CHAPTER 5

Introduction to Risk, Return, and

the Historical Record

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Broad learning goals:

• Appreciating the fact that although there are

theories on the relationship between risk and
expected returns on assets, neither expected
returns nor risk are directly observable!
Asset prices are a function of news about the fortunes
(events) of firm and economy. Since there is no theory
about the frequency and magnitude of those events,
there is no “natural” level of risk.
• Use of historical records in order to have
estimates of risk and expected returns.

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Specific learning goals:

• Understanding the determinants of the level of

interest rates (a form of returns) – both nominal
and real rate of interest.
• Comparing rates of interest (return) over
different holding periods (or on different assets).
• Estimating expected return, risk and risk
premium.

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Interest Rate

• A promised rate of return on an asset

denominated in some unit of account (dollar,
euro, PPP units) over some time period.
• Interest rate on default-free a security is usually
considered risk-free only for the particular unit of
account and maturity period of the security.
• Note that a risk-free security is not really risk-
free when it’s returns are measured using a
different unit of account or are evaluated over a
different period.
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Level of interest rate - Determinants

• Interest rates and forecast of their future values

are key to many investment decisions. Example:
investment in short-term CD versus long-term
CD.
• Although forecasting interest rate is notoriously
difficult, we have good understanding of the
fundamental factors that determine the level of
interest rate.

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Interest Rate Determinants

• Supply
– Households
• Demand
– Businesses
• Government’s Net Supply and/or Demand
– Federal Reserve Actions

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Real and Nominal Rates of Interest

• Nominal interest rate: • Let R = nominal rate,

Growth rate of your r = real rate and i =
money. inflation rate. Then:
• Real interest rate: r  R i
• Exact relation
Growth rate of your between R, r, and i
purchasing power.
(1  R )  (1  r )(1  i )
Ri
 r 
1 i
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Equilibrium Real Rate of Interest

• Equilibrium real rate is determined by the following

set of fundamental factors
– Supply (propensity of households to save)
– Demand (expected profitability of investments)
– Government actions (monetary and fiscal
policies)

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Figure 5.1 Determination of the Equilibrium

Real Rate of Interest

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Equilibrium Nominal Rate of Interest

• Factors affecting real rate PLUS expected inflation rate.
• As inflation rate increases, investors demand higher nominal
return (to maintain the expected real return on investment).
• Fisher (1930) argued that the nominal rate ought to increase
one-for-one with increase in the expected inflation rate, E(i):
R  r  E (i )
• The Fisher equation (hypothesis) implies that the real rate is
reasonably stable and hence an increase in nominal rate
would predict higher inflation rate.
• Real rate may not remain stable (LT bond prices are more
volatile and hence may include a risk premium, which
implies a different expected real rate for LT bonds)!
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Taxes and the Real Rate of Interest

• Tax liabilities are based on nominal income, but

you should be more concerned about your after-
tax real return. See how the latter is penalized
when inflation increases in the presence of a tax
rate (t): R (1  t )  i  ( r  i )(1  t )  i  r (1  t )  it
• Inflation protected tax system provides r (1  t )
• Example: t = 30%, R = 12%, i = 8%, r ≈ 4%
Inflation protected tax system would provide 2.8% as
against 0.4% under the current (traditional) system. Your
inflation penalty i x t = 2.4%!!!
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Rates of Return for Different Holding

Periods (similar-risk securities)
• Assume zero-coupon treasury securities with
several different maturities.
• Par = $100, T=maturity (in years), P=price,
rf(T)=total risk free return for T years is
100
rf (T )  1
P(T )
• Are total returns on investments with differing
horizons comparable?
• Calculate rate of return over a common period.

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Example 5.2 Annualized Rates of Return

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Effective Annual Rate

• EAR: An annualized rate using compound

interest; percentage increase in funds invested
over a 1-year horizon.
1
(1  EAR )T  1  rf T   => (1  EAR )  1  rf T   T

• Check that the 25 year security in the previous

slide with rf(T)=3.2918 will have EAR = 6%.
• EAR are generally used to compare longer-term
investments (T>1, by convention).

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Annual Percentage Rate

• APR: This is also an annualized rate like EAR, but
assumes simple interest. Generally used to compare
shorter-term investments (T<1, by convention).
• If T<1 (e.g., a quarter or T=0.25) and there are n
periods in a year [note when T<1, then n = 1 / T]
• Then APR  n  R f (T ) => R f (T )  T  APR
1 1
n T T
(1  EAR )  [1  rf (T )]  [1  rf (T )]  [1  T  APR ]
T

APR 
1  EAR  1
[EAR  APR; diff. grows with n]
T

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APR at higher compounding frequency

• Given that T<1 and n = 1 / T

1 n
 APR 
T
(1  EAR )  [1  T  APR ]  1  
 n 
As n   or T  0
APRCC
(1  EAR )  e => ln(1  EAR )  APRcc

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Table 5.1 APR vs. EAR

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Risk and Risk Premiums

Holding Period Return (HPR): Single Period

P1  P 0  D1
HPR 
P0
P0 = Beginning price, P1 = Ending price
D1 = Dividend during period one

Note: HPR assumes D1 is paid at the end of holding

period and hence, to the extent D1 is received earlier,
HPR ignores reinvestment income.

