Chapter Five

Risk, Return, and the Historical

Record

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 Learning Objectives

• Interest rate determinants

• Rates of return for different holding periods
• Risk and risk premiums
• Estimations of return and risk
• Normal distribution
• Deviation from normality and risk estimation
• Historic returns on risky portfolios

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 Interest Rate Determinants

• Supply
• Households
• Demand
• Businesses
• Government’s net demand
• Federal Reserve actions

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 Real and Nominal Rates of Interest

• Nominal interest rate (rn):

• Growth rate of your money
• Real interest rate (rr):
• Growth rate of your purchasing power

rn  i
rr  rn  i rr 
1 i
• Where i is the rate of inflation
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 Figure 5.1 Determination of the
Equilibrium Real Rate of Interest

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 Equilibrium Nominal Rate of Interest

• As the inflation rate increases, investors will

demand higher nominal rates of return
• If E(i) denotes current expectations of
inflation, then we get the Fisher Equation:

rn  rr  E i 

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 Taxes and the Real Rate of Interest

• Tax liabilities are based on nominal income

• Given a tax rate (t) and nominal interest rate (rn),
the real after-tax rate is:

rn 1  t   i   rr  i 1  t   i  rr 1  t   it
• The after-tax real rate of return falls as the
inflation rate rises

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 • The continuously compounded annual percentage rate, r cc , that provides an EAR
of 5.8% is 5.638% This is virtually the same as the APR for daily compounding.
But for less frequent compounding, for example, semiannually, the APR necessary
to provide the same EAR is noticeably higher, 5.718%. With less frequent
compounding, a higher APR is necessary to provide an equivalent effective return.

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 Rates of Return for Different
Holding Periods
• Zero Coupon Bond:
• Par = $100
• Maturity = T
• Price = P
• Total risk free return for T time period
100
rf (T )  1
P(T )
• Where P(T) is Price
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 Example 5.2
Annualized Rates of Return

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 Effective Annual Rate (EAR)

• EAR: Percentage increase in funds invested

over a 1-year horizon

1
1  EAR  1  rf T  T

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 Annual Percentage Rate (APR)

• APR: Annualizing using simple interest

1  EAR 
T
1
APR 
T
To find the APR corresponding to an EAR of 5.8% with various common
compounding periods, and, conversely, the values of EAR implied by an APR of
5.8%.

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 Table 5.1 APR vs. EAR

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 Table 5.2 T-Bill Rates, Inflation Rates,
and Real Rates, 1926-2012

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 Bills and Inflation, 1926-2012
• Moderate inflation can offset most of the
nominal gains on low-risk investments
• A dollar invested in T-bills from 1926–2012
grew to $20.25 but with a real value of only
$1.55
• Negative correlation between real rate and
inflation rate means the nominal rate doesn’t
fully compensate investors for increased in
inflation
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 Figure 5.3 Interest Rates and Inflation,
1926-2012

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 Risk and Risk Premiums

• Rates of return: Single period

P 1  P 0  D1
HPR 
P0
• HPR = Holding period return
• P0 = Beginning price
• P1 = Ending price
• D1 = Dividend during period one

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 Rates of Return: Single Period
Example
Ending Price = $110
Beginning Price = $100
Dividend = $4

$110  $100  $4
HPR   .14, or 14%
$100

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 Expected Return and
Standard Deviation
• Expected returns

E (r )   p( s)r ( s)
s

• p(s) = Probability of a state

• r(s) = Return if a state occurs
• s = State

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 Scenario Returns: Example

State Prob. of State r in State

Excellent .25 0.3100
Good .45 0.1400
Poor .25-0.0675
Crash .05-0.5200

E(r) = (.25)(.31) + (.45)(.14) + (.25)(−.0675) + (0.05)(− 0.52)

E(r) = .0976 or 9.76%

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 Expected Return and
Standard Deviation
• Variance (VAR):

   p s r s   E r 
2 2

• Standard Deviation (STD):

2
STD  
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 Scenario VAR and STD: Example

• Example VAR calculation:

σ2 = .25(.31 − 0.0976)2 + .45(.14 − .0976)2
+ .25(− 0.0675 − 0.0976)2 + .05(−.52 − .0976)2
= .038

• Example STD calculation:

σ  .038
 .1949

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 Time Series Analysis
of Past Rates of Return
• True means and variances are unobservable
because we don’t actually know possible
scenarios like the one in the examples
• So we must estimate them (the means and
variances, not the scenarios)

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 Returns Using Arithmetic and
Geometric Averaging
• Arithmetic Average
n
1 n
E (r )   p( s)r ( s)   r ( s)
s 1 n s 1
• Geometric (Time-Weighted) Average
1/ n
g  TV 1
TVn  (1  r1 )(1  r2 )...(1  rn )
= Terminal value of the investment

