Investment Analysis

Investment Analysis
Lecture 03 Risk and Return Vitali Alexeev

School of Economics and Finance University of Tasmania, Australia CRICOS Provider Code: 00586B
Alexeev (University of Tasmania)
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Lecture Outline
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Q&A Interest Rate Annualized Rates of Return Holding Period Returns Expected Return and Standard Deviation Geometric versus Arithmetic Averages Risk and Return Trade-o The Normal Distribution Skew and Kurtosis Other measures of risk Must know Practice Questions Workshop Links
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Q&A
Q&A
A few " hiccups" with online posting of the recordings but I am getting better at this and issues are now xed Mid semester test: 50 MCQs - 2 hours, FF - in class, DE - online All (or most) groups are now nalized. If you are still looking for a group member, please e-mail me directly. Group composition need not be constant throughout the semester. You are allowed to change the group composition for every group assignment as long as the number of group members is less or equal 3.
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Interest Rate
Interest Rate Determinants
Supply
Households
Demand
Businesses
Governments Net Supply and/or Demand

Federal Reserve Actions
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Interest Rate
Real and Nominal Rates of Interest
Nominal interest rate: Growth rate of your money Real interest rate: Growth rate of your purchasing power Let R = nominal rate, r = real rate and i = ination rate. Then: Real Rates of Interest Approx. r Exact r R i R i = 1+i (1) (2)
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Interest Rate
Equilibrium Real Rate of Interest
Determined by: Supply Demand Government actions Expected rate of ination
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Interest Rate
Equilibrium Nominal Rate of Interest
As the ination rate increases, investors will demand higher nominal rates of return If E (i) denotes current expectations of ination, then we get the Fisher Equation: Nominal rate = real rate + ination forecast Equilibrium Nominal Rate of Interest R = r + E (i)
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Interest Rate
Taxes and the Real Rate of Interest
Tax liabilities are based on nominal income The after-tax real rate of return falls as the ination rate rises. Given a tax rate (t) and nominal interest rate (R), the Real after-tax rate is: Real after-tax rate R (1 t) i = (r + i) (1 t) i = r (1 t) it
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Annualized Rates of Return
Rates of Return for Dierent Holding Periods
Example: Consider Zero Coupon Bond, Par = $100, T =maturity, P=price, rf (T )=total risk free return Total risk free return rf (T ) =
100 P(T )
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Eective Annul Rate (EAR)
EAR denition: percentage increase in funds invested over a 1-year horizon 1 + EAR = [1 + rf (T )] T
1
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Annual Percentage Rate (APR)
APR denition: annualizing using simple interest APR =

(1+EAR)T 1 T
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APR vs. EAR
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Statistics for T-Bill Rates, Ination Rates and Real Rates, 1926-2009
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Bills and Ination, 1926-2009
Moderate ination can oset most of the nominal gains on low-risk investments. A dollar invested in T-bills from 19262009 grew to $20.52, but with a real value of only $1.69. (Hint: recall slide 12 in Lecture 2. How much did you "really" make on Large cap stocks? on cash accounts? Negative correlation between real rate and ination rate means the nominal rate responds less than 1:1 to changes in expected ination.
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Risk and Risk Premiums
Holding Period Return HPR = Example: Ending Price = 110 Beginning Price = 100 Dividend = 4 HPR = (110 - 100 + 4 )/ (100) = 14%
P1 P0 +D1 P0
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Holding Period Returns

Holding Period Returns (HPR) Simple returns (for adjusted data) Simple returns (for unadjusted data) Log returns Return on Foreign Investment Ination adjusted Pt Pt1 Pt1 Pt + Dt Pt1 rt = Pt1 Pt rt = ln Pt1 Pt ft 1 rt = Pt1 ft1 1 + rnominal 1 + rreal = 1 + rination rt =
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Annualizing Returns
Eective Annual Return (EAR): The return on an investment expressed on an annualized basis. What is the number of holding periods in a year? For arithmetic average of simple returns (1 + )n 1 r For arithmetic average of log returns n r
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Expected Return and Standard Deviation
Expected return E (r ) =
s
p (s) r (s)
p (s) = probability of a state r (s) = return when the state occurs s = state
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Scenario Returns: Example
State (s) Excellent Good Poor Crash
Prob. of State (p(s)) .25 .45 .25 .05
Ret. in state (r (s)) 0.3100 0.1400 -0.0675 -0.5200
E (r ) = (.25)(.31) + (.45)(.14) + (.25)(.0675) + (0.05)(0.52) = .0976 or 9.76%
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Variance and Standard Deviation

