Portfolio Management and

Wealth Planning
Doç. Dr. Ayben Koy

akoy@ticaret.edu.tr
 Effective Annual Rate
 Total return as a rate of return for a common period,
 But we express all investment returns as effective annual rate (EAR).

Effective annual rate defined as the percentage increase in funds invested over a 1 year horizon.

• 1 + EAR = is the terminal value of a 1 $ investment for a 1-year

investment.
 Effective Annual Rate
 In general,
 rf(T) : total return
 T = holding period;
 EXAMPLE
 For the investments less then 1 year period;

 For a 6-month bill with 2.71% half year return,

 1 + EAR = (1.0271)^2 = 1,0549

 EAR = 5.49%

 We can gain 5.49% in a year from this investment

 EXAMPLE ?
 How much is the effective annual rate for a 3 month bill with a 1.5% return?
 Annual Percentage Rates (APR)
 Rates on short term investments (T is shorter than 1 year!) are annualized by simple interest.
 EXAMPLE
 For a 6 month bond, if the 6-month return is 2.71%,

 Per period rate is = 2*2.71 = 5.42%

 EXAMPLE ?
 How much is the annual rate for a 3 month bill with a 1.5% return?
 EXAMPLE ?
 If the annual rate for a 6 months investment is 6%, how much is the return for every 4 months?
 EXAMPLE ?
 If the effective annual rate for a 6 months investment is 6%, how much is the return for every 4
months?
Real rate & Nominal rate
 EXAMPLE ?
 If the nominal return on a one year investment is 15% and the inflation rate is 12%, how much
is the real rate?
 EXAMPLE ?
 How much is the real effective annual rate for a 6 month bill with a 8% return?
inflation rate: 10%
 Expected Return
 The expected rate of return is a probability – weighted averages of the rates of return in each
scenario.
 EXAMPLE

Probability Holding period

return (HPR)
Boom 0.3 0.34
Normal 0.5 0.14
Growth
Recession 0.2 -0.16
 E(r) = 0.3 * 0.34 + 0.5 * 0.14 + 0.2 * -0.16

= 0.14
 EXAMPLE?

Probability Holding period

return (HPR)
Boom 0.30 0.30
Normal 0.40 0.20
Growth
Recession 0.30 -0.10
 Components of Risk
 Diversifiable (Unsystematic) Risk
 Results from uncontrollable or random events that are firm-specific
 Can be eliminated through diversification
 Examples: labor strikes, lawsuits

 Nondiversifiable (Systematic) Risk

 Attributable to forces that affect all similar investments
 Cannot be eliminated through diversification
 Examples: war, inflation, political events
Components of Risk
 The Standard Deviation
 The standard deviation of the rate of return is a measure of risk.

 It is defined as the square root of variance.

 The higher volatility in outcomes, the higher will be the average value of these squared
deviations.
The Standard Deviation
 EXAMPLE
Probability Holding period return (HPR)

Boom 0.3 0.34

Normal 0.5 0.14
Growth

Recession 0.2 -0.16

E(r) = 0.14
 1) you should calculate expected return
 2) you should calculate the standard deviation
 EXAMPLE?

Probability Holding period return (HPR)

Boom 0.35 0.25

Normal 0.40 0.15
Growth

Recession 0.25 -0.05

 Excess Returns and Risk Premiums

 Risk Premium is the difference between holding period return and risk-free rate.

 Risk-free assets are Tbills, Money market funds, Money in the bank,…
 CFA QUESTION 1
 Given 100.000$ to invest, what is the expected risk premium in dollars of investing in equities
versus risk free T-bills based on the following table?
EXP. RETURN INVESTING IN EQUITIES
 (0.60 x 0.50) + ( 0.40 x – 0.30) = 0.18

The Expected Risk Premium: 0.18 – (5000/100000) = 0.18 – 0.05 = 0.13

CFA QUESTION 2
 (0.20 X -0.25) + (0.30 X 0.10 ) + (0.50 X 0.24)

 = 10 %
CFA QUESTION 3
 Reference
 Bodie, Z., Kane, A., & Marcus, A. J. Essentials of Investments 8th Edition. McGraw-Hill.