Fundamental Principles of Finance

 There is no free lunch available, no arbitrage.

 Keeping other things equal, individuals:
 Prefer more over less (non-satiation).
 Prefer to consume today then later (impatient).
 Avoid risk (risk aversion).
 All agents maximizes their utility functions.
 Prices are determined in equilibrium.
 Financial markets are competitive/efficient.
 Frictions to trade are central to financial markets.
Chapter 5

Introduction to Risk, Return,

and the Historical Records.
Learning Objectives
 Determination of interest rate, difference between
nominal and real interest rate.
 Comparing the returns for different holding periods.
 Historical returns on safe investments.
 Risk and Premiums.
 Characteristics of normal distribution and how well it
manifest the financial returns.
 VAR, ES ,LPSD and Sortino Ratio.
 Historical returns on risky portfolios and inferences
for future.
Real and Nominal Rates of Interest
 Nominal interest rate: Growth rate of your money.
 Even if an interest rate is risk-free for one unit of account
and time period, it will not be risk-free for other units or
periods.
 Real interest rate: Growth rate of your purchasing power.
 As the inflation rate increases, investors will demand
higher nominal rates of return.
 R = nominal rate, r = real rate and i = inflation rate.

 And if E(i) denotes current expectations of inflation, then

we get the Fisher Equation:
Example
Determinant of Level of Interest Rates.

Supply Households/savers
• Demand
Businesses/investment
Government’s
– Deficits and increased
government borrowing,
shifts demand curve right
– Expansionary monetary
policy, increasing money
supply shifts supply curve
Right.
Understanding ?????

 Demand curve to the …..

 Supply of funds curve to……..
 Supply of funds curve to ……..
Understanding ????
Comparing Rates of Return for
Different Holding Periods.
 Zero Coupon Bond : Given the price P(T) of a
treasury bond with $100 par value with maturity
of T years, the total risk-free return available for
time horizon T years can be represented as,

 For given T=1, above provides the risk free rate

for investment horizon of one year.
Example
Continuation…
 It is very obvious from the above table that these
returns for different horizons are non-
comparable.
 To compare the returns of the zero-coupon
treasuries with different maturities is to calculate
their annual returns.
 There are two methods to estimate that, one this
effective annual rate (EAR) and second is
annual percentage rate (APR).
Continued…
 EAR

 APR
 Conversion of rf(T) in APR requires,
 APR= n x rf(T), if rf(T) is monthly return then APR= 12 x
rf(T), conversely rf(T)= T x APR.
 n is number of compounding periods in a year
Continued..
 Relationship between APR and EAR.
Continuous Compounding.
 From table 5.1 is quite obvious that as T decreases the
difference between EAR and APR increases. We want to
drive a relationship between EAR and APR when T
approaches in limit to 0.

 The end result is

Table 5.1.
Assignment.
 Find EAR and APR through equivalence formula for
different treasuries with different compounding periods
and P(T)= discount price (par value is $100).
 Compounding period,1 year, 6 months, one quarter, one
month, one week, one day.
 P(T), 94.52, 97.22, 98.60, 99.53, 99,90, 99.98.
 Compute the APR and EAR of one day bond and show
that holds.
Concept Check

rf(T)=0.01
EAR= (1+rf(T))1/T -1
EAR=ercc -1
T-Bill versus Inflation rate
T-Bill versus Inflation rate
Summary Bills and Inflation
 Moderate inflation can offset most of the nominal gains
on low-risk investments.
 A dollar invested in T-bills from1965–2009 grew to
$10.52, but with a real value of only $1.69.
T-Bills versus Inflation Rate (Pakistan)
T-Bills and Inflation
0.05

0.04

0.03

0.02

0.01

0
1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 0 0 1 1 2 2 3 3 4 4 5 5
2 00 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 201 201 201 201 201 201 201 201 201 201 201 201
/ / / / / / / / / / / / / / / / / / / / / / / / / / / / /
31 /28 /30 /28 /29 /27 /31 /28 /31 /28 /31 /28 /31 /29 /29 /27 /31 /26 /31 /28 /31 /29 /31 /28 /30 /28 /29 /27 /31
-0.01
/
8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8 2 8

Inflation Rate Nominal Interest Rates

Summary Bills and Inflation (Pakistan)
Returns In Pakistan
WI(RP) WI(RR) WI(NI)

7 7

4
3
3

1 1

0
4/19/2001 1/14/2004 10/10/2006 7/6/2009 4/1/2012 12/27/2014 9/22/2017
Risk and Risk Premiums
Rates of Return: Single Period

HPR = Holding Period Return

P0 = Beginning price
P1 = Ending price
D1 = Dividend during period
one
Simple example of one period HPR

Ending Price = 48
Beginning Price = 40
Dividend = 2

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

Expected Return and Standard
Deviations.
 Expected returns

p(s) = probability of a state

r(s) = return if a state occurs
s = state

Variance:
Example
Do it yourselves…
Concept Check 3
Exercise
HPR related ….
Time Series Analysis of Past rates of
Return.
 Scenario Analysis.
 Assigning probability to an outcome.
 Expected Returns.
 Expected variance.
 Time Series.
 Realized returns from past series.
 Need to infer the probabilities, like from which
distribution then returns are drawn.
Continued…
 In the case of realized returns we assume each state of
nature is equally likely.

