Week 3

Risk and return

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1

Rates of Return
• Holding-Period Return (HPR)
• Rate of return over given investment period

PS − PB + Div
HPR =
PB
where
PS = Sale Price
PB = Buy Price
Div = Cash Dividend
Rates of Return: Example
• What is the HPR for a share of stock that was
purchased for $25, sold for $27 and distributed
$1.25 in dividends?
PS − PB + Div $27 − 25 + 1.25
HPR = = 13%
PB 25

Capital Gains Yield? Dividend Yield?

$27 − 25 $1.25
= 8% = 5%
25 25
Rates of Return: Measuring over Multiple Periods
• 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

• Dollar-weighted average return

• Internal rate of return on investment
Rates of Return of a Mutual Fund: Example

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of quarter 1 1.2 2 0.8
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of quarter 1.2 2 0.8 1.56

Arithmetic Average Geometric Average

10% + 25% + (−20%) + 20% 1
= 8.75% [(1.1) × (1.25) × (.8) × (1.2)] − 1 =7.19%
4
4

−-0.1
1.0 −.5 .8 .96
Dollar-Weighted 0 =
−1.0 + + + +
1 + IRR (1 + IRR) (1 + IRR) (1 + IRR) 4
2 3

IRR = 3.38%
Rates of Return

• Annualising Rates of Return

• APR = Annual Percentage Rate
• Per-period rate × Periods per year
• Ignores Compounding

• EAR = Effective Annual Rate

• Actual rate an investment grows
• Does not ignore compounding
Rates of Return: EAR vs. APR
For n periods of compounding:
APR n
EAR =
(1 + ) −1
n
1
= [( EAR + 1) − 1] × n
APR n

where
n = compounding per period

For Continuous Compounding:

= e APR − 1
EAR
=
APR ln( EAR + 1)
Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1+ R
1+ r =
1+ i
where
r = Real Interest Rate
R = Nominal Interest Rate
i = Inflation Rate

Example : What is the real return on an investment that earns a nominal 10%
return during a period of 5% inflation?
1 + .10
1=
+r = 1.048
1 + .05
r = .048 or 4.8%
Inflation and The Real Rates of Interest
• Equilibrium Nominal Rate of Interest
• Fisher Equation
• R = r + E(i)
• E(i): Current expected inflation
• R: Nominal interest rate
• r: Real interest rate
Interest Rates, Inflation, and Real Interest Rates

Source: Bodie, Kane and Marcus (2019: 117)

Inflation and The Real Rates of Interest
• U.S. History of Interest Rates, Inflation, and
Real Interest Rates
• Since the 1950s, nominal rates have increased
roughly in tandem with inflation
• 1930s/1940s: Volatile inflation affects real rates
of return
Risk and Risk Premiums
• Scenario Analysis and Probability Distributions
• Scenario analysis: Possible economic scenarios; specify
likelihood and HPR

• Probability distribution: Possible outcomes with probabilities

• Expected return: Mean value

• Variance: Expected value of squared deviation from mean

• Standard deviation: Square root of variance

Scenario Analysis for the Stock Market

Source: Bodie, Kane and Marcus (2019: 117)

Risk and Risk Premiums
• The Normal Distribution

• Transform normally distributed return into

standard deviation score:
𝑟𝑟𝑖𝑖 − 𝐸𝐸(𝑟𝑟𝑖𝑖 )
𝑠𝑠𝑠𝑠𝑖𝑖 =
𝜎𝜎𝑖𝑖

• Original return, given standard normal return:

𝑟𝑟𝑖𝑖 = 𝐸𝐸 𝑟𝑟𝑖𝑖 + 𝑠𝑠𝑠𝑠𝑖𝑖 × 𝜎𝜎𝑖𝑖
Normal Distribution r = 10% and σ = 20%

Source: Bodie, Kane and Marcus (2019: 119)

Risk and Risk Premiums
• Normality over Time
• When returns over very short time periods are
normally distributed, HPRs up to 1 month can be
treated as normal
• Use continuously compounded rates where
normality plays crucial role
Risk and Risk Premiums
• Deviation from Normality and Value at Risk
• Kurtosis: Measure of fatness of tails of probability
distribution; indicates likelihood of extreme outcomes
• Skew: Measure of asymmetry of probability distribution

• Using Time Series of Return

• Scenario analysis derived from sample history of returns
• Variance and standard deviation estimates from time
series of returns:
Risk and Risk Premiums: Value at Risk

• Value at risk (VaR):

•Measure of downside risk
•Worst loss with given probability, usually 5%
Risk and Risk Premiums
• Risk Premiums and Risk Aversion
• Risk-free rate: Rate of return that can be earned
with certainty
• Risk premium: Expected return in excess of that
on risk-free securities
• Excess return: Rate of return in excess of risk-
free rate
• Risk aversion: Reluctance to accept risk
• Price of risk: Ratio of risk premium to variance
Risk and Risk Premiums: Sharpe Ratios
• The Sharpe (Reward-to-Volatility) Ratio
• Ratio of portfolio risk premium to standard
deviation
• Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios
Portfolio Risk Premium E (rp ) − rf
SP =
Standard Deviation of Excess Returns σP
where
E (rp ) = Expected Return of the portfolio
rf = Risk Free rate of return
σ P = Standard Deviation of portfolio excess return
Excess Returns

Source: Bodie, Kane and Marcus (2019: 135)

The Historical Record: World Portfolios
• World Large stocks: 24 developed countries,
~6000 stocks
• U.S. large stocks: Standard & Poor's 500 largest
cap
• U.S. small stocks: Smallest 20% on NYSE,
NASDAQ, and Amex
• World bonds: Same countries as World Large
stocks
• U.S. Treasury bonds: Barclay's Long-Term
Treasury Bond Index
Historical Return and Risk

Source: Bodie, Kane and Marcus (2019: 127)

Historic Returns: Treasury Bills

Source: Bodie, Kane and Marcus (2019: 126)

Historic Returns: Treasury Bonds

Source: Bodie, Kane and Marcus (2019: 126)

Historic Returns: Equity Markets

Source: Bodie, Kane and Marcus (2019: 126)

Asset Allocation across Portfolios

• 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
Asset Allocation across Portfolios

• The Risk-Free Asset

• 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
Portfolio Asset Allocation: Expected Return and Risk

Expected Return of the Complete Portfolio

E (rC ) = y × E (rp ) + (1 − y) × r f
where E (rC ) = Expected Return of the complete portfolio
E (rp ) = Expected Return of the risky portfolio
rf = Return of the risk free asset
y = Percentage assets in the risky portfolio

Standard Deviation of the Complete Portfolio

σ C= y ×σ p
where σ C = Standard deviation of the complete portfolio
σ P = Standard deviation of the risky portfolio
Investment Opportunity Set

Source: Bodie, Kane and Marcus (2019: 132)

Asset Allocation across Portfolios

• Capital Allocation Line (CAL)

• Plot of risk-return combinations available by
varying allocation between risky and risk-free
• Risk Aversion and Capital Allocation
• y: Preferred capital allocation
Passive Strategies and the Capital Market Line

• Passive Strategy
• Investment policy that avoids security analysis

• Capital Market Line (CML)

• Capital allocation line using market-index
portfolio as risky asset
Passive Strategies and the Capital Market Line

• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple
• Expense ratio of active mutual fund averages 1%
• Expense ratio of hedge fund averages 1%-2%,
plus 10% of returns above risk-free rate
• Active management offers potential for higher
returns
Homework problems
• BKM chapter 5
• Problems 5, 6, 8, 12-14
• CFA problems 4-6
• Web master problems 1, 2