Variance 2 = Standard Deviation = Example: 2 = .25(.31 0.0976)2 + .45(.14 .0976)2 + +.25(0.0675 0.0976)2 + .05(.52 .0976)2 = .038 = .038 = .1949
s
p (s) [r (s) E (r )]2
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Time Series Analysis of Past Rates of Return

Arithmetic Average of rate of return
T
E [r ] =
t=1
p (t) r (t) 1 T
T
r (t)
t=1
Arithmetic Average, sometimes, denoted as . I will use both, E [r ] and r r interchangeably. Geometric Average of rate of return G (r ) =
1/T
T t=1 (1
+ rt ) 1
Geometric Average is the Terminal Value of the Investment

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Arithmetic Averages versus Geometric Averages

The arithmetic average return answers the question: What was your return in an average year over a particular period? The arithmetic average tells you what you earned in a typical year. The geometric average return answers the question: What was your average compound return per year over a particular period? The geometric average tells you what you actually earned per year on average, compounded annually. When should you use the arithmetic average and when should you use the geometric average? For the purpose of forecasting future returns:
The arithmetic average is probably too high for long forecasts. The geometric average is probably too low for short forecasts.
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Variance and Standard Deviation Formulas
Estimated Variance = expected value of squared deviations Variance 2 =

1 T T t=1 [r
(t) ]2 r
When eliminating the bias, Variance and Standard Deviation become: Standard deviation (bias corrected) =
1 T 1 T t=1 [r
(t) ]2 r
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Geometric versus Arithmetic Averages
Note: the higher the the higher the discrepancy between E [r ] and G[r ].
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A Brief History of Risk and Return
We know that stock prices are (generally) unpredictable. Why do we look at the past returns? Our goal is to see what nancial market history can tell us about risk and return. There are two key observations:
First, there is a substantial reward, on average, for bearing risk. Second, greater risks accompany greater returns.
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The Reward-to-Volatility (Sharpe) Ratio
The Reward-to-Volatility (Sharpe) Ratio for portfolios Risk Sharpe = St.Dev. of Premium Excess Returns
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Historical Average Returns

Average returns are helpful in summarizing historical nancial data How do you use this number? If you are making a guess about the size of the return for a year selected at random, your best guess is the average.
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Average Returns: Lessons
Risk-free rate: The rate of return on a riskless, i.e., certain investment. Risk premium: The extra return on a risky asset over the risk-free rate; i.e., the reward for bearing risk. The First Lesson: There is a reward, on average, for bearing risk. The Second Lesson: The greater the potential reward, the greater the risk.
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Return Variability Review and Concepts
Variance is a common measure of return dispersion. Sometimes, return dispersion is also call variability. Standard deviation is the square root of the variance.
Sometimes the square root is called volatility. Standard Deviation is handy because it is in the same units as the average.
Normal distribution: A symmetric, bell-shaped frequency distribution that can be described with only an average and a standard deviation. Does a normal distribution describe asset returns?
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Historical Returns, Standard Deviations, and Frequency Distributions: 19262006
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The Normal Distribution and Large Company Stock Returns
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Returns on Some Non-Normal Days
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Risk and Return Trade-o
The risk-free rate represents compensation for just waiting. Therefore, this is often called the time value of money. First Lesson: If we are willing to bear risk, then we can expect to earn a risk premium, at least on average. Second Lesson: Further, the more risk we are willing to bear, the greater the expected risk premium.
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Historical Risk and Return Trade-O
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Risk and Return Trade-O
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Risk and Return Trade-O
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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, too. Future scenarios can be estimated using only the mean and the standard deviation.
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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 skew and kurtosis
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Skew and Kurtosis
Skew and Kurtosis
Skew S = Average Kurtosis K = Average

(r )4 r 4 (r )3 r 3
In Normal distribution S = 0, K = 3 always. The formula for kurtosis above is actually a formula for excess kurtosis: -3 above is to make K = 0, so when we get a number dierent from zero, we can say that kurtosis is above or below that of Normal distribution.
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Skew and Kurtosis
Normal and Skewed Distributions
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Skew and Kurtosis
Normal and Fat-Tailed Distributions (mean = .1, SD =.2)
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Other measures of risk
Value at Risk (VaR)

