CHAPTER 5 Learning About

Return and Risk

from the
Historical Record

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Factors Influencing Rates

• Supply
– Households
• Demand
– Businesses
• Government’s Net Supply and/or Demand
– Federal Reserve Actions

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 Real and Nominal Rates of Interest

• Nominal interest rate

– Growth rate of your money
• Real interest rate
– Growth rate of your purchasing power
• If R is the nominal rate and r the real rate and
i is the inflation rate:

r  R i

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 Equilibrium Real Rate of Interest

• Determined by:
– Supply
– Demand
– Government actions
– Expected 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:
R  r  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), nominal interest rate
(R), after-tax interest rate is R(1-t)
– Real after-tax rate is:
R (1  t )  i  ( r  i )(1  t )  i  r (1  t )  it

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Comparing Rates of Return for Different
Holding Periods

Zero Coupon Bond

100
rf (T )  1
P (T )

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Example 5.2 Annualized Rates of Return

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Formula for EARs and APRs

1
EAR  {1 r f (T ) }T 1
1
T

APR  (1 EAR )

T

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 Table 5.1 Annual Percentage Rates
(APR) and Effective Annual Rates (EAR)

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 Bills and Inflation, 1926-2005

• Entire post-1926 history of annual rates:

– www.mhhe.com/bkm
• Average real rate of return on T-bills for the
entire period was 0.72 percent
• Real rates are larger in late periods

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 Table 5.2 History of T-bill Rates, Inflation
and Real Rates for Generations, 1926-2005

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Figure 5.2 Interest Rates and Inflation,
1926-2005

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 Figure 5.3 Nominal and Real Wealth
Indexes for Investment in Treasury Bills,
1966-2005

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 Risk and Risk Premiums
Rates of Return: Single Period
P1  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 = 48
Beginning Price = 40
Dividend = 2

HPR = (48 - 40 + 2 )/ (40) = 25%

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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

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

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 Variance or Dispersion of Returns

Variance:
   p ( s ) r ( s )  E ( r ) 
2 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

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Time Series Analysis of Past Rates of
Return

Expected Returns and

the Arithmetic Average

1 n
E ( r )   s 1 p ( s ) r ( s )   s 1 r ( s )
n

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 Geometric Average Return

TV n
 (1  r1 )(1  r2 ) x x  (1  rn )
TV = Terminal Value of the
Investment
g  TV 1/ n
1
g= geometric average
rate of return

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 Geometric Variance and Standard
Deviation Formulas
• Variance = expected value of squared
deviations 2
1 n
    r ( s )  r 
2

n s 1

• When eliminating the bias, Variance and

Standard Deviation become:
2
1 n
  r (s)  r 
n  1 j 1  

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The Reward-to-Volatility (Sharpe) Ratio

Risk Premium
Sharpe Ratio for Portfolios =
SD of Excess Return

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Figure 5.4 The Normal Distribution

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Figure 5.5A Normal and Skewed Distributions
(mean = 6% SD = 17%)

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Figure 5.5B Normal and Fat-Tailed
Distributions (mean = .1, SD =.2)

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Figure 5.6 Frequency Distributions of
Rates of Return for 1926-2005

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Table 5.3 History of Rates of Returns of Asset
Classes for Generations, 1926- 2005

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Table 5.4 History of Excess Returns of Asset
Classes for Generations, 1926- 2005

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

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 Figure 5.8 Standard Deviations of Real Equity
and Bond Returns Around the World, 1900-2000

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Figure 5.9 Probability of Investment Outcomes
After 25 Years 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

The Terminal Value will then be:

T
 g 1 
2 2
1
T gT  T
[1 E (r )]   e 20   e 20
 

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Figure 5.10 Annually Compounded, 25-Year
HPRs from Bootstrapped History and
A Normal Distribution (50,000 Observation)

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Figure 5.11 Annually Compounded,
25-Year HPRs from Bootstrapped
History(50,000 Observation)

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Figure 5.12 Wealth Indexes of Selected
Outcomes of Large Stock Portfolios and
the Average T-bill Portfolio

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Table 5.5 Risk Measures for Non-Normal
Distributions

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