TOPIC 2

BASICS OF RISK AND RETURN

Related Chapters 5,6:
“Risk, Return, and the Historical Record”
“Capital Allocation to Risky Assets”
Reading:
1. Investments, 11th edition. Zvi Bodie, Alex Kane, Alan J. Marcus – Chapters 5,6

Prepared by: Ilyas Imachikov

For a typical person living in Almaty: However, from the standpoint of a
• A time deposit in a commercial bank professional – we have a much wider
• A mutual fund, although not popular array of possible instruments:
still • Stocks
• Real estate • Bonds
• Personal business • Real estate
• Automobile (even though not a • Precious metals
profitable investment) • Collectibles

• Options
Every individual security has its own risk • Futures
and return characteristics; • Other derivative securities
But should be judged on its contributions
to both the expected return and the risk
of the entire portfolio.

In this chapter we are going to look at the ABC of the risk and return which
will help us in understanding the portfolio management process.
A key measure of investors’ success is the rate at which their funds have grown during the
investment period.
Holding-period return (HPR) – rate of return over a given investment period

HPR may be recalculated to APR or some any other measure of rate of return. But don’t
misinterpret it. HPR is a broader definition.
Ex: HPR =
The HPR of a share of stock depends on
1. Capital Gain / Price appreciation - the increase (or decrease) in the price of a share over the
investment period as well as on
2. Dividend Yield / Dividends received - any dividend income the share has provided.
The HPR of a bond depends on
1. Capital Gain / Price appreciation - the increase (or decrease) in the price of a bond over the
investment period as well as on
2. Interest Yield / Coupons received– interest received in form of coupons on the bond
If you purchase the bond at its face value and hold it till maturity → then Price Appreciation = 0
Note: The definition ignores the pattern and timing of payments.
Ex: it doesn’t take into account the reinvestment income between the receipt of the
dividend and the end of a holding period.
This is usually important in valuation of bonds and other fixed-rate investments.

Ex: _____________________________________________________________________
Suppose you are considering investing some of your money, now all invested in a bank
account, in a stock market index fund. The price of a share in the fund is currently $100,
and your time horizon is one year. You expect the cash dividend during the year to be $4.
You expect the price per share after one year at $110.
• Calculate the expected HPR
• Calculate the expected Capital Gain For the Holding
• Calculate the expected Dividend Yield Period of one year
Note: The definition ignores the pattern and timing of payments.
Ex: it doesn’t take into account the reinvestment income between the receipt of the
dividend and the end of a holding period.
This is usually important in valuation of bonds and other fixed-rate investments.

Ex: _____________________________________________________________________
Suppose you are considering investing some of your money, now all invested in a bank
account, in a stock market index fund. The price of a share in the fund is currently $100,
and your time horizon is one year. You expect the cash dividend during the year to be $4.
You expect the price per share after one year at $110.
• Calculate the expected HPR
• Calculate the expected Capital Gain Yield For the Holding
• Calculate the expected Dividend Yield Period of one year

Capital Gain Yield Dividend Yield

Ex: _____________________________________________________________________
Suppose you are considering investing some of your money, now all invested in a bank
account, in a stock market index fund. The price of a share in the fund is currently $100,
and your time horizon is one year. You expect the cash dividend during the year to be $4.
You expect the price per share after one year at $110.
• Calculate the expected HPR
• Calculate the expected Capital Gain Yield For the Holding
• Calculate the expected Dividend Yield Period of one year

Capital Gain Yield Dividend Yield

Capital Gain Yield

Dividend Yield
HPR
The holding period return is a simple and unambiguous measure of investment return over a single
period. But often you will be interested in average returns over longer periods of time.
Ex: Consider a fund that starts with $1 mln under management at the beginning of the year. The
fund receives additional funds to invest from new and existing, and also receives requests for
redemptions from existing shareholders. Its net cash flow can be positive or negative.
Table 5.1 1st 2nd 3rd 4th
Quarterly cash Quarter Quarter Quarter Quarter
flows and rates
of return of a
Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8
mutual fund
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0
Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0
Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0
*New investment less redemptions and distributions, all assumed to occur at the end of each quarter

