Computing Returns
Return and Risk
Return =
An Example
„ You bought IBM stock at $40 last month. The
price of IBM stock is $45 today. IBM paid $1
dividend yesterday. What is your holding
period return?
„ Dollar return per share: $45-$40+$1=$6
„ Rate of return: $6 / $40 = 15%
Percentage Return or Dollar
Return?
„ So the rate of return presents the complete
picture.
„ In this course, return means the rate of return.
„ 0.01% is called a basis point.
„ Return is not unitless. We tend to annualize
returns.
„ Returns are bounded below at -100%.
Ending Price - Beginning Price + Dividends
Beginning Price
Percentage Return or Dollar
Return?
„ It is more convenient to use the percentage
return, or the rate of return.
„ A $1,000 return is quite good for an initial
investment of $1,000, but not so impressive if
the initial investment is $1 million.
„ A 10% return implies that if you invest $1000
you would make $100 and if you invest $1
million you will make $100,000.
10% or 10?
„ We like to express return in percentage
terms. 10% is the same as 0.1 but not the
same as 10.
„ P = $1 / (10 - 5) = $0.20
„ P = $1 / (10% - 5%) = $20
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 Averaging Returns
„ Suppose you invested half of your money in X
and half of your money in Y.
„ The return of X is 100% and the return of Y is
-50%.
„ What is the average return?
Averaging Returns
„ Suppose you invested all of your money in X
„ The return of X is 100% last year and -50%
this year.
„ What is your average return over the two
years?

Future Return is unknown Return and Risk

„ Under uncertainty, we measure “reward” by
P − P + Dt using the expected (or average) return.
Rt +1 = t +1 t
Pt „ We measure “risk” by using the variance of
returns
„ Investments are risky.
„ Pt+1 is not known at time t; hence Rt+1 is
not known at time t.
„ How do we capture the randomness of
Rt+1?

Expected Return and

Variance Sample Mean and Variance
N
1
N
µ X = E ( X ) = p1 X 1 + p2 X 2 + L + p N X N = ∑ pi X i
X=
N
∑X
i =1
i

i =1
2

∑ (X i − X )
1 N
Vaˆr ( X ) =
N
Var ( X ) = σ = ∑ pi [ X i − E ( X )]
2 2
X N − 1 i =1
i =1

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 Annualize Return Annualize Variance
„ There are two ways you can annualize
„ Variance is proportional to time
returns.
Annualized Variance = σ2 × T
„ Suppose R is the per period return and T is
the number of periods per year.
„ Standard deviation is proportional to the
square root of time
„ APR = R × T
Annualized Standard Deviation = σ × T0.5

„ EAR = ( 1 + R ) T - 1

Excess Returns Expected Return of A Portfolio

„ The raw return includes compensation for „ Adding more assets to a portfolio does
both the time value of money and the risk of not make the calculation of expected
the security. return more difficult.
„ An excess return or risk premium is the
compensation for risk bearing alone.
„ E(Rp) = w1E(R1) + w2E(R2) + … wnE(Rn)
Excess Return or Risk Premium = Ri − R f = Rie
„ This is the raw return less the risk-free rate.

Variance of A Portfolio More on Covariance

„ We are often interested in the variance of a
portfolio. If there are two assets in the
portfolio,
Var(w1X +w2 Y) = w12Var(X) + w22Var(Y)
+ 2w1w2Cov(X,Y)
where Cov(X,Y)=Corr(X,Y)σ(X)σ(Y)
„ Now consider the three asset case.
Var(w1X + w2Y + w3Z) = w12Var(X) + w22Var(Y)
+w32Var(Z) + 2w1w2Cov(X,Y)+ 2w1w3Cov(X,Z)+
2w2w3Cov(Y,Z)
„ The formula gets very complicated when
there are many assets in the portfolio.

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 Matrix Notation Portfolio Return and Risk
„ R is a column vector of expected returns „ Using matrix notation for portfolio return and
„ W is a column vector of portfolio weights risk,
„ ∑ is the covariance matrix E (R p ) = w1 R1 + w2 R2 + ... + wn Rn = w′R
Var (R p ) = w12σ 12 + w22σ 22 + ... + wn2σ n2
„ Example:
⎡ 0.1 ⎤ ⎡0.4⎤ ⎡0.04 0.01 0.01 ⎤
+ 2w1w2σ 1, 2 + 2w1w3σ 1,3 + ...
R = ⎢⎢ 0.2 ⎥⎥ W = ⎢⎢0.3⎥⎥ Σ = ⎢⎢ 0.01 0.09 − 0.01⎥⎥
= w' Σw
⎢⎣0.15⎥⎦ ⎢⎣0.3⎥⎦ ⎢⎣ 0.01 − 0.01 0.04 ⎥⎦

Mean Standard Deviation

Excel Functions Excel Functions

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Excel Functions Covariance

Correlation Data Analysis

Covariance Covariance Matrix