Topic 1 - Chapter Five

Risk, Return, and the Historical

Record

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 Chapter Overview

• Interest rate determinants

• Rates of return for different holding periods
• Risk and risk premiums
• Estimations of return and risk
• Normal distribution
• Historic returns on assets

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 This week’s lecture - Objectives

After this week’s lecture you should:

• describe the major factors that influence the level
of interest rates
• calculate rates of return for different holding
periods, effective annual rate (EAR) and annual
percentage rate (APR)
• calculate risk and return statistical measures, such
as holding period returns, average returns,
expected returns, and standard deviations

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 Interest Rate Determinants

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

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 Figure 5.1 Determination of the
Equilibrium Real Rate of Interest

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 Inflation Risk

• Real rate of interest –

One Year change in purchasing power
Today
Later – From 100 burgers to 104.8
burgers (= 4.8%)

Inflation
• Nominal rate of interest
Price=$10 Price=$10.5 (Quoted rate)
– From $1,000 to $1,100 (=
10%)
$1,000 $1,100
(=100 burgers) (=104.8 burgers)
• Nominal rate includes both
• purchasing power
• inflation

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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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 Example 5.1
Approximating the Real Rate

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 Concept Check

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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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 Rates of Return for Different
Holding Periods
• Zero Coupon Bond:
• Par = $100
• Maturity = T
• Price = P
• Total risk free return
100
rf (T ) 1 (5.6)
P(T )

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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
T
1 EAR 1 rf T

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 Example 5.3
Effective Annual Rate versus Total Return

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 Annual Percentage Rate (APR)

• APR: Annualizing using simple interest

• Relationship between per-period rate and APR:

𝑟𝑓 𝑇 = 𝑇 × 𝐴𝑃𝑅
• For example if APR=5.42%, then the per-6-month rate
is 𝑟𝑓 1/2 = 1/2 × 𝐴𝑃𝑅=2.71%

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 Annual Percentage Rate (APR)
• Relationship between EAR and APR

1/ T 1/ T
1 EAR [1 rf (T )] [1 T APR]
T
1 EAR 1
APR
T

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

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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

HPR P1 P 0 D1
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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 Annual Returns for a Five-Year Period

• Time series of annual holding period return

for the S&P 500

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 What is your Five-Year Holding Period Return?

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 Returns Using Geometric Averaging

• Terminal value of the investment

TVn (1 r1 )(1 r2 )...(1 rn )

• Geometric (Time-Weighted) Average

g TV 1/ n 1

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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

• 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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 Concept Check

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 Concept Check

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 Annual Returns for a Five-Year Period

• Time series of annual holding period return

for the S&P 500

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 Returns Using Arithmetic Averaging

• Arithmetic Average

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

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 How Do We Describe a Distribution of
Returns?

• Central tendency
• We will use the expected value as a measure of
central tendency
• The expected value is a probability weighted
average of the outcomes
• Standard deviation (or variance)
• We will use the standard deviation as the measure
of the dispersion for distribution

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 Standard Deviation

• Variance (VAR):

2 2
p s r s E r
s

• Standard Deviation (STD):

2
STD
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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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 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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 Estimating
Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations
n
2 1 2
ˆ rs r
n s 1

• Unbiased estimated standard deviation

n 2
1
ˆ rs r
n 1 j 1

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 The Reward-to-Volatility (Sharpe)
Ratio
• Sharpe Ratio: how the future expected excess return
compares to the risk you're taking
Risk premium
SD of excess returns
• Risk Premium
• The difference between the expected HPR on a risky asset and the
risk-free rate
• Excess Return
• The difference in any particular period between the actual rate of
return on a risky asset and the actual risk-free rate

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 Concept Check
Period HPR
2003 0.2869
2004 0.1088
2005 0.0491

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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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 Distribution of Returns on the S&P500

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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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 Skewness
• Skewness: a measure of asymmetry

• Normal distribution has a skewness measure of zero.

• When a distribution is skewed to the left, the extreme negative
values dominate and the measure is negative.
• When a distribution is skewed to the right, the extreme positive
values dominate and the measure is positive.
• When the distribution is skewed to the left, the standard
deviation will underestimate risk.

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Figure 5.5 A Normal and Skewed Distributions

Mean = 6%, SD = 17%

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 Kurtosis
• Kurtosis: measures the degree of fat tails
• likelihood of extreme values on either side of the mean at the
expense of a smaller likelihood of moderate deviations.

• Normal distribution has a kurtosis measure of zero.

• Fat tails implies there is greater probability mass in extreme
events in the tails.
• Again, standard deviation will underestimate the likelihood of
extreme events.

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 Figure 5.5B Normal and Fat-Tailed
Distributions

Mean = .1, SD = .2

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 Summary Statistics of Annual Total Returns
from 1926 to 2009

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 The Empirical Distribution of Annual Returns for U.S.
Large stocks (S&P 500), Small stocks, Treasury Bonds
and Treasury Bills （1926-2012）

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 Historical Risk-Return Trade-off

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 Readings
• BKM 5.1-5.8

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