How would we characterize fund performance over the year, given that fund experienced both cash
inflows and outflows?
We have three possible measures

Arithmetic Average Geometric Average Dollar Weighted Return

• Each measure has its advantages and shortcomings

• Measures may vary considerably, so it’s important to understand their differences.
 Table 5.1 1st 2nd 3rd 4th
Quarterly cash Quarter Quarter Quarter Quarter
Arithmetic flows and rates
of return of a Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8
Average mutual fund
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0
The sum of Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0
returns in each Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0
period divided *New investment less redemptions and distributions, all assumed to occur at the end of each quarter
by the number
of periods

For our example the

arithmetic average return (10+25-20+25)/4 = 10%
would be:

Shortcomings
• This statistics ignores compounding thus doesn’t represent an equivalent, single
quarterly rate for the year.
Advantages
• The arithmetic average is a useful forecast of performance in future quarters (iff the
sample is large enough or representative enough to make accurate forecasts)
 Table 5.1 1st 2nd 3rd 4th
Geometric Quarterly cash Quarter Quarter Quarter Quarter
flows and rates
Average of return of a Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8
The single per- mutual fund
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
period return that Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0
gives the same Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0
Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0
cumulative
*New investment less redemptions and distributions, all assumed to occur at the end of each quarter
performance as
Geometric
the sequence of average
actual returns return
In calculating the
geometric average return (1+0.10)×(1+0.25) ×(1-0.20)×(1+0.25) = (1+rG)4
we use compounding
rG = [(1+0.10)×(1+0.25) ×(1-0.20)×(1+0.25)] 1/4 – 1 = 0.0829 or 8.29%
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Assets under management at start of quarter ($ mln) 1,0 1,1 1,4 1,1
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
Total assets before net inflows ($ mln) 1,1 1,4 1,1 1,4
Net Inflow ($ mln)*
Assets under management at end of quarter ($ mln) 1,1 1,4 1,1 1,4
Notice the
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
same
Assets under management at start of quarter ($ mln) 1,0 1,1 1,2 1,3 performance
Holding-period return (%) 8,29% 8,29% 8,29% 8,29% for both cases
Total assets before net inflows ($ mln) 1,1 1,2 1,3 1,4
Net Inflow ($ mln)*
Assets under management at end of quarter ($ mln) 1,1 1,2 1,3 1,4
 Table 5.1 1st 2nd 3rd 4th
Geometric Quarterly cash Quarter Quarter Quarter Quarter
flows and rates
Average of return of a Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8
The single per- mutual fund
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
period return that Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0
gives the same Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0
Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0
cumulative
*New investment less redemptions and distributions, all assumed to occur at the end of each quarter
performance as
1st 2nd 3rd 4th 1st 2nd 3rd 4th 1st 2nd 3rd 4th
the sequence of Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
actual returns 1,0 1,2 2,0 1,7 1,0 1,2 1,5 1,0 1,0 1,4 1,6 0,9
10,0% 25,0% 25,0% -20,0% 10,0% -20,0% 25,0% 25,0% 25,0% -20,0% 10,0% 25,0%
1,1 1,5 2,5 1,4 1,1 1,0 1,8 1,3 1,3 1,1 1,7 1,2
0,1 0,5 -0,8 0,0 0,1 0,5 -0,8 0,0 0,1 0,5 -0,8 0,0
1,2 2,0 1,7 1,4 1,2 1,5 1,0 1,3 1,4 1,6 0,9 1,2

