Chapter Five

Risk, Return, and the

Historical Record

Name:
• Devi Twi Jayanti - 123012011036
• Afriyanti - 123012011024
• Yudha Kusuma - 123012011072
• Dwi Harini - 123012011090
 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

rr  rn  rn  i
rr  1
• Where i is the rate of inflation
i
i

5-2
Determination of the Equilibrium Real
Rate of Interest

5-3
 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 
5-4
 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:

• The after-tax real rate of return falls as the inflation rate

rises

5-5
 example
• you are in a 30% tax bracket and your
investments provide a nominal return of 12%
while inflation runs at 8%,
Nominal rate : 12%
Inflasi : 8%
Real rate = 12% - 8% = 4%

= (4% + 8%) (1-30%)-8%

= 0.0278
= 2,8%
But the tax code does not recognize that the first 8%.

after-tax nominal return is 12%(1 − .3) = 8.4%, so your after-tax real

interest rate is only 8.4% − 8% = .4%. As predicted by Equation 5.5,
your after-tax real return has fallen by
it = 8% × .3 = 2.4%.
Comparing Rates of Return for Different
Holding Periods

• For T = 1, Equation 5.6 provides the risk-free rate for an investment horizon of 1 year.

5-7
 Effective Annual Rate (EAR)
• In general, we can relate EAR to the total return, rf (T ), over a
holding period of length T by using the following equation:
 Annual Percentage Rate
(APR)
• APR: Annualized rates on short-term
investments (by convention, T < 1
year) often are reported using simple
rather than compound interest

APR = n × rf (T ).
n = 1/T
Example:
Deposit 6-month, rate of 2.71%
APR = n × rf (T ).
= 1/0.5 × 2.71
= 5.42%.
 Annual Percentage Rate (APR)

Therefore, the relationship among the compounding period, the EAR, and the APR is

APR  1 EAR  1

T

T
APR vs.
EAR

5-11
 Holding Period
Return
• Rates of return: Single period

HPR  P1  P 0
 D1
P0
• HPR = Holding period
return
• P0 = Beginning price
• P1 = Ending price
• D1 = Dividend during 5-12

period one
 HPR: Single Period
Example
• Ending Price = $110

• Beginning Price = $100

• Dividend = $4

$110  $100  $4
HPR  $100  .1 4 , o r 1 4 %

5-13
 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
5-14
 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%

5-15
 Expected Return and Standard
Deviation

• Variance (VAR):

s p s r s   E r
2
 

• Standard Deviation
2

(STD):

STD   2

5-16
 Scenario VAR and STD: Example

• The expected rate of return on the index • The variance of the rate of return (σ2 )
E(r) = (.25 × .31) + (.45 × .14) + [.25 × (− .0675 σ2 = .25(.31 − 0.0976)2 + .45(.14 − .0976)2
)] + [.05 × (− .52)] = .0976 + .25(− 0.0675 − 0.0976)2 + .05(−.52 − .0976)2
= .038

• Standard deviation is calculated:

5-17
σ = √.0380  = .1949 = 19.49%
Returns Using Arithmetic and
Geometric Averaging
• Arithmetic
Average n
n
1 r(s)
E(r)  
s1
p(s)r(s)  
n s1

• Geometric (Time-Weighted) Average

g  TV 1/ n
1
TV n  (1  r1 )
(1  r2 )...(1  rn )

= Terminal value of the investment 5-18

 Estimating
Variance and Standard Deviation

• Estimated Variance

• Expected value of squared deviations

n

1
ˆ 
2
 r s  r
 2
n s1

• Unbiased estimated standard 2

n
deviation 1
ˆ n  r  s  r

 1
j
1 
5-19
 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 5-20

SD of excess returns
 The Normal
Distribution
• Investment management is easier when returns are normal

• Standard deviation is a good measure of risk when returns

are symmetric

• 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
5-21
 The Normal
Distribution

Mean = 10%, SD = 20%

5-22
 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 of portfolio

measure
performance
• Need to consider skewness and kurtosis

5-23
Normal and Skewed
Distributions

Mean = 6%, SD = 17%

5-24
Normal and Fat-Tailed
Distributions

Mean = .1, SD = .2
5-25
 Historic Returns on Risky
Portfolios

5-26
 Risk Aversion

The investment process .includes two major tasks:

• The first task is securities and market analysis, in

which we assess the risks and expected returns
of all available investment instruments.

• The second task is the formation of an optimal

asset portfolio.
 Speculation and Gambling

Speculation is "taking a large enough

investment risk to earn a commensurate return.“

gamble is "betting or betting on an uncertain

outcome".
 Risk and Risk Aversion

• Investors who are risk averse refuse to invest in

a portfolio that is fair game or worse. Risk
averse investors only consider risk-free
portfolios or speculative prospects with a
positive risk premium.

But as risk increases with return, the most

attractive portfolio becomes unclear.
Thank You