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Rates of Return: Single Period Example

Assume following information relates to

shares of an stock-index fund
Ending Price = $110
Beginning Price = $100
Dividend = $4

HPR = ($110 - $100 + $4 )/ ($100) = 14%

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Expected Return and Standard

Deviation
Note that P1 and D1 are clearly uncertain!
Scenario Analysis: One way is to try and quantify
your belief about the state of the market/economy
and the stock-index fund in terms of some
alternative scenarios with associated probabilities.
Once you’ve your probability distribution, you use
that to calculate expected returns and risk.
Time Series Analysis: From historical records of
prices you also can achieve good guidance on
expected returns and risk.
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Scenario Analysis

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Scenario Returns: Example

Expected Return: E (r )   p ( s ) r ( s )
s

State Pr. of State[p(s)] r in State [r(s)]

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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Variance and Standard Deviation

Variance (VAR):

2
   p( s)  r ( s)  E (r )
2

Standard Deviation (STD):

2
STD  
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Scenario VAR and STD

• 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:
  .038
 .1949

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Excess Returns and Risk Premiums

• Should you invest in this index fund?
• Balance expected reward for the risk involved.
Remember you’ve a risk-free alternative to invest in!
• Risk Premium = Expected Return – Risk-free Rate
• Excess Return = Realized Return – Risk-free Rate
• Risk premium is the expected value of excess
returns; and therefore, the standard deviation of
excess returns is a measure of risk.
• The degree to which you’re willing to commit funds
for the investment in question is your risk aversion.
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Time Series Analysis of Past Returns

Time series analysis may help you generate more
reliable estimates of expected returns and risk
than that you might have obtained using scenario
analysis.
The Arithmetic Average of rate of return:
n 1 n
E ( r )   s 1 p ( s )r ( s )   s 1 r ( s )
n
If historical returns fairly represents the true
(unknown) probability distribution of returns,
arithmetic average provides a good forecast of the
investment’s expected return (expected HPR).
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Measuring actual performance of

investments: Geometric Average Return
• Geometric Average Return

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Measuring actual performance of

investments: Geometric Average Return
n
TV n  (1  r1 )(1  r2 )...( 1  rn )  (1  g )
TV = Terminal value of the investment
g = Geometric average rate of return
1
g  TV n 1

Note: Arith. Avg. 2.10% Vs. Geo. Avg. 0.54% !

It arises from the asymmetric effect of positive and
negative rates of returns (of the same magnitude) on
the terminal value of the investment (portfolio).

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Time Series Variance and Standard Deviation

• Estimated Variance = expected value of squared

deviations
n _ 2 n _ 2
1   1  
   r s   r 
ˆ 2
ˆ
   r s   r 
n s 1   n s 1  
• When eliminating the bias, Variance and
Standard Deviation become:
n _ 2 n _ 2
1   1  
2
ˆ    r s   r  ˆ    r s   r 
n  1 j 1   n  1 j 1  

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Reward-to-Volatility Ratio - Sharpe Ratio

• In a competitive market place, investors price

risky asset so that the RP is commensurate
with the risk of that expected excess returns.
We will stress the point again when
discussing equilibrium asset (security) pricing
in later chapters.

• Sharpe Ratio for Portfolios:

Risk Premium
Sharpe Ratio 
SD of Excess Returns
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Mean, SD and Sharpe Ratio Estimates

from Higher-Frequency Observations
• Assuming identical return distributions (same mean and
variance) across periods, observation frequency has no
impact on the accuracy of mean estimates.
• When monthly returns are uncorrelated (independent)
from one month to another, monthly variances simply
add up. Hence, for example, the T-month variance is T
times the 1-month variance.
• Accordingly, the Sharpe ratio will be higher when
annualized from higher frequency returns. For example,
to annualize the Sharpe ratio from monthly rates, we
multiply the numerator by 12 and the denominator by
sqrt(12).
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The Normal Distribution

• The bell-shaped normal distribution appears naturally
in many applications. Variables that are subject to
multiple random influences will exhibit normal
distribution.
• Investment management is easier when returns are
normal.
– Standard deviation is a good measure of risk when
returns are symmetric.
– If security returns are symmetric, portfolio returns will be,
too.
– Future scenarios can be estimated using only the mean
and the standard deviation.
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Figure 5.4 The Normal Distribution

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Normality and Risk Measures

• What if excess returns are not normally

distributed?
– Standard deviation is no longer a complete
measure of risk
– Sharpe ratio is not a complete measure of
portfolio performance
– Need to consider skew and kurtosis

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Skew and Kurtosis

Skew Kurtosis
Equation 5.19 • Equation 5.20
 ( R  R )3   (R  R )4 
skew  average 3  kurtosis  average 4  3
  ˆ   ˆ 

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Figure 5.5A Normal and Skewed

Distributions

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Figure 5.5B Normal and Fat-Tailed

Distributions (mean = .1, SD =.2)

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