In each case we will calculate the same geometric average return of 8,29%
Shortcomings
• The geometric average is often called a time-weighted average return because it doesn’t take into account
variations in money under management in each quarter. In other words, it doesn’t take into account
differences in customer deposits and withdrawals in and out of fund.
Advantages
• Makes a use of compounding thus does represent an equivalent, single quarterly rate of return for the
year. → A good representative measure to evaluate past performance.
• Sometimes we wish to ignore variations in money under management.
• Ex: Published data on past returns earned by mutual funds are required to be time-weighted returns.
• Logic is that as a fund manager doesn’t have a full control of the amount of funds under
management, we should not weight returns in one period more heavily than those in other
periods when assessing typical past performance.
 Table 5.1 1st 2nd 3rd 4th
Dollar Quarterly cash Quarter Quarter Quarter Quarter
flows and rates
Weighted of return of a Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8
Return mutual fund
Holding-period return (%) 10,0% 25,0% -20,0% 25,0%
Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0
The internal rate Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0
of return on an Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0
investment *New investment less redemptions and distributions, all assumed to occur at the end of each quarter
When we wish to account for the
varying amounts under Time
management, we treat the fund 0 1 2 3 4
cash flows to investors as we
Net cash flow ($ mln) -1,0 -0,1 -0,5 0,8 1,0
would a capital budgeting
problem in corporate finance. The project which needs cash outflows and provides cash inflows
The IRR is the interest rate that sets the present value of the cash flows realized on the portfolio
(including $1mln liquidation value) equal to the initial cost of establishing the portfolio.

The dollar weighted return in

this example is less than the
time-weighted return of 8.29%
because the portfolio returns
were higher when less money
was under management.
Shortly, how to use each ratio
• The arithmetic average is a useful forecast of performance in future quarters (iff the
sample is large enough or representative enough to make accurate forecasts)
• Geometric average is a good representative measure to evaluate past performance.
• When we wish to account for the varying amounts under management we may use
dollar weighted average.
Shortly, how to use each ratio
• The arithmetic average is a useful forecast of performance in future quarters (iff the
sample is large enough or representative enough to make accurate forecasts)
• Geometric average is a good representative measure to evaluate past performance.
• When we wish to account for the varying amounts under management we may use
dollar weighted average.

Question
• Assuming that our fund is going to attract some $400’000 and $300’000 in net cash
inflows in quarters 1 and 2, respectively, of the next year. What dollar amount of
assets under management should we expect at the end of each quarter, given the
information provided from the table 5.1?
 Question
• Assuming that our fund is going to attract some $400’000 and $300’000 in net cash
inflows in quarters 1 and 2, respectively, of the next year. What dollar amount of
assets under management should we expect at the end of each quarter, given the
information provided from the table 5.1?

1st 2nd 3rd 4th 1st 2nd

Quarter Quarter Quarter Quarter Quarter Quarter
Assets under management at start of quarter ($ mln) 1,0 1,2 2,0 0,8 1,0 1,5
Holding-period return (%) 10,0% 25,0% -20,0% 25,0% 10,0% 10,0%
Total assets before net inflows ($ mln) 1,1 1,5 1,6 1,0 1,1 1,7
Net Inflow ($ mln)* 0,1 0,5 -0,8 0,0 0,4 0,3
Assets under management at end of quarter ($ mln) 1,2 2,0 0,8 1,0 1,5 2,0
Example: Return measures
An investor purchased $1,000 of a mutual fund’s shares. The fund had the following total
returns over a 3-year period: +5%, –8%, +12%. Calculate the value at the end of the 3-year
period, the holding period return, the mean annual return, and the geometric mean
annual return.
Example: Money-weighted rate of return
Assume an investor buys a share of stock for $80 at t = 0 and at the end of the next year (t = 1), she
buys an additional share for $70. At the end of Year 2, the investor sells both shares for $85 each. At
the end of each year in the holding period, the stock paid a $1.50 per share dividend. What is the
money-weighted rate of return?
Answer:
Step 1: Determine the timing of each cash flow and whether the cash flow is an inflow (+), into the
account, or an outflow (–), available from the account.