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 Estimating
Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations
1 n
ˆ   r s   r 
2 2

n s 1

• Unbiased estimated standard2 deviation

1 n
ˆ   r s   r 
n  1 j 1
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 The Reward-to-Volatility (Sharpe)
Ratio
• Excess Return
• The difference in any particular period between
the actual rate of return on a risky asset and the
actual risk-free rate
• Risk Premium
• The difference between the expected HPR on a
risky asset and the risk-free rate
• Sharpe Ratio
Risk premium
SD of excess returns
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 Risk premium =Rs. 5.76%
Standard deviation = 19.49%
Sharpe ratio = 5.76/19.49

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 • A good way to use history to learn about the distribution of long-term future returns
is to simulate these future returns from the available sample. A popular method to
accomplish this task is called bootstrapping.
• Bootstrapping is a procedure that avoids any assumptions about the return
distribution, except that all rates of return in the sample history are equally likely.
• Is to assess the potential effect of deviations from normality on the probability
distribution of a long-term investment in U.S. stocks.

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 The Normal Distribution
• Investment management is easier when returns are
normal
• Standard deviation is a good measure of risk when
returns are symmetric
• If security returns are symmetric, portfolio returns will
be as well
• Future scenarios can be estimated using only the
mean and the standard deviation
• The dependence of returns across securities can be
summarized using only the pairwise correlation
coefficients
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 Figure 5.4 The Normal Distribution

Mean = 10%, SD = 20%

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 Normality and Risk Measures

• What if excess returns are not normally

distributed?
• Standard deviation is no longer a complete
measure of risk
• Sharpe ratio is not a complete measure of
portfolio performance
• Need to consider skewness and kurtosis

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 Importance of Normal Distribution in
Investment Management
• Is symmetric, that is, the probability of any positive deviation above the mean is
equal to that of a negative deviation of the same magnitude
• When assets with normally distributed returns are mixed to construct a portfolio,
the portfolio return also is normally distributed.
• Scenario analysis is greatly simplified when only two parameters: (mean and SD)
need to be estimated to obtain the probabilities of future scenarios

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Figure 5.5A Normal and Skewed Distributions

1. Distribution is skewed to
the right:
The standard deviation
overestimates risk, because
extreme positive deviations
from expectation (which are
not a source of concern to the
investor) nevertheless
increase the estimate of
volatility.
2. Distribution is negatively
skewed, the SD will
underestimate risk

Mean = 6%, SD = 17%

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 Figure 5.5B Normal and Fat-Tailed
Distributions

Mean = .1, SD = .2

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 Kurtosis
• Higher frequency of extreme negative returns
may result from negative skew and/or kurtosis
(fat tails)—an important point.
• Therefore, we would like a risk measure that
indicates vulnerability to extreme negative
returns

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 Normality and Risk Measures

• Value at Risk (VaR)

• Loss corresponding to a very low percentile of the entire
return distribution, such as the fifth or first percentile
return
• VaR(.05, normal distribution) = Mean + (-1.65)SD, when portfolio
returns are normally distributed
• Expected Shortfall (ES)/Conditional Tail Expectation
• Also called conditional tail expectation (CTE), focuses on the
expected loss in the worst-case scenario (left tail of the
distribution)
• More conservative measure of downside risk than VaR

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 Standard deviation as a measure of risk when the return
distribution is
nonnormal presents three problems

(1) the asymmetry of the distribution suggests we should look at negative outcomes
separately;
(2) because an alternative to a risky portfolio is a risk-free investment vehicle, we
should look at deviations of returns from the risk-free rate rather than from the sample
average; and
(3) fat tails should be accounted for.

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 Normality and Risk Measures

• Lower Partial Standard Deviation (LPSD)

and the Sortino Ratio
• Similar to usual standard deviation, but uses only
negative deviations from the risk-free return, thus,
addressing the asymmetry in returns issue
• Sortino Ratio (replaces Sharpe Ratio)
• The ratio of average excess returns to LPSD

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 Historic Returns on Risky Portfolios

• The second half of the 20th century, politically and

economically the most stable sub-period, offered the
highest average returns
• Firm capitalization is highly skewed to the right:
Many small but a few gigantic firms
• Average realized returns have generally been higher
for stocks of small rather than large capitalization
firms

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 Historic Returns on Risky Portfolios

• Normal distribution is generally a good

approximation of portfolio returns
• VaR indicates no greater tail risk than is characteristic
of the equivalent normal
• The ES does not exceed 0.41 of the monthly SD,
presenting no evidence against the normality
• However
• Negative skew is present in some of the portfolios
some of the time, and positive kurtosis is present in all
portfolios all the time

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 Figure 5.7 Nominal and Real Equity Returns
Around the World, 1900-2000

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 Figure 5.8 SD of Real Equity & Bond Returns
Around the World

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 Figure 5.9 Probability of Investment with a
Lognormal Distribution

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 Terminal Value with Continuous
Compounding

• When the continuously compounded rate of

return on an asset is normally distributed, the
effective rate of return will be lognormally
distributed

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