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Learning Module 2: Risk & Return Measurement: Portfolio Management

This learning module provides an overview of risk and return measurement in portfolio management. It discusses key concepts such as interest rates and their determinants, rates of return over different holding periods, risk premiums, and methods for estimating expected returns and risk including standard deviation and the normal distribution. It also examines how returns have behaved historically for different risky portfolios and notes that while the normal distribution often approximates returns well, skewness and excess kurtosis are sometimes present.

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Yaonik Himmatramka
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37 views23 pages

Learning Module 2: Risk & Return Measurement: Portfolio Management

This learning module provides an overview of risk and return measurement in portfolio management. It discusses key concepts such as interest rates and their determinants, rates of return over different holding periods, risk premiums, and methods for estimating expected returns and risk including standard deviation and the normal distribution. It also examines how returns have behaved historically for different risky portfolios and notes that while the normal distribution often approximates returns well, skewness and excess kurtosis are sometimes present.

Uploaded by

Yaonik Himmatramka
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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LEARNING MODULE 2:

RISK & RETURN


MEASUREMENT
Portfolio Management
Overview
◦ Interest rate determinants
◦ Rates of return for different holding periods
◦ Risk and risk premiums
◦ Estimations of return and risk
◦ Normal distribution
◦ Deviation from normality and risk estimation
◦ Historic returns on risky portfolios
RISK & RETURN
MEASUREMENT
Interest Rate Determinants
◦ Supply
◦ Households
◦ Demand
◦ Businesses
◦ Government’s net demand
◦ RBA / Fed actions
Real versus Nominal Interest Rates
rnom  Nominal Interest Rate
rreal  Real Interest Rate
i  Inflation Rate Note : rreal  rnom  i
rnom  i
rreal 
1 i
◦ 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:

rnom  rreal  E  i 
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 )
Effective Annual Rate (EAR) and
Annual Percentage Rate (APR) 1
◦ Effective Annual Rate (EAR) [1]: 1  EAR  1  rf  T   T
◦ Compare returns on investments with different horizons.

 1  EAR   1
T

APR 
◦ Annualized Percentage Rate (APR) [2]:
T
◦ For [1]: (1+EAR)^T = 1+rf(T) => (1+EAR)^T – 1 = rf(T) => APR = rf(T) / T => [2]
T-Bill Rates, Inflation Rates, and Real Rates, 1926-2015

Moderate i offsets most nominal gains on low-risk investments


$1 in T-bills from 1926–2015 grew to $20.25 but with a real
value of only $1.55, due to inflation
Negative correlation between rreal and i  rnom doesn’t fully
compensate investors for increases in i.
Risk and Risk Premiums
◦ Rates of return: Single period
E ( P1)  P 0  E ( D1)
HPR 
P0
◦ HPR = Holding period return
◦ P0 = Beginning price
◦ E(P1) = Expected Ending price
◦ E(D1) = Expected Dividend during period one
◦ (Could replace this with coupon payment if looking at bonds)
Example: Single Period Rates of Return
Expected Ending Price = $110
Beginning Price = $100
Expected Dividend = $4
E ( P1)  P 0  E ( D1) $110  $100  $4
HPR  
P0 $100
$110  $100 $4
 
$100 $100
 10%  4%  14% Holding Period Return

Capital Gains Yield Dividend Yield


Expected Return and Standard Deviation
◦ Expected returns
◦ p(s) = Probability of a state
E (r )   p( s)  r ( s)
◦ r(s) = Return if a state occurs s
◦ s = State

   p  s    r  s   E  r  
2 2
◦ Variance (VAR):
s

◦ Standard Deviation (STD): STD   2


Example: Returns and Standard Deviation
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%
 2  .25  (.31  0.0976) 2  .45  (.14  .0976) 2 σ  .038
.25  (0.0675  0.0976)2  .05  (.52  .0976) 2
 .1949
 .038
Returns Using Arithmetic and
Geometric Averaging
n n
1
E (r )   p( s)r ( s)   r ( s)
◦ Arithmetic Average

n s 1 s 1

◦ Geometric (Time-Weighted) Average


◦ Terminal value of the investment:
TVn  (1  r1 )(1  r2 )...(1  rn )
◦ Geometric Average:
g  TVn1/ n  1
Estimating
Variance and Standard Deviation
◦ Estimated Variance
◦ Expected value of squared deviations
n
1
ˆ    r  s   r 
2 2

n s 1
r is sample average, not the true population’s average: thus to reduce the bias, we have
◦ Unbiased estimated standard deviation n 2
1
ˆ   r s  r 
n  1 j 1
The Normal Distribution
◦ Investment management is easier with normal returns:
◦ Symmetric Returns  Standard deviation is a good measure of risk
◦ Symmetric Returns  Portfolio returns will be as well
◦ Only mean and standard deviation needed to estimate future scenarios
◦ Pairwise correlation coefficients summarize the dependence of returns
across securities
Normality and Risk Measures
◦ What if excess returns are not normally distributed?
◦ STD is no longer a complete measure of risk
◦ Skewness:  ( R  R )3 
Skew  Average  
 ˆ
3

 ( R  R )4 
Kurtosis  Average   3
 ˆ 4

◦ Kurtosis:
Skewness in picture
Kurtosis in picture
Normal and Skewed Distributions : application of
skewness

Mean = 6%

STD = 17%
Normal and Fat-Tailed Distributions: application of
kurtosis

Mean = 10%

STD = 20%
Historic Returns on Risky Portfolios
Historic Returns on Risky Portfolios
◦ The second half of the 20th century offered the highest average returns

◦ Firm capitalization is highly skewed to the right: Many small but a few gigantic firms

◦ Average realized returns have generally been higher for small stocks vs. large stocks

◦ Normal distribution is generally a good approximation of returns


◦ VaR indicates no greater tail risk than equivalent normal
◦ ES ≤ 0.41 of monthly SD  no evidence against normality

◦ However
◦ Negative skew is present in some portfolios some of the time
◦ Positive kurtosis is present in all portfolios all the time
Average “Excess” Returns Around the
World: 1900-2015

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