You may use the IRR

formula in excel to
calculate this
See also http://www.verisi.com/resources/dollar-weighted-returns.htm
From bank management we remember that there may be a lot of interest rate quotations,
such as, Simple Interest, Discount Rate, APR, etc.
The same is true for Quoting Rates of Return.
How to report profitability of various investment instruments?
Returns on assets with regular cash flows, such as mortgages (with monthly payments)
and bonds (with semiannual coupons), usually are quoted as APRs.
APR annualizes per-period rates using a simple interest approach, but ignores
compounding of interest.
We can translate APR into EAR by remembering that
APR = Per-period rate × Periods per year
1 + EAR = (1 + Rate per period)n
We can retranslate the relationship between APR and EAR as follows:
1 + EAR = (1 + Rate per period)n = (1 + APR/n)n

APR = [(1+EAR)1/n – 1] × n
The EAR diverges by greater amounts from the APR as n becomes larger (i.e., as we
compound cash flows more frequently).
With continuous compounding (when n approaches to ∞) the relationship between the
APR and EAR becomes
1+EAR = eAPR
Or equivalently,
APR = ln(1 + EAR)
Example: Annualizing Treasury-Bill Returns
Suppose you buy a $10’000 face value Treasury bill maturing in one month for
$9’900. On the bill’s maturity date, you collect the face value.
•What is the HPR for this one-month investment?
•What is the APR for this period?
•What is the EAR?

Compare this investment with the same T-bill but with face value of $100’000,
maturing in three months and a current price of $97’059.
•What is the HPR for this one-month investment?
•What is the APR for this period?
•What is the EAR?

Why does the EAR differ in the two cases?

Which investment has a higher EAR?
Which investment looks to be more profitable?
Example: Annualizing Treasury-Bill Returns
$10’000 bill

APR on this investment is = 1.01 × 12 = 12.12%

1+ EAR = (1.0101)12 => EAR = 12.82%

$100’000 bill

APR on this investment is = 3.03 × 12 = 12.12%

1+ EAR = (1.0303)4 = > EAR = 12.68%

Which investment has a higher EAR? $10’000 bill

Which investment looks to be more profitable? $10’000 bill
Why does the EAR differ in the two cases? Answer: Compounding
 Other Return Measures

• preferred measure for selecting and

evaluating the relative performance of the
portfolio managers
• also preferred for attribution, risk, and
other value-added reporting

commissions on managerial and administrative

trades and other Gross expenses such as management Net
HPR - costs directly = return - fees, custodial fees, taxes, and any = return
related to trading other administrative expenses

• These returns are what the investor is interested in knowing.

• also be used for measuring the actual performance of the
manager at the fund level.

if we take two identical funds, the fund having less assets will seem to have lower net returns
compared to a fund with larger asset base because of the fee benefit for larger fund.
For this reason, many mutual funds that don’t have large assets under management will waive
off some fees to make their returns attractive to investors.
Other Return Measures

Pretax nominal return After-tax nominal return

refers to the return refers to the return after
prior to paying taxes. paying taxes.
Dividend income, interest
income, short-term capital
gains, and long-term
capital gains may all be
taxed at different rates.
Leveraged return
gain or loss on the investment as a
percentage of an investor’s cash
investment.
Consider ROE vs ROA
When we want to quantify risk regarding our expected HPR, we face two questions
1. What HPRs are possible?
2. How likely is each case?
Scenario Analysis:
1. Devise a list of possible economic outcomes, or scenarios
2. Specify the likelihood of each scenario and the HPR the asset will realize in that scenario.
The list of all possible HPRs with associated probabilities is called the probability distribution
of HPRs.

Consider an investment in a broad portfolio of stocks (say, an index fund) which we will
refer to as the “stock market”. A very simple scenario analysis for the stock market
(assuming only three possible scenarios) is illustrated in the table below:

Table 5.2 State of the Economy Scenario, s Probability, p(s) HPR

Probability Boom 1 0.25 44%
distribution of
HPR on the Normal growth 2 0.50 14%
stock market Recession 3 0.25 -16%
Table 5.2 State of the Economy Scenario, s Probability, p(s) HPR
Probability Boom 1 0.25 44%
distribution of
HPR on the Normal growth 2 0.50 14%
stock market Recession 3 0.25 -16%

The probability distribution helps us derive measurements for both the reward and the risk of
the investment.
Reward from the investment is its expected return, which you can think of as the average HPR
you would earn if you were to repeat an investment in the asset many times.
The general formula the expected return is:
Number of scenarios HPR in each
scenario
Expected HPR
Probability of
each scenario

