BSc (Hons) Accounting & Finance

Investment Management FIN3024

Week 3 - Risk and Return


Interest rates and financial assets
MGS
Rates
Interest rates affects
the required return
on other financial
assets
Real vs Nominal Interest Rates
Nominal Interest Rate (R):
The growth rate of your money.
Includes an inflation (i) component.
Approximation: R r + i.

Real Interest Rate (r):
The growth rate of your purchasing power.

Exact calculation: derived from

Approximate then calculate the exact real interest rate:
Malaysias 2013 inflation rate
Maybank 12-month FD rate
i
i R
r
+

=
1 i
R
r
+
+
= +
1
1
1
Equilibrium Real Rate of Interest







If r is low, households will not be willing to save (low supply) and
would want to borrow (creating high demand).
If r is high, households will save (increasing supply) and will not wish
to borrow (lowering demand).
The market will be at equilibrium where demand = supply at point E.
The government and the central bank can shift the supply and
demand curves to the left or right. In this example, the government
has increased the demand for funds (by budget deficit) and causes
the equilibrium point to move from E to E. The result is a higher real
interest rate.
E
E

Govt
Supply
Demand
r
Amount of borrowed funds
equilibrium r
Equilibrium funds lent
Effective vs Nominal Interest Rates
Nominal in this sense, is different to the nominal used in
comparison to real interest rates.

When interest rates are quoted, they should state:
The horizon (per annum, per month, etc). If no specific horizon
is stated, assume that it is per annum.
The compounding frequency.

If you want to take a loan, a bank may quote an interest rate of
say, 8% per annum. The horizon is annual but this does not
mean that the compounding frequency is also annually. In fact,
the banks often compound interest monthly or quarterly or
semi-annually.
The quoted annual rate of 8% is a nominal interest rate.
The effective rate is the actual interest rate you will pay and
has to be calculated.
Example
If I have $100 invested at 8% per annum, how much do I accumulate
if interest is compounded: annually, semi-annually, quarterly,
monthly?

Annually
At the end of the year I have: 100*(1+0.08) = 108.00
Semi-annually
Every 6 months I earn 8%/2 = 4%.
At the end of the year I have: 100*(1+0.04)(1+0.04) = 108.16
OR: 100*(1+0.04)
2
= 108.16

Quarterly
Every quarter I earn 8%/4 = 2%.
At the end of the year I have: 100*(1.02)(1.02)(1.02)(1.02) = 108.24
OR: 100*(1.02)
4
= 108.24
Monthly:
Every month I earn 8%/12 = 0.67%.
At the end of the year I have: 100*(1.0067)
12
= 108.30
Effective Interest Rate
We can use the previous calculations to determine the
effective interest rates. This is the measure of how much
interest was actually earned.
Annual compounding: 8% p.a. effective
Semi-annual compounding: 8.16% p.a. effective
Quarterly compounding: 8.24% p.a. effective
Monthly compounding: 8.30% p.a. effective
To convert interest rates from nominal to effective, use:




Where m is the compounding frequency, i is the nominal
Interest rate and i is the effective interest rate per annum.
1 1
|
|
.
|

\
|
+ =
m
m
i
EAR
Example
Maybanks 1 month Fixed Deposit rate is 3% p.a.
Assuming you deposited $10,000 into the FD above, and you
rollover the interest every month up to a year. How much will
you have?
Month Amount
0 10,000
1 10,025
2 10,050.06
3 10,075.19
4 10,100.38
5 10,125.63
6 10,150.94
7 10,176.32
8 10,201.76
9 10,227.26
10 10,252.83
11 10,278.46
12 10,304.16
Your annual return would be
3.0416%, which is the EAR for a
nominal rate compounded monthly
3% per year so it is 0.25% per month.
(3%/12 = 0.25%)
Maybank FD rate
Maybank FD Rates

What would be the EAR of 1,3,6 and 12 months Maybank Fixed
Deposit rate, assuming that you rollover your interest earned
for a year?

EAR vs APR
If we are given possible investment returns in the form of various
nominal and effective rates, how can we decide which is best?

APR (Annual Percentage Rate) is an annualised simple interest
rate. We have met this before in a different form: APR = I

the
nominal rate per annum. The comparison between APRs would
not be useful because their compounding frequency would be
different.

EAR (Effective Annual Rate) is typically used as a standardised
rate to express all investment returns over one year. It is the
percentage increase in funds over 1 year. We have met this
before: EAR = i, the effective rate per annum.

