Lecture 3 Review

How securities are traded in both primary

markets and secondary markets
Types of orders
Cost of trading
Calculations in buying on margin and short
selling

2-1
 Objective
Learning about factors influencing the
level of interest rate
Risk and Return Stat Measure
Holding Period, Expected return
Ex post or Ex ante

2-2
 Factors affecting Rates
Supply
– Households
Demand
– Businesses
Government’s Net Supply and/or Demand
– Federal Reserve Actions
Expected rate of inflation

2-3
 Determination of
Equilibrium Real Rate of Interest

2-4
Real and Nominal Interest Rate
Nominal interest rate (rn):
– Growth rate of your money
Real interest rate (rr):
– Growth rate of your purchasing power
where is the rate of inflation
As the rate of inflation increases, investors
will demand higher nominal rates of
returns

2-5
Inflation, Taxes, and Returns
Tax liabilities are based on nominal
income
The inflation rate for 2020 was 2.1%.
Suppose you earn 6% nominal, pre-tax
rate of return and if you have 15% tax
bracket, and face 2.1% inflation rate, what
is your real rate?
rreal  [6% x (1 - 0.15)] – 2.1%  3%

2-6
 Return for Holding Period-
Zero coupon bond with FV=100
T=maturity, P=price, r=risk free rate

100
r f
(T ) 
P (T )
1

2-7
Annualized Rates of Return

2-8
 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%

2-9
 General Formula
for EARs and APRs
EAR  {1 r f (T )} 1
[1 / T ]

1 r (T )
T

APR  (1 EAR ) 

f

T
T

2-10
 Holding Period Return
Rates of return: Single period

HPR  P P D
1 0 1

P 0

P0  Beginning Price
P1  Ending Price
D1  Cash Dividend

2-11
 Rates of Return:
Single Period Example

Suppose you buy stock and sell in 1 year

Ending Price = 24
Beginning Price = 20
Dividend = 1

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

2-12
 Rates of Return:
Multiple Period Example
Suppose you buy stock and sell in 2 year
Ending Price = 45
Beginning Price = 52
Dividend at year 2 = 8

HPR = ( 45 – 52 + 8 )/ 52 = 1.92%
HPR_ann=1.92/2=0.96%
HPR_ann=(1+0.0192)^(1/2)-1=0.957%
2-13
 Holding Period Return Quiz
What is your current value of your WSS
portfolio? What is your return so far with
the beginning balance of $1M?
Annualized return?
What is the best (worst) performing
security with the highest (lowest) holding
period return so far?

2-14
 Time Series Analysis
Holding period returns can be collected
over time
Time series observations of HPRs help us
to estimate (or forecast) the true means
and variances of asset return distribution

2-15
 Expost Return & 
n HPR
r  T r  average HPR
T 1 n n  # observatio ns
n
1
Expost Variance :  2  
n  1 i 1
( ri  r ) 2

Expost Standard Deviation : σ  σ 2

Annualizing the statistics:

rannual  rperiod  # periods

 annual   period  # periods

2-16
5-16
Annual Holding Period Returns

Geom. Arith. Stan.

Series Mean% Mean% Dev.%
World Stk 9.41 11.17 18.38
US Lg Stk 10.23 12.25 20.50
US Sm Stk 11.80 18.43 38.11
Wor Bonds 5.34 6.13 9.14
LT Treas 5.10 5.64 8.19
T-Bills 3.71 3.79 3.18
Inflation 2.98 3.12 4.35

2-17
Annual Holding Period Excess Returns

Arith. Stan.
Series Mean% Dev.%
World Stk 7.37 18.69
US Lg Stk 8.46 20.80
US Sm Stk 14.64 38.72
Wor Bonds 2.34 8.98
LT Treas 1.85 8.00

2-18
Histograms of Rates of Return

2-19
Nominal Real Equity Returns Around the World

2-20
Standard Deviations of Real Equity and
Bond Returns Around the World

2-21
Expected and Realized Returns
At the start of the investment period, asset
prices are not known. We can only
calculate the expected return.
At the end of the investment period, we
know what happened to asset prices, so
we can calculate the realized return.
Two numbers are very different.
Usually, you assume…

2-22
 Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness, Kurtosis

* If a distribution is approximately normal,

the distribution is described by
characteristics 1 and 2

2-23
Normal Distribution

s.d. s.d.

r
Symmetric distribution

2-24
Normal and Skewed Distributions

Mean = 6%, SD = 17%

2-25
Normal and Fat-Tailed Distributions

Mean = .1, SD = .2

2-26
 Measuring Mean:
Scenario or Subjective Returns

Subjective expected returns

E(r) = S p(s) r(s)

s
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states

2-27
 Numerical Example:
Subjective or Scenario Distributions
State Prob. of State rin 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

2-28
Measuring Variance or Dispersion
of Returns

Subjective or Scenario
Variance = S p(s) [rs - E(r)] 2
s
Standard deviation = [variance]1/2
Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095

2-29
 Scenario Assumption
If returns are normal, the first two
moments (e.g. mean and standard
deviation) are sufficient
If returns are not normal, they are not
sufficient. We need to consider skewness
and kurtosis or other non-normal risk
measures

2-30