Calculate the expected return on the stock market

Table 5.2 State of the Economy Scenario, s Probability, p(s) HPR
Probability Boom 1 0.25 44%
distribution of
HPR on the Normal growth 2 0.50 14%
stock market Recession 3 0.25 -16%

The probability distribution helps us derive measurements for both the reward and the risk of
the investment.
Reward from the investment is its expected return, which you can think of as the average HPR
you would earn if you were to repeat an investment in the asset many times.
The general formula the expected return is:
Number of scenarios HPR in each
scenario
Expected HPR
Probability of
each scenario

Calculate the expected return on the stock market:

E(r) = 0.25×44% + 0.50×14% + 0.25×(-16%) = 14%
Does the return we have calculated represent the actual return that we will have?
Can we state that we will earn a 14% return on our investment in stocks?
What is the possibility that there will be any deviation in actual return from our expected 14%?
Of course there is a risk to our investment and actual return may deviate from our expected
14%.
• If a “boom” materializes actual return would be 44%, representing a 30% positive surprise.
• In a recession the return may be disappointing -16%, representing a 30% negative surprise.

Risk surrounding the investment is a function

of the magnitudes of possible surprises.
The measures of risk to be introduced is
variance and standard deviation.
•What these two measures tell us is by how
much we can expect actual returns to be
different from expected returns.
•Formulas, you know them:

For our example:

What does this

number tell us?
Drawback to the use of variance and standard deviation as a measures of risk:
• treat positive and negative deviations symmetrically, whereas a risk is associated with
negative deviations.
• However, evidence shows that for fairly short holding periods, the returns of almost all
diversified portfolios are well described by a normal distribution.
• In conditions stated above we may use standard deviation as a measure of possible
negative surprises.

A share of stock of A-Star Inc. is now selling for $23.50. A financial analyst summarizes
the uncertainty about next year’s HPR on the stock by specifying three possible
scenarios:
End-of- Annual
Business conditions Scenario, s Probability, p(s) Year price Dividend
High growth 1 0.35 $35 $4.40
Normal growth 2 0.30 $27 $4.00
No growth 3 0.35 $15 $4.00

• What are the annual HPRs of A-Star stock for each of the three scenarios? Calculate the
expected HPR and the standard deviation of the HPR.
A share of stock of A-Star Inc. is now selling for $23.50. A financial analyst summarizes
the uncertainty about next year’s HPR on the stock by specifying three possible
scenarios:
End-of- Annual
Business conditions Scenario, s Probability, p(s) Year price Dividend
High growth 1 0.35 $35 $4.40
Normal growth 2 0.30 $27 $4.00
No growth 3 0.35 $15 $4.00

• What are the annual HPRs of A-Star stock for each of the three scenarios? Calculate the
expected HPR and the standard deviation of the HPR.

Probability, End-of-Year Annual Purchase Price Capital Total $

Business conditions Scenario, s p(s) price Dividend of stock Gain Return HPR

High growth 1 0,35 $35,00 $4,40 $23,50 $11,50 $15,90 67,66%

Normal growth 2 0,30 $27,00 $4,00 $23,50 $3,50 $7,50 31,91%

No growth 3 0,35 $15,00 $4,00 $23,50 -$8,50 -$4,50 -19,15%

E(r) = 0.35×67.66% + 0.30×31.91% + 0.35×(-19.15%) = 26.55%

How much, if anything, should you invest in an index stock fund such as the one described
in Table 5.2?
First, you must ask how much of an expected reward is offered to compensate for the risk
involved in investing money in stocks?
The reward for additional risk is measured as the difference between the expected HPR
on the index stock fund and the risk-free rate (the rate you can earn by leaving money in
risk-free assets such as T-bills, MMF, or the bank), and usually is named as the risk-
premium.
Ex: If the rf in the example is 6%, and the expected index fund return is 14%, then the risk
premium on stocks is 8% per year.
The degree to which investors are willing to commit funds to stocks depends on risk
aversion.
In theory then, there must always be a positive risk premium on stocks in order to induce
risk-averse investors to hold the existing supply of stocks instead of placing them in risk-
free assets.

