Risk and Return: Past

and Prologue

Bodie, Kane, and Marcus

Essentials of Investments,
5
9th Edition
Holding-Period Return (HPR)
Rate of return over given investment period
HPR= [PS − PB + CF] / PB
Where,
• PS = Sale price
• PB = Buy price
• CF = Cash flow during holding period
Holding-Period Return (HPR): Example
You put up $50 at the beginning of the year for an
investment. The value of the investment grows 4%
and you earn a dividend of $3.50. Your HPR was
___.
𝐻𝑃𝑅 = [PS − PB + CF] / PB

PS = Sale price = %50*1.04=52

PB = Buy price =$50
CF = Cash flow = $3.50

𝐻𝑃𝑅 = [$52− $50 + $3.50] / $50 =$5.5/$50 =11%

Measuring Investment Returns
• Arithmetic average
• Sum of returns in each period divided by number of periods

• Geometric average
• Single per-period return; gives same cumulative performance as
sequence of actual returns
• Compound period-by-period returns; find per-period rate that
compounds to same final value

• Dollar-weighted average return

• Internal rate of return on investment
Measuring Investment Returns: Example

Arithmetic average
The arithmetic average of -11%, 15%, and 20% is ___.

−11% + 15% + 20%

𝐴𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑟𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 = = 8%
3

Geometric average
The geometric average of -12%, 20%, and 25% is ___.
𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒
= (1 + −12% )(1 + +20% )(1 + +25% ) 1/3 −1
= 9.70%
Annualizing Rates of Return
 Annual Percentage Rate (APR) annualizes per-period
rates using a simple interest approach, ignoring compound
interest.
APR = Per-period rate × Periods per year
◦ Effective annual rate (EAR) is the rate at which your invested
funds actually grow.
𝑨𝑷𝑹 𝒏
1+EAR = (𝟏 + 𝑹𝒂𝒕𝒆 𝒑𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅)𝒏 = (𝟏 + )
𝒏
Where, n= compounding periods in the year

◦ We can also find APR:

APR = [(1 + EAR)1/n – 1] x n
 With continuous compounding, the relationship between the
APR and EAR becomes:
1 + EAR = eAPR
Annualizing Rates of Return: Example
• Example: The buyer of a new home is quoted a mortgage rate
of 0.5% per month. What is the one-year APR on the loan?
APR = Per-period rate × Periods per year
 APR= 0.5%*12 = 0.005*12 =0.06 = 6%
• Example: A loan for a new car costs the borrower 0.8% per
month. What is the EAR?
𝑨𝑷𝑹 𝒏
𝟏 + 𝑬𝑨𝑹 = (𝟏 + )
𝒏
𝑨𝑷𝑹 𝒏
𝑬𝑨𝑹 = (𝟏 + ) −𝟏
𝒏
𝑬𝑨𝑹 = (𝟏 + 𝟎. 𝟎𝟎𝟖)𝟏𝟐 −𝟏 = 𝟏𝟎. 𝟎𝟑%
Annualizing Rates of Return: Example
• Example: You have an APR of 7.5% with continuous
compounding. The EAR is ____.
1 + EAR = eAPR
Thus, EAR = e0.75-1 = 7.79%
• Example: You have an EAR of 9%. The equivalent APR with
continuous compounding is ____.
1 + EAR = eAPR
Thus,
Ln(1+EAR) = ln(eAPR) Remember: ln(e)=1 as those functions are inverse
 Ln(1+EAR) = APR
APR =ln(1+0.09) = 8.62%
Definitions
• Scenario analysis: Possible economic scenarios (s);
specify likelihood and Holding-Period Return -HPR- (r(s))
• Probability distribution: Possible outcomes with
probabilities (p(s))
• Expected return: Mean value of distribution of HPR (E[r])
𝑆

𝐸[𝑟] = ෍ 𝑝 𝑠 𝑟(𝑠) , 𝑠 = 1, … , 𝑆
𝑠=1

• Variance: Expected value of squared deviation from mean

𝑆

𝑉𝑎𝑟[𝑟] = 𝜎 2 = ෍ 𝑝 𝑠 𝑟 𝑠 − 𝐸[𝑟] 2 , 𝑠 = 1, … , 𝑆
𝑠=1

• Standard deviation: Square root of variance

1/2
𝑆𝐷 𝑟 = 𝜎 = 𝑉𝑎𝑟 𝑟 = 𝑉𝑎𝑟[𝑟]
 Scenario analysis: Probability distribution:
• Possible economic scenarios; • Possible outcomes with
• Specify likelihood and Holding-Period • Possible probabilities
Return (HPR)

Expected return: mean value of distribution of HPR

E[R] = 0.05*(-37)+ 0.25*(-11)+0.40*(14)+0.30*(30)=10.0
Variance: Expected value of squared deviation from mean
V[R]= 0.05*(-37-10)2+ 0.25*(-11-10)2+0.40*(14-10)2+0.30*(30-10)2=347.10
Standard deviation: Square root of variance
SD[R] = (V[R])0.5 = (347.10) 0.5 = 18.63
𝑆 𝑆
2 1/2
𝐸[𝑟] = ෍ 𝑝 𝑠 𝑟(𝑠) 𝑉𝑎𝑟 𝑟 = ෍ 𝑝 𝑠 𝑟 𝑠 − 𝐸 𝑟 𝑆𝐷 𝑟 = 𝑉𝑎𝑟[𝑟]
𝑠=1 𝑠=1
 Mean

