Lecture Note 8
Return
If you buy a stock today for $100, and tomorrow you sell the stock at $120, what is your return?
Stock return
Suppose you bought Microsoft stock for $28.08 last year, and sold it for $27.39 immediately after
$3.08 dividend was paid today. What is your realized return from holding the stock?
o The returns on a stock over one period (Rt) can be divided into
________________ __________ and ______________ __________ __________:
𝑅𝑅𝑡𝑡 =
Lecture Note 8
Arithmetic Average Return VS Geometric Average Return VS Holding Period Return
Arithmetic Average Return =
Geometric Average Return =
A stock has had the following returns over the last five years:
29% −8% 9% −25% 2%
What are the arithmetic and geometric average returns for the stock?
A fund manager made the following returns over the last two years:
−50%, 50%.
What are the arithmetic and geometric average returns for the stock?
Holding Period Return
Lecture Note 8
Risk and Uncertainty
2005 2006 2007
4.9% 15.8% 5.5%
• Statistical concepts:
Mean return = 𝑅𝑅𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = ∑ 𝑅𝑅𝑖𝑖 /N
1
(R )
Var =
T −1
(
(R1 − R )2 + (R2 − R )2 + ... + (RT − R )2 )
Standard deviation =
• 95% Prediction Interval
For example, we found the average return for the S&P 500 from 2005 to 2009 to be 3.1% with a
standard deviation of 24.1%. What is a 95% prediction interval for 2010’s return?
Lecture Note 8
Suppose your great-grandparents had indeed invested $100 on your behalf at the end of 1925.
How would that $100 have grown if it were invested in one of the following?
(Assumption: Any dividends or interest earned in the account are reinvested until the end of 2015)
1. Standard & Poor’s 500 (S&P 500): A portfolio, constructed by Standard & Poor’s,
comprising 90 U.S. stocks up to 1957 and 500 U.S. stocks after that.
2. Small Stocks: A portfolio, updated quarterly, of U.S. stocks traded on the NYSE with
market capitalizations in the bottom 20%.
3. World Portfolio: A portfolio of international stocks from all of the world’s major stock
markets in North America, Europe, and Asia.
4. Corporate Bonds: A portfolio of long-term, AAA-rated U.S. corporate bonds with
maturities of approximately 20 years.
5. Treasury Bills: An investment in one-month U.S. Treasury bills (reinvested as the bills
mature).
Lecture Note 8
The Distribution of Annual Returns for U.S. Large Company Stocks (S&P 500), Small Stocks,
Corporate Bonds, and Treasury Bills, 1926–2015
Lecture Note 8
Portfolio Risk and Return
• Consider a two-asset portfolio P:
Let 𝑤𝑤1 be the proportion invested in asset 1 and
𝑤𝑤2 be the proportion invested in asset 2
𝑟𝑟𝑝𝑝 =
𝜎𝜎𝑝𝑝2 =
• Covariance (𝑟𝑟1 , 𝑟𝑟2 ) = ∑{ �𝑟𝑟1 − 𝑟𝑟1,𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 ��𝑟𝑟2 − 𝑟𝑟2,𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚�}/N
• Correlation coefficient = 𝜌𝜌1,2 =
The range of values that the correlation coefficient (rho) can take:
≤ 𝜌𝜌1,2 ≤
Correlation Matrix (𝝆𝝆𝟏𝟏,𝟐𝟐)
Lecture Note 8
Correlation Matrix (𝝆𝝆𝟏𝟏,𝟐𝟐)
An investor holds Microsoft and Cisco stocks with equal weights. Given that 𝜎𝜎𝑀𝑀 = 0.25, 𝜎𝜎𝐶𝐶 = 0.28,
and 𝜌𝜌1,2 = 0.52, respectively, the portfolio’s variance is:
𝜎𝜎𝑝𝑝2 = 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 2𝑤𝑤1 𝑤𝑤2 cov(1,2)
= 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 2𝑤𝑤1 𝑤𝑤2 𝜌𝜌1,2 𝜎𝜎1 𝜎𝜎2
• Diversification
Case 1: 𝜌𝜌1,2 = + 1
𝑟𝑟𝑝𝑝 =
𝜎𝜎𝑝𝑝2 =
𝜎𝜎𝑝𝑝 =
Lecture Note 8
Case 2: 𝜌𝜌1,2 = 0
𝑟𝑟𝑝𝑝 =
𝜎𝜎𝑝𝑝2 =
<
𝜎𝜎𝑝𝑝 <
Case 3: 𝜌𝜌1,2 = − 1
𝑟𝑟𝑝𝑝 =
𝜎𝜎𝑝𝑝2 =
𝜎𝜎𝑝𝑝 =
Lecture Note 8
Suppose Janet Smith holds 100 shares of JPMorgan Chase stock and 300 shares of Bank of
America stock. JPMorgan Chase is currently sold at $80 per share, while Bank of America is sold
at $40. The expected returns of JPMorgan Chase and Bank of America are 15% and 20%,
respectively, and the standard deviations are 8% and 20%, respectively. Assume that the
correlation coefficient between the two stocks is 0.38.