In fact,
• In long term, most often, we may see that stock market returns are generally higher than bond
market returns, with greater risks associated with those returns of course.
• During bad times at stock market, we may see an outflow of capital from stock to bond markets, i.e.,
reward for excessive risk drops, and thus people take their funds out to a safer place. This is a partly
explanation of course. See the case below
As an addition
for your better
understanding
of stock and
bond markets

But don’t take

this as a
universe rule
For your understanding:
Gilt-edged securities, or gilts, are
bonds issued by the U.K.
government. Similar to U.S.
Treasury bonds, they are debt
obligations with maturities ranging
from 1 month to 30 years.
So, we will assume that the risk premium that an investor demands to hold a risky portfolio
rather than placing all of her funds in safe T-bills offering the risk-free rate is proportional to
the product of her risk aversion, A, and the variance of the risky portfolio’s rate of return :
variance of the risky portfolio’s rate of return

Risk premium

Risk aversion

Notes to the formula:

• Investors would not demand a risk premium for a risk-free portfolio (for which = 0)
• As the portfolio’s variance or an investor’s risk aversion increase, we need a higher risk
premium to satisfy the investor for these two factors.
• The factor of ½ is merely a scale factor. It is widely used by convention, but has no
bearing on the analysis.
• To use this equation, all rates of return must be expressed as decimals rather than
percentages.
• This model is a good thing to understand the factors affecting the risk premium. It may
be impossible to use this model for analysis.
By examining risk-return trade-off offered by a representative portfolio (and willingly held by the
representative investor) we should be able to infer something about the typical investor’s risk
aversion.
If investors trade off risk against return in the manner specified by the equation above, then we
can infer the degree of risk aversion from the characteristics of the market portfolio, M, as:

If risk premium is 8%, and the standard deviation is 20%, then we

would infer risk aversion of this investor to be A = 0.08/0.202 = 2

In practice,
• We cannot observe risk premium investors expect to earn on their investments.
• We can only observe actual returns after the fact.
• Different investors may have different expectations about the risk and return of various
assets.
• The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for
the risk taken, the higher the Sharpe ratio number the better.
• When comparing two assets each with the expected return E[R] against the same benchmark with
return Rf, the asset with the higher Sharpe ratio gives more return for the same risk.
• Investors are often advised to pick investments with high Sharpe ratios. However like any
mathematical model it relies on the data being correct. Pyramid schemes with a long duration of
operation would typically provide a high Sharpe ratio when derived from reported returns, but the
inputs are false.
• Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance
of portfolio or mutual fund managers.
• The Sharpe measure is applicable only to well diversified portfolios, such as S&P 500, or other wide-
range stock indices.

Concept Check 5.3

a. A respected analyst forecasts that the return of the S&P 500 Index portfolio over the
coming year will be 10%. The one-year T-bill rate is 5%. Examination of recent returns of
the S&P 500 Index suggest that the standard deviation of returns will be 18%. What
does this information suggest about the degree of risk aversion of the average investor,
assuming that the average portfolio resembles the S&P 500?
b. What is the Sharpe measure of the portfolio in (a)?
Concept Check 5.3
a. A respected analyst forecasts that the return of the S&P 500 Index portfolio over the
coming year will be 10%. The one-year T-bill rate is 5%. Examination of recent returns of
the S&P 500 Index suggest that the standard deviation of returns will be 18%. What
does this information suggest about the degree of risk aversion of the average investor,
assuming that the average portfolio resembles the S&P 500?
b. What is the Sharpe measure of the portfolio in (a)?

Answers:

a. If the average investor chooses the S&P 500 portfolio, then the implied degree of
risk aversion is given by “A”.