The terminology used in everyday finance is APR and EAR.
Accumulating
If we have a principal of P, the accumulation after one year
is given by:


If we accumulate for a number of years, n:
m
m
i
P
|
.
|

\
|
+ 1
mn
m
i
P
|
.
|

\
|
+ 1
Examples
Find:
(a) The simple interest on $1,000 for 2 years at 10% p.a.
(b) The simple interest on $1,000 for 2 years at 1% per month.
(c) The compound interest on $1,000 for 4 years at an effective
rate of 12% p.a.
(d) The compound interest on $1,000 for 3 years at 10%
compounded semi-annually.
(e) The accumulation of $1,000 if it is invested at 5%
compounded quarterly for 2 years.
(f) The accumulation of $1,000 if it is invested at 8%
compounded monthly for 5 years.
Continuous Compounding
Without calculation, which is the better investment: $100
compounded annually at 12% p.a. or compounded monthly at
12%?

The more frequently your interest is compounded, the higher
the return. The extreme limit of compounding frequency is
continuous compounding. This is like compounding every
split-second. As the number of times compounding gets
bigger, the smaller the affect (or the affect diminishes).
Example: P=100,000 ; i=8%p.a. ;n=1
m=2 100,000(1.08/2)
2x1
= 108,160

m=4 100,000(1.08/4)
4x1
= 108,243
m=12 100,000(1.08/12)
12x1
= 108,300
m=365 100,000(1.08/365)
365x1
= 108,327
m=8,760 100,000(1.08/8,760)
8,760x1
= 108,328
m=525,600 100,000(1.08/525,600)
525,600x1
= 108,328

83
57
27
1
0.5
Continuous Compounding

In other words, we should be more familiar with the exponential
function (e
X
) on your calculator.



Example
i=8%p.a.
n=1
m=continuous compounding

EAR = (e
0.08
)
1
-1 = 8.33%

1 ) ( =
n i
e EAR
Discounting
The opposite of accumulating is discounting. If I have an
accumulated value of S, I can calculate the principal, P by
using:



Find the present value of $8,000 due in 5 years at :
(a) an effective rate of 7% per annum
(b) 7% compounded monthly
(c) 7% compounded semi annually
(d) 7% compounded daily
(e) 7% compounded continuously
( ) ) ( 1 1
m
n
mn
n
e S
m
i
S i S P

=
|
.
|

\
|
+ = + =
Returns
Consider a share bought for $100, paid dividends of $4 at the
end of the year and worth $110 at the end of the year.
The holding period is how long the asset is held or how long
the return period is. In this example it is one year.
The dividend yield is the %return from dividends. 4/100 = 4%.
The capital gain is the return on the share value. 10/100 =
10%.
The holding period return (HPR) is the total return over the
investment period: 14/100 = 14%.
HPR = Capital Gain + Dividend Yield
.
ice hare BeginningS
id DividendPa ice hare BeginningS ice e EndingShar
HPR
Pr
Pr Pr +
=
Using Historical Data
Generally, maximising your return is thought of as the ultimate
goal of investment.
Minimising investment risk is just as important.
How do we predict future levels of risk and return? We can
use historical data as an estimate.
There is no guarantee that the historical record exhibits the
worst (and best) that could occur in the future.
More on using historical data later.
Expected Returns
Future share price is uncertain, dividends are uncertain so HPR is
uncertain also. The possible outcomes are assigned probabilities.
The expected return is calculated as an average of what the
return might be.


A share is now priced at $70. Calculate the expected return of
the stock if you are given the following probability distribution:




(0.25x97.25) + (0.5x81.50) + (0.2x65.20) + (0.05x40.10) = 80.11
i
i
i
r p r r E

= = ) (
Outlook Excellent Good Poor Crash
Probability 0.25 0.5 0.2 0.05
Yrend Price 97.25 81.50 65.20 40.10

= =
i
i
r
n
r r E
1
) (
Standard Deviation
The standard deviation (sd or std dev) of the rate of return is a
measure of the returns uncertainty or risk.
It is a measure of the deviations from E(r).
(Sigma, lower case) is used to represent sd.

If different probabilities If all probabilities are same





sd is the square root of the variance (var).
var =
2
or = var

2
= 0.25(97.25-80.11)
2
+ 0.5(81.5-80.11)
2
+ 0.2(65.2-80.11)
2
+
0.05(40.10-80.11)
2
= 446
= 14.10


( )
2
2

=
i
i i
r r p o
2
2
2
1
r r
n
i
i
=

o
2
2
2
r r p
i
i i
=

o
( )
2
2
1

=
i
i
r r
n
o
Excess Returns & Risk Premiums
Risk-free rate (r
f
) is the rate earned on risk-free assets like T-
Bills.
The risk premium is the expected rate of return above r
f

risk premium = E(r) r
f
The excess return is the actual rate of return above r
f

excess return = r r
f

Risk Appetite refers to the degree of risk that investors are
willing to undertake.
Risk Aversion means an unwillingness to undertake excessive
risk. A risk averse investor will only invest in a risky asset (eg.
stocks) if there is a risk premium to compensate for the
additional risk.
Investors are assumed to be risk averse.
Sharpe Ratio
How do we measure the trade-off between reward and risk?
Which asset would you choose to invest in, x or y, if:
a) E(r
x
) = 10%,
x
= 9% and E(r
y
) = 10%,
y
= 6%.
b) E(r
x
) = 12%,
x
= 8% and E(r
y
) = 10%,
y
= 8%.
c) E(r
x
) = 9%,
x
= 7% and E(r
y
) = 12%,
y
= 9%.

The Sharpe Ratio is a measure of reward to volatility. The higher the
Sharpe Ratio, the higher the return to risk ratio for that asset.



Suppose for part (c) above, that r
f
= 5%, which asset would you
choose?
Asset X: Sharpe Ratio = (0.09-0.05)/0.07 = 0.57
Asset Y: Sharpe Ratio = (0.12-0.05)/0.09 = 0.78
turns Excess of SD
emium Risk
o SharpeRati
Re _ _ _
Pr _
=
Time Series Analysis
We can use historic time series data on securities to calculate
their past return and standard deviation.

Arithmetic average: This method is useful to estimate what the
expected return may be by averaging the past returns. For all
data, we assign equal probabilities so if there are n
observations, we give each one a probability of 1/n. We
calculate the expected return as follows:


This, however, does not give us an accurate reflection of the
actual return over the past period.

= =
= =
n
s
n
s
s r
n
s r s p r E
1 1
) (
1
) ( ) ( ) (
Geometric (Time-Weighted)
Average
The geometric average focuses on the holding period
returns (HPR) of the security.
First the terminal value is calculated: TV = (1+r
1
) x (1+r
2
)
x (1+r
3
) x x (1+r
n
)
The geometric average, g, is calculated from:




g is called the time-weighted average return as each
past return receives an equal weight in the process of
averaging.
n
n
i
i
n
r TV g
1
1
1
) 1 ( ) 1 (
|
|
.
|

\
|
+ = = +
[
=
Example
Calculate the arithmetic and geometric averages of the
following rates of return:



Arithmetic Avg:
E(r) = (1/5)(-0.1189-0.2210+0.2869+0.1088+0.0491)
= 0.02098 = 2.1%
Geometric avg:
(1 + g) = ((1-0.1189)(1-0.2210) (1+0.2869) (1+0.1088)
(1+0.0491))1/5
= 1.0054
Therefore g = .0054 = 0.54%
What accounts for the differences in the two results?
Period 2001 2002 2003 2004 2005
HPR -0.1189 -0.2210 0.2869 0.1088 0.0491
Year HPR Amount
2000 10,000
2001 -0.1189 8,811
2002 -0.221 6,863
2003 0.2869 8,832
2004 0.1088 9,794
2005 0.0491 10,274
Geometric Example
Return = (274/10,000)/5
= 0.0054 = 0.54%
Same result as using the
formula in previous slide.
Practice Questions
Over a period of 10 years, a stock had an end-of-year price of
54, 52, 61, 57, 58, 58, 57, 56, 55, 60.
Calculate the average annual return on the stock.
Calculate the std. dev. of the returns on this stock.

The stock prices at the end of each of five weeks are: 20.10,
20.08, 20.05, 20.20, 20.60. Estimate the weekly rate of return
and volatility of the stock.

The end-of-month stock prices at the end of each of 6 months
are: 33.50, 32.08, 35.69, 33.20, 34.50, 32.25. Estimate:
1. the monthly rate of return and volatility of the stock.
2. the annual rate of return and volatility of the stock.


Risk = Volatility = Std Dev
In finance, risk is volatility: basically how much a stock price
varies. In relation to your statistics knowledge, this risk is the
standard deviation.
In this comparison, which stock has a higher risk?







.


Gold vs Silver
By simply observing the graph, which appears riskier?











So which would you expect to have the higher return?
What can you say about the correlation?
Gold or S&P 500?
Which was riskier over the past year: Gold or S&P 500?










Does this relate to their volatility over the past 10 years?
Has their correlation been similar to this also?
Interest Rates vs Return on Stocks
Example
Malaysia 3 month T-bill rate 3%
Sunway REIT
Annual Dividend 8.9 sen per share
Closing Price RM 1.32 per share
Dividend Yield 0.089/1.32 = 6.74% dividend yield
Sunway REIT pays 3.74% extra yield in return for risk premium.

T-bill rate increased to 3.20% (+20 basis points)
Investors require higher return for risk premium.
Investors require Sunway REIT dividend yields to be 6.94%,
because risk free rate increase. Assuming dvd remains constant:
0.089/x = 6.94%
x = RM 1.28 per share
Interest Rates vs Return on Stocks
Example
Malaysia 3 month T-bill increased to 3.2%
Sunway REIT
Annual Dividend 8.9 sen per share
Closing Price RM 1.32 per share
Dividend Yield 0.089/1.32 = 6.74% dividend yield

Sunway REIT pays 3.74% extra yield in return for risk
premium.