Returns with lower Returns with higher Returns with lower

probability probability probability
Value at Risk (VaR)
 Measures the maximum loss that could be
suffered over a given time horizon with
specified probability, usually 5%. Return
distribution

5% 95%

Returns
Loss VaR Profit
Value at Risk (VaR)
• In a given probability distribution we need to know
what return corresponds to a 5% probability.
• VaR can be derived from the mean and standard
deviation of the distribution. However, the VaR
calculation does not require normal distributions.
• If returns are normally distributed, we can use a
standard normal table or the Norminv function in
Excel.
𝑉𝑎𝑅 = 𝐸 𝑟 + 𝑠𝑑 𝜎
Where,
E[r] = expected return, 𝜎 = standard deviation,
Value at Risk (VaR): Example
A $500,000 stock portfolio has an annual expected
return of 12% and a standard deviation of 35%.
What is the portfolio VaR at a 5% probability level?
From Excel: = Norminv (0.05,0,1) = -1.64485 standard
deviations.
𝑽𝒂𝑹 = 𝑬 𝒓 + 𝒔𝒅 𝝈
= 0.12 + (−1.64485 ∗ 0.35) = −45.57%
𝑽𝒂𝑹$ = $500,000 ∗ −0.4557 = −$227,850

What does this number mean? The greatest annual

expected loss 95% of the time is $227,850.
Value at Risk (VaR): Example

5% probability 95% probability that the maximum

of losing amount the investor is going to lose
$227,850 is not going to exceed $227,850

5% VaR 95% Probability

$227,850 density

Portfolio
Return
Loss Profit
r=-45.57% E[r]=12%
VaR
Risk Premiums and Risk Aversion
• Risk-free rate: rate of return that can be earned
with certainty
• Risk premium: difference between the expected
return of a risky asset and the risk-free rate. Risk
premium may be called an ‘excess return’
• Excess return: rate of return in excess of risk-free
rate
Excess return or Risk Premiumasset = E[rasset] – rf
• Risk aversion: investor’s reluctance to accept risk
• Price of risk: ratio of risk premium to variance
Sharpe Ratio (Reward-to-Volatility)
• Risk aversion implies that investors will
accept a lower reward (measured by their
portfolio risk premium) in exchange for a
sufficient reduction in the standard deviation.
• The Sharpe ratio is used to rank portfolios in
terms of this risk-return trade-off.
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝐸 𝑟𝑃 − 𝑟𝑓
=
𝜎𝑃
Sharpe Ratio (Reward-to-Volatility)
• The Sharpe Ratio of a risky portfolio
quantifies the increase in risk premium for
each increase of 1% in the portfolio standard
deviation.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑜𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝐸 𝑟𝑃 − 𝑟𝑓
=
𝜎𝑃

• A risk-free asset would have a risk premium

of zero and a standard deviation of zero.
Sharpe Ratio (Reward-to-Volatility)
• Example. The Sharpe ratio of a portfolio
with an annual risk premium of 8% and
standard deviation of 20% is:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑜𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝐸 𝑟𝑃 −𝑟𝑓 0.08
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = = = 0.4
𝜎𝑃 0.20

• A higher Sharpe ratio indicates a better

reward per unit of volatility, i.e., a more
efficient portfolio.
Definitions
Asset Allocation
• Portfolio choice among broad investment classes

Complete Portfolio
• Entire portfolio, including risky and risk-free assets

Capital Allocation
• Choice between risky and risk-free assets
Risk-Free Asset
Examples of risk-free assets:
• Treasury bonds (still affected by inflation)
• Price-indexed government bonds
• Money market instruments effectively risk-free
• Risk of CDs and commercial paper is miniscule
compared to most assets
Capital Allocation Line (CAL)
Line that depicts the
Sharpe ratio possible allocations
between the risky and
E(rp) = the riskless portfolio is
expected
termed the Capital
rate of
return Allocation Line.

y = proportion
E[rp]-rf of investment
rf = budget
rate of
return on
risk-free
asset
σp = standard deviation CAL: Plot of risk-return
combinations available
E(rC) = return on complete portfolio P = portfolio composition by varying allocation
E(rC) = yE(rp) + (1 − y)rf rp = actual rate of return between risky and risk-
σC = yσrp + (1 − y) σrf free.
 Combinations (y) less than one Combinations (y) above P
With 100% of
represent varying percentages are possible by borrowing
your money in
invested in the risky asset (P) money at F. This is
the risky asset
and (1-y) the percentage conceptually equivalent to
(P) you will
invested in the risk free (F). buying stock on margin.
have a 15%
expected
return and a
22% standard
deviation.

With all of your

money in the
risk free asset
(F) you will
have a 7%
return and a
More risk-averse investors Less risk-averse investors
zero standard
(choose a lower y) (choose a larger y)
deviation.
5.6 Passive Strategies and the Capital Market Line

• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple
• Active management offers potential for higher
returns