 Similarly for the variance we have to estimate it from the

observed data.
Continued…
 For the calculation of variance we estimated
mean of the returns from the realized data,
therefore the degree of freedom is reduced
which can be adjusted as under.
Example…
The Geometric (Time-Weighted)
Average.
 The arithmetic average provides the estimate for
the expected return, but it does not tell us about
the actual performance of the portfolio.
 In previous spreadsheet there is shown the
wealth index from investing 1$ in the S&P index.
This can be traced through geometric mean.
Continued…
 There is visible difference between Geo.M and
Arithmetic. M, and this difference is wide if observations
are more apart. For that read example 5.7.
 However, if distribution of returns is normal that they are
interlinked with this relationship.
Sharpe Ratio
 Some thing about Sharpe ratio. If the returns are
normally distributed and the portfolio is well diversified
then the Sharpe ratio is very good guide for return
volatility relationship.
Normal Distribution.
 Even if the normal distribution is not the most accurate
description of financial returns. It is still the standard to
interpret returns in terms of normal distribution.
 One of the obvious benefit of describing return as such is
that we need to estimate just two parameters only, the
mean and, the standard deviation to describe the whole
data. See how,
 Suppose the returns on S&P-500 are approximately
normally distributed with mean 1% and Standard
deviation of 6%. What is the probability that the return on
the index in any month is negative.
 Calculated the z value and look into probability table.
Normal distribution.
 Some stylized facts about normal distribution.
Deviation from Normality and Risk
Measures.
 The deviation from normality is usually observed
by calculating higher moments of return
distributions.
 In terms of returns these moments can be
expressed as Where n shows the order
of moment, now first moments is always zero.
The second moment is variance, the third
moment is skew and fourth is kurtosis.
What does Skew and Kurtosis tell…
 Positive skew means more positive returns and
negative skew means more negative returns.
Continued….
 The kurtosis should be 0 for normal distribution , if it is
positive then it means that there much more data in the
tails of the distribution.
Value at Risk
 One of the most important measure of risk, it is a value
below which, there are 5% of the worst returns.
Alternatively above this, there are 95% of the returns.
 When portfolio returns are normally distributed then we
can find this value using simple relationship.

 Otherwise to estimate VAR we start with percentiles,

which divides the whole data into 100 parts.
 The VaR is 5th percentile of the sample distribution.
Assume that the sample is of 84 annual returns (1926-
2009). The 5th percentile number comes out 4.2.
Continued…
 This means it is between 4th and 5th observation. We
have the data as -25.03%, -25.69, -33.49%, -41.03%,
-45.64%.
 VaR=-25.69+.2(25.69-25.03)=-25.56%
 VaR= .2(-25.03%)+.8(-25.69)=-25.56%.
 Expected Shortfall.
 Another more realistic measure of downside risk is
expected short (EC), given we find ourselves in worst
case scenario.
Continued…
 In continuation of above example the EC is
calculated, by first finding the equally likely
probabilities of the returns. For example for last
four returns the probability is 4/4.2 and for VaR
value the probability is .2/4.2.
 Now take the average of last four returns as (-
45.64%-41.03%-33.49%-25.69%)/4 = -36.4625.
Lastly E (C) = (-36.4625)*4/4.2 + (-
25.56)*.2/4.2= -35.94%.
Lower Partial Standard Deviation and
Sortino ratio.
 When distribution of the returns is not normal then the
standard deviation scales down the risk. Because the
when distribution is negatively skewed then the both part
of the distribution must be seen separately.
 To account for this factor, the LPSD, takes the variance
of only those observations in which the excess returns
are negative. The issue with this method is that it ignores
the frequency of negative returns.
 The Sortino ratio is counter part of sharp ratio and when
returns are not normally distributed, then it ratio is more
suggestive of real situation.
Log Normal Distribution
 Take the example of profits of 5.54% and loses of
-3.54% on the monthly basis and probability of their
occurrence is 0.5. Mean return is 1% and SD is 4.54%.
Binomial Distribution
Continued…
 If we run this experiment for 300 months and draw the
distribution.
Risk in the Long Run and the
Lognormal Distribution.
 When the continuously compounded rate of
return on an asset is normally distributed at
every instant, the effective rate of return, the
actual HPR, will be lognormally distributed.
 Ignore the difference between normally and
lognormal distribution if time period is small.
Continued.
  
 The month return rcc is 0.96% and is 4.5%, the risk free rate is .
5%. Find the probability of short fall for a month.
=NORMSDIST((.005-.0096)/.045) = 0.46

 If investment horizon is of 300 months, then what would be the

probability of short fall. Mean = T*0.0096 and SD= .045 x (T).
Similarly for risk free rate Mean = T * 0.005
=NORMSDIST(-1.38/0.779) = 0.038
 Problem 1

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

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

5-53
 Problem 5

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

Boom: (50 – 40 + 2)/40 = 0.30 =
Normal: 30.00%
(43 – 40 + 1)/40 = 0.10 = 10.00%
Recession: (34 – 40 + 0.50)/40 = –0.1375 = –
E(HPR) = 13.75%
[(1/3) x 30%] + [(1/3) x 10%] + [(1/3) x (–13.75%)] = 8.75%
2(HPR) 0.031979

5-54
 Problem 5 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%

5-55