Risk, Return and The Historical Record: Bodie, Kane, and Marcus Eleventh Edition

Chapter
Risk, Return and the

5 Historical Record
Bodie, Kane, and Marcus

Essentials of Investments
Eleventh Edition
5.1 Rates of Return
• Holding-Period Return (HPR)
• Rate of return over given investment period
PS  PB  Div
HPR 
PB
where
PS  Sale Price
PB  Buy Price
Div  Cash Dividend
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2
5.1 Rates of Return: Example
• What is the HPR for a share of stock that was
purchase for $25, sold for $27 and distributed
$1.25 in dividends?
PS  PB  Div $27  25  1.25
HPR    13%
PB 25
Capital Gains Yield? Dividend Yield?

$27  25 $1.25
 8%  5%
25 25
5.1 Rates of Return: Measuring over Multiple Periods
• Arithmetic average
• Sum of returns in each period divided by number of periods
• Geometric average
• Single per-period return
• Gives same cumulative performance as sequence of actual
returns
• Compound period-by-period returns
• Dollar-weighted average return

• Internal rate of return on investment
Table 5.1 Rates of Return of a Mutual Fund: Example
1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of quarter 1 1.2 2 0.8
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of quarter 1.2 2 0.8 1.56
Arithmetic Average Geometric Average

10%  25%  ( 20%)  20% 1
 8.75% [(1.1)  (1.25)  (.8)  (1.2)]  1  7.19% 4
4
1.0 .5 .8 .96

Dollar-Weighted 0  1.0    
1  IRR (1  IRR ) (1  IRR ) (1  IRR ) 4
2 3
IRR  3.38%
5.1 Rates of Return
• Annualizing Rates of Return

• APR = Annual Percentage Rate
• Per-period rate × Periods per year
• Ignores Compounding
• EAR = Effective Annual Rate

• Actual rate an investment grows
• Does not ignore compounding
5.1 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)
5.2 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%
• Equilibrium Nominal Rate of Interest
• Fisher Equation
• R = r + E(i)
• E(i): Current expected inflation
• R: Nominal interest rate
• r: Real interest rate
Figure 5.1 Interest Rates, Inflation, and Real Interest Rates
• U.S. History of Interest Rates, Inflation, and
Real Interest Rates
• Since the 1950s, nominal rates have increased
roughly in tandem with inflation
• 1930s/1940s: Volatile inflation affects real rates
of return
5.3 Risk and Risk Premiums
• Scenario Analysis and Probability Distributions
• Scenario analysis: Possible economic scenarios; specify
likelihood and HPR
• Probability distribution: Possible outcomes with probabilities
• Expected return: Mean value
• Variance: Expected value of squared deviation from mean
• Standard deviation: Square root of variance
Spreadsheet 5.1 Scenario Analysis for the Stock Market
• The Normal Distribution
• Transform normally distributed return into

standard deviation score:
• Original return, given standard normal return:
Figure 5.2 Normal Distribution r = 10% and σ = 20%
• Normality over Time
• When returns over very short time periods are
normally distributed, HPRs up to 1 month can be
treated as normal
• Use continuously compounded rates where
normality plays crucial role
• 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:
5.3 Risk and Risk Premiums: Value at Risk
• Value at risk (VaR):

• Measure of downside risk
• Worst loss with given probability, usually 5%
• Risk Premiums and Risk Aversion
• Risk-free rate: Rate of return that can be earned
with certainty
• Risk premium: Expected return in excess of that
on risk-free securities
• Excess return: Rate of return in excess of risk-
free rate
• Risk aversion: Reluctance to accept risk
• Price of risk: Ratio of risk premium to variance
5.3 Risk and Risk Premiums: Sharpe Ratios
• The Sharpe (Reward-to-Volatility) Ratio
• Ratio of portfolio risk premium to standard
deviation
• Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios
Portfolio Risk Premium E (rp )  rf
SP 
Standard Deviation of Excess Returns P
where
E (rp )  Expected Return of the portfolio
rf  Risk Free rate of return
 P  Standard Deviation of portfolio excess return
Table 5.5: Excess Returns
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
Table 5.3: Historical Return and Risk
Historic Returns: Treasury Bills
Historic Returns: Treasury Bonds
Historic Returns: Equity Markets
5.5 Asset Allocation across Portfolios
• Asset Allocation
• Portfolio choice among broad investment
classes
• Complete Portfolio
• Entire portfolio, including risky and risk-free
assets
• Capital Allocation
• Choice between risky and risk-free assets
• The Risk-Free Asset
• Treasury bonds (still affected by inflation)
• Price-indexed government bonds
• Money market instruments effectively risk-free
• Risk of CDs and commercial paper is miniscule
compared to most assets
5.5 Portfolio Asset Allocation: Expected Return and Risk
y = share invested in the risky portfolio.
Expected Return of the Complete Portfolio So, 1-y is the share of risk free portfofolio.
E (rC )  y  E (rp )  (1  y )  r f
where E (rC )  Expected Return of the complete portfolio
E (rp )  Expected Return of the risky portfolio
rf  Return of the risk free asset
y  Percentage assets in the risky portfolio
Standard Deviation of the Complete Portfolio

 C  y  p Rf is constant over time (sigma(Rf) = 0)
where  C  Standard deviation of the complete portfolio

 P  Standard deviation of the risky portfolio
Sharpe Ratio
c m
Figure 5.6 Investment Opportunity Set
y=1
y=0
• Capital Allocation Line (CAL)

• Plot of risk-return combinations available by
varying allocation between risky and risk-free
• Risk Aversion and Capital Allocation
• y: Preferred capital allocation
5.6 Passive Strategies and the Capital Market Line
• Passive Strategy
• Investment policy that avoids security analysis
• Capital Market Line (CML)

• Capital allocation line using market-index
portfolio as risky asset
The only difference between the CAL and the CML is that in the CML we have
M instead of P, because M is the market portfolio that replicates a market index.
5.6 Passive Strategies and the Capital Market Line
• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple
• Expense ratio of active mutual fund averages 1%
• Expense ratio of hedge fund averages 1%-2%,
plus 10% of returns above risk-free rate
• Active management offers potential for higher
returns Because there are strategies that offer higher returns
than passive investing, but some traders don’t perform
better than the makret and pay a lot in fees.

Risk, Return and The Historical Record: Bodie, Kane, and Marcus Eleventh Edition

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Risk, Return and The Historical Record: Bodie, Kane, and Marcus Eleventh Edition

Uploaded by

Copyright:

Available Formats

Chapter

Risk, Return and the

Bodie, Kane, and Marcus

Capital Gains Yield? Dividend Yield?

• Dollar-weighted average return

1st 2nd 3rd 4th

Arithmetic Average Geometric Average

1.0 .5 .8 .96

• Annualizing Rates of Return

• EAR = Effective Annual Rate

For Continuous Compounding:

• Probability distribution: Possible outcomes with probabilities

• Expected return: Mean value

• Variance: Expected value of squared deviation from mean

• Standard deviation: Square root of variance

• Transform normally distributed return into

• Original return, given standard normal return:

• Using Time Series of Return

• Value at risk (VaR):

Standard Deviation of the Complete Portfolio

where  C  Standard deviation of the complete portfolio

• Capital Allocation Line (CAL)

• Capital Market Line (CML)

• Cost and Benefits of Passive Investing

You might also like