(a) Calculate the expected return and standard deviation of her portfolio
(b) If she sold 200 shares of Bank of America today to pay the tuition, what would the expected
return and standard deviation of her new portfolio be?
Lecture Note 8
Efficient Frontier & Global Minimum Variance Portfolio
Lecture Note 8
Portfolio variance when the number of assets increases
Consider a 3-asset portfolio:
𝜎𝜎𝑝𝑝2 = 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 +
+ 2𝑤𝑤1 𝑤𝑤2 Cov(1,2) +
+
= 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 𝑤𝑤32 𝜎𝜎32
+ 𝑤𝑤1 𝑤𝑤2 Cov( ) + 𝑤𝑤1 𝑤𝑤3 Cov( )
+ 𝑤𝑤2 𝑤𝑤1 Cov( ) + 𝑤𝑤2 𝑤𝑤3 Cov( )
+ 𝑤𝑤3 𝑤𝑤1 Cov( ) + 𝑤𝑤3 𝑤𝑤2 Cov( )
N-asset portfolio:
𝜎𝜎𝑝𝑝2 = 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙ + 𝑤𝑤𝑁𝑁2 𝜎𝜎𝑁𝑁2
+ 𝑤𝑤1 𝑤𝑤2 Cov(1,2) + 𝑤𝑤1 𝑤𝑤3 Cov(1,3) + ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙ + 𝑤𝑤1 𝑤𝑤𝑁𝑁 Cov(1, N)
+ 𝑤𝑤2 𝑤𝑤1 Cov(2,1) + 𝑤𝑤2 𝑤𝑤3 Cov(2,3) + ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙ + 𝑤𝑤2 𝑤𝑤𝑁𝑁 Cov(2, N)
+ ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙
+ 𝑤𝑤𝑁𝑁 𝑤𝑤1 Cov(𝑁𝑁, 1) + 𝑤𝑤𝑁𝑁 𝑤𝑤2 Cov(𝑁𝑁, 2) + ∙∙∙∙∙∙∙∙∙∙∙ + 𝑤𝑤𝑁𝑁 𝑤𝑤𝑁𝑁−1 Cov(N, N − 1)
Lecture Note 8
Historical Volatility and Return for 500 Individual Stocks, Ranked Annually by Size
(Annual Data from 1926 to 2014)
Lecture Note 8
Risk of an Individual Asset
Total risk =
Systematic risk is also called:
Unsystematic risk is also called:
Estimation of Beta
Regress return on return.
= 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 + 𝜀𝜀𝑖𝑖
Lecture Note 8
Lecture Note 8
Capital Asset Pricing Model (CAPM)
𝑅𝑅𝑖𝑖 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑖𝑖 (𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓 )
• The risk-free rate is 4%. The beta for the Jordan Company is 1.5, and the expected return
of the market is 10%. What is the required rate of return for the Jordan Company?
Lecture Note 8
The CAPM and Portfolios
• Suppose you are the money manager of a $ 4 million investment fund. The fund consists
of 4 stocks with the following investments and betas:
Stock Investment Beta
A $ 400,000 1.5
B 600,000 -0.5
C 1,000,000 1.25
D 2,000,000 0.75
Total 4,000,000
If the market rate of return is 11% and the risk-free rate is 3%, what is the fund’s overall
beta and its required rate of return?
1) Portfolio Beta
2) Required Rate of Return
Lecture Note 8
• The earnings, dividends, and stock price of CT Inc. are expected to grow at 7% per year
in the future (forever). CT’s common stock sells for $29 per share, and its last dividend
was $2. The firm’s beta is 1.6. The risk-free rate is 4%, and the expected return on the
market is 10%. Would your recommendation be to buy or sell the stock? Why?