What does the Sharpe ratio of 0.28

tell us?
It tells that over this year we may
b. expect that, each increase in portfolio
standard deviation of 1% will be
rewarded by an increased risk
premium of 0.28%.
Example 5.4: Historical Means and Standard Deviations

(1) In the table to the left you may see the rates of return
Year Rate of Return for the S&P 500 portfolio.
1 16,9% 1. Calculate average rate of return on the S&P 500
2 31,3% portfolio over the period of 5 years.
3 -3,2% 2. Calculate the standard deviation of returns for the
4 30,7% period of these 5 years.
5 7,7%
Total 83,4%
(2) 1. Calculate average rate of
(1) (2) Deviation from (3) return (by the way,
Rate of Deviation from Average Return Squared
which average would
Year Return Average Return (in decimals) Deviation
1 16,9% 0,2% 0,2 0,0 you use?)
2 31,3% 14,6% 14,6 213,2 2. Calculate deviation from
3 -3,2% -19,9% -19,9 396,0 average return.
4 30,7% 14,0% 14,0 196,0 3. Find variance.
5 7,7% -9,0% -9,0 81,0 4. Find standard deviation.
Total 83,4% 886,2
Average rate of return = 83.4/5 = 16.7
Variance = 886.2/(5-1) = 221.6
Example 5.5: The Risk Premium and Growth of Wealth
Consider two investors with $1 mln as of December 31, 2000. One invests in the small stock
portfolio, and the other in T-bills. Suppose both investors reinvest all income from their
portfolios and liquidate their investments five years later, on December 31, 2005. The annual
rates of return for the 5-year period is given in the table.
Return on Return on
Small Stocks T-bills
2001 28,82% 3,72%
2002 -11,72% 1,66% These are actual rates
2003 74,54% 1,01% of return on S&P 500
2004 14,34% 1,37% Index for the period of
2001-2005
2005 3,20% 3,13%

1. Calculate the amount of wealth for each portfolio at the end of each year.
2. Calculate the total dollar return for the five year period.
3. Suppose you put your money in a one-year bank account paying interest once at the end
year, and revolve the account each year so that interest earned in a given year is
reinvested in the next year, what should be the APR on the bank account be to provide
you the same result as the two portfolios?
 Small Stocks T-bills Wealth of each portfolio:
Return Wealth Index Return Wealth Index Small Stocks = $2’342’200
2000 1,0000 1,0000 T-bills = $1’113’500
2001 28,82% 1,2882 3,72% 1,0372
2002 -11,72% 1,1372 1,66% 1,0544 Total $ return of each portfolio:
2003 74,54% 1,9849 1,01% 1,0651 Small Stocks = $1’342’200
2004 14,34% 2,2695 1,37% 1,0797 T-bills = $113’500
2005 3,20% 2,3422 3,13% 1,1135 The difference in total return is
dramatic!!!
Suppose you put your money in a one-year bank account paying interest once at the end
year, and revolve the account each year so that interest earned in a given year is reinvested
in the next year, what should be the APR on the bank account be to provide you the same
result as the two portfolios?
Answer: to find this we can use the geometric average return:
________Small Stocks_______ ___________T-Bills___________

The large difference in geometric average reflects the large difference in cumulative wealth
provided by the small stock portfolio over this period.
Some historical evidence

Geometric Arithmetic Standard

Table 5.4 Decile Average (%) Average (%) Deviation (%)
Size-Decile 1 Largest 9,6 11,4 19,1
portfolios of 2 10,9 13,2 21,6
the NYSE / 3 11,4 13,8 22,9
AMEX /
4 11,9 14,8 25,2
NASDAQ
Summary 5 12,0 15,2 26,6
Statistics of 6 12,1 15,6 27,6
Annual 7 12,4 16,3 30,0
Returns, 8 12,5 17,0 32,5
1927-2006 9 12,2 17,5 35,3
10 Smallest 13,8 20,4 40,9

Total Value Weighted Index 10,1 12,1 20,2

From here we may see that Smaller companies have greater average return, measured
by both geometric and arithmetic averages, and higher risk associated with these
returns measured by standard deviation.
Do the historical rates of return we reviewed in the previous section, measured in nominal
dollars, reflect the increase in our purchasing power?
Inflation rate – the rate at which prices are rising, measured as the rate of increase of such
indices as CPI or GDP deflator.
Nominal interest rate – the interest rate in terms of nominal (not adjusted for purchasing
power) dollars.
Real interest rate – the excess of the interest rate over the inflation rate. The growth rate of
the purchasing power derived from an investment.
The relationship between these three factors may be summarized by the equations given
below:

• The growth factor of your

purchasing power, 1+r
Real Inflation
interest rate • Equals the growth factor
rate Nominal of your money, 1+R
interest
rate • divided by the new price
level, 1+i
Approximated relationship Exact relationship
Approximate rule overstates the real value by the factor of 1+i, but is perfectly exact for
continuous compounded rates.
Example 5.6: Real Versus Nominal Rates
If the interest rate on a one-year CD is 8%, and you expect inflation to be 5% over the coming
year.
1. Calculate the real interest rate using approximated formula.
2. Calculate the real interest rate using exact formula.
3. By how many percent does the approximated formula overstate the expected real rate.

To summarize about these issues:

Answers: In interpreting the historical returns on various
1. asset classes we must recognize that to obtain
real returns on these assets, we must reduce the
r = 8% - 5% = 3% nominal returns by the inflation rate.
In fact, while the return on the U.S. Treasury
Bill usually is considered to be riskless, this is
2. true only in regard to its nominal return. To infer
the expected real rate of return on a T-bill, you
must subtract your estimate of the inflation rate
over the coming period.
It is always possible to calculate the real rate
3. after the fact. The future real rate, however, is
unknown, and you need to rely on expectations.
Approximated formula overstates the
In other words, because future inflation is
expected real rate by only 0.14%, or
risky, the real rate of return is risky even if the
14 b.p.
nominal rate is risk-free.
Fischer Equation r = R - E(i) Expected
Real Inflation
interest Nominal
rate
rate interest
Logic: rate
Because investors should be concerned with their real returns – the increase in their
purchasing power – we would expect that as inflation increases, investors will demand
higher nominal rates of return on their investments. This higher rate is necessary to
maintain the expected real return offered by an investment.
Take a look on Figure 5.4 you may see that periods of high inflation and high nominal
interest rates generally coincide.
Concept Check 5.5
a. Suppose the real interest rate is 3% per year, and the expected inflation rate is 8%.
What is the nominal rate of interest?
b. Suppose the expected inflation rises to 10%, but the real rate is unchanged. What
should we expect to happen to the nominal interest rate?
Answers:
a. R = r + E(i) => 3% = r + 8% => r = 5%
b. R = r + E(i) => 3% = r + 10% => r = 7%
First steps of investment process generally consists of two decisions:
1. Asset allocation
2. Security selection
In this and the next chapter we will talk generally with the asset allocation decision.
Asset allocation – portfolio choice among broad investment classes. “How much of
our money to allocate among different broad asset classes, such as bonds, stocks,
precious metals, international or sovereign securities, etc.”

Most investment professionals consider asset allocation the most important part of the
portfolio construction.

The most fundamental decision of investing is the allocation of your assets: How much should you
own in stock? How much should you own in bonds? How much should you own in cash reserves?...
That decision [has been shown to account] for an astonishing 94% of the differences in total
returns achieved by institutionally managed pension funds… There is no reason to believe that the
same relationship does not also hold true for individual investors.
John Bogle, at that time chairman of the Vanguard Group of Investment Companies
How will we proceed:
1. We will denote the investor’s portfolio of risky assets as P, and the risk-free asset as F.
2. We will assume for the sake of illustration that the risky component of the investor’s overall
portfolio comprises two mutual funds: one invested in stocks and the other invested in long-
term bonds.
3. For now we take the asset composition as given and focus only on the allocation between it
and risk-free securities.

When we shift wealth from the risky portfolio (P) to the risk-free asset, we don’t change
the relative proportions of the various securities within the risky portfolio. Rather, we
reduce the relative weight of the risky portfolio as a whole in favor of risk-free assets.
An example of asset allocation
Assume that total market value of an investment portfolio is $300’000 distributed as
follows among risky and risk-free assets:
Asset Risk prospects $ Amount
Ready Assets money market fund Risk-free $90 000
Vanguard S&P 500 Index Risky $113 400
Ready Assets MMF (F)
Fidelity Investment Grