Chapter 2
Risk, Return, and the Historical
Record
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Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Overview
• Interest rate determinants
1
• Rates of return for different holding periods
2
• Risk and risk premiums
3
• Estimations of return and risk
4
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Key Formula
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Interest Rate Determinants
• Supply
• Households
• Demand
• Businesses
• Government’s net demand
• Federal Reserve actions
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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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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:
rn = rr + 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) 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
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
1 + EAR = 1 + rf (T ) T
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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 = $110
Beginning Price = $100
Dividend = $4
$110 − $100 + $4
HPR = = .14, or 14%
$100
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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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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
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 and
Standard Deviation
• Variance (VAR):
= p(s )r (s ) − E (r )
2 2
• Standard Deviation (STD):
STD = 2
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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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Exercise 1
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Time Series Analysis
of Past Rates of Return
• True means and variances are unobservable
because we don’t actually know possible
scenarios like the one in the examples
• So we must estimate them (the means and
variances, not the scenarios)
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Returns Using Arithmetic and
Geometric Averaging
• Arithmetic Average
n
1 n
E (r ) = p( s )r ( s) = r ( s)
s =1 n s =1
• Geometric (Time-Weighted) Average
g = TV 1/ n −1
TVn = (1 + r1 )(1 + r2 )...(1 + rn )
= Terminal value of the investment
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Estimating
Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations
n
1
ˆ = r (s ) − r
2 2
n s =1
• Unbiased estimated standard deviation
n 2
1
ˆ = r (s ) − r
n − 1 j =1
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a. What are expected return and standard deviation of the two stocks. (2 scores)
What are expected return and
standard deviation of the two stocks
Period X Y
Q4-2017 52 30
Q1-2018 50 39
Q2-2018 55 30
Q3-2018 58 37
Q4-2018 66 39
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Exercise 2
a) Expected Return of A and B.
b) Standard deviation of A and B
c) Covariance of A and B
Economic Return % of Return % of
Probability
conditions stock A stock B
Bad 0.2 14 20
OK 0.4 -5 -2
Good 0.4 10 9
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The Reward-to-Volatility (Sharpe)
Ratio
• Excess Return
• The difference in any particular period between
the actual rate of return on a risky asset and the
actual risk-free rate
• Risk Premium
• The difference between the expected HPR on a
risky asset and the risk-free rate
• Sharpe Ratio Risk premium
SD of excess returns
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CFA Problems
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CFA Problems (Cont.)
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Next Week Requirements
• Read Chapter 4
• Complete exercise 1,2,3,4,5,7(p.165, 166, Hull)
and submit to e-learning.
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