A measure of loss most frequently associated with extreme negative returns VaR is the quantile of a distribution below which lies q% of the possible values of that distribution
The 5% VaR , commonly estimated in practice, is the return at the 5th percentile when returns are sorted from high to low.
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Value at Risk (VaR)
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Expected Shortfall (ES)
Also called conditional tail expectation (CTE) More conservative measure of downside risk than VaR
VaR takes the highest return from the worst cases ES takes an average return of the worst cases
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Lower Partial Standard Deviation (LPSD) and the Sortino Ratio
Issues:
Need to consider negative deviations separately Need to consider deviations of returns from the risk-free rate.
LPSD: similar to usual standard deviation, but uses only negative deviations from rf Sortino Ratio replaces Sharpe Ratio
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Must know
Must know
1 2 3 4 5
sample vs. log returns: when to use which geometric vs arithmetic averages: when to use which population vs. sample variance/st.dev fat-tailed distribution skewed to the left (right)
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Practice Questions
Practice Questions I
Try online MCQ at http://highered.mcgraw-hill.com/sites/0073530700/ student_view0/chapter5/multiple_choice_quiz.html Also look at how goemetric mean is calculated in Spreadsheet 5.2 at http://highered.mcgraw-hill.com/sites/0073530700/ student_view0/chapter5/excel_templates.html - useful for your portfolio reports.
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Workshop
Workshop Material I
Review requirements for Portfolio Report 1, PR1, and briey PR2 (if time permits).
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Links
Links I
1 2 3
www.411stocks.com (to nd expected earnings) www.investopedia.com (for more on risk measures) www.teachmefinance.com (also contains more on risk measure)
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Links
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Investment Analysis

Lecture 03 Risk and Return Vitali Alexeev

Alexeev (University of Tasmania)

Alexeev (University of Tasmania)

Alexeev (University of Tasmania)

Interest Rate Determinants

Governments Net Supply and/or Demand

Alexeev (University of Tasmania)

Real and Nominal Rates of Interest

Alexeev (University of Tasmania)

Equilibrium Real Rate of Interest

Determined by: Supply Demand Government actions Expected rate of ination

Alexeev (University of Tasmania)

Equilibrium Nominal Rate of Interest

Alexeev (University of Tasmania)

Taxes and the Real Rate of Interest

Alexeev (University of Tasmania)

Annualized Rates of Return

Rates of Return for Dierent Holding Periods

Alexeev (University of Tasmania)

Annualized Rates of Return

Eective Annul Rate (EAR)

Alexeev (University of Tasmania)

Annualized Rates of Return

Annual Percentage Rate (APR)

APR denition: annualizing using simple interest APR =

Alexeev (University of Tasmania)

Annualized Rates of Return

APR vs. EAR

Alexeev (University of Tasmania)

Annualized Rates of Return

Alexeev (University of Tasmania)

Annualized Rates of Return

Bills and Ination, 1926-2009

Alexeev (University of Tasmania)

Annualized Rates of Return

Risk and Risk Premiums

Alexeev (University of Tasmania)

Holding Period Returns

Holding Period Returns

Alexeev (University of Tasmania)

Holding Period Returns

Alexeev (University of Tasmania)

Expected Return and Standard Deviation

Expected Return and Standard Deviation

Alexeev (University of Tasmania)

Expected Return and Standard Deviation

Scenario Returns: Example

State (s) Excellent Good Poor Crash

Prob. of State (p(s)) .25 .45 .25 .05

Ret. in state (r (s)) 0.3100 0.1400 -0.0675 -0.5200

E (r ) = (.25)(.31) + (.45)(.14) + (.25)(.0675) + (0.05)(0.52) = .0976 or 9.76%

Alexeev (University of Tasmania)

Expected Return and Standard Deviation

Variance and Standard Deviation

p (s) [r (s) E (r )]2

Alexeev (University of Tasmania)

Expected Return and Standard Deviation

Time Series Analysis of Past Rates of Return

Geometric Average is the Terminal Value of the Investment

Expected Return and Standard Deviation

Arithmetic Averages versus Geometric Averages

Alexeev (University of Tasmania)

Expected Return and Standard Deviation