7

= $100,000 x (1.05)7 =
$140,710.04

→
5-82
5-82
 Problem 2

a. The holding period returns for the three scenarios are:

Boom: (50 – 40 + 2)/40 = 0.30 = 30.00%
Normal: (43 – 40 + 1)/40 = 0.10 = 10.00%
Recession: (34 – 40 + 0.50)/40 = –0.1375 = –13.75%
E(HPR) = [(1/3) x 30%] + [(1/3) x 10%] + [(1/3) x (–13.75%)] = 8.75%
2(HPR) σ 2(HPR)  [(1/3) x (30% – 8.75%)2 ]  [(1/3) x (10% – 8.75%)2 ]  [(1/3) x (–13.75%– 8.75%)2 ]  0.031979
σ (HPR)  17.88%
→
5-83
5-83
 Problem 2 Cont.

Risky E[rp] = 8.75%

Risky p = 17.88%
b. E(r) = (0.5 x 8.75%) + (0.5 x 4%) = 6.375%

 = 0.5 x 17.88% = 8.94%

→
5-84
5-84
 Problems 3 & 4

3. For each portfolio: Utility = E(r) – (0.5  4  2 )

Investment E(r)  U
1 0.12 0.30 -0.0600
2 0.15 0.50 -0.3500
3 0.21 0.16 0.1588
4 0.24 0.21 0.1518
We choose the portfolio with the highest utility
value, which is Investment 3.
→
5-85
5-85
 Problems 3 & 4 Cont.

4. When an investor is risk neutral, A = 0_ so that the portfolio with the

highest utility is the portfolio with the _______________________.
highest expected return
Investment 4
So choose ____________.

→
5-86
5-86
 Problem 5

b. DWR
a. TWR Return = [(capital gains + dividend) / Cash
Time Explanation
Year price] flow
Purchase of three shares at $100 per
(110 – 100 + 4)/100 = 14.00% 0 -300
2007-2008 share
a. TWR

2008-2009 Purchase of two shares at $110,

(90 – 110 + 4)/110 = –14.55%
1 -208 plus dividend income on three shares
held
2009-2010
(95 – 90 + 4)/90 = 10.00%
Dividends on five shares,
2 110
plus sale of one share at $90
14.00%  14.55%  10.00%
AAR   3.15% Dividends on four shares,
3 3 396 plus sale of four shares at $95 per share
GAR  [1.14x(1  0.1455)x1. 10] 1/3  1  2.33%
$300 $208 $110 $396
$0      -0.1661%
(1  IRR) 0 (1  IRR) 1 (1  IRR) 2 (1  IRR) 3
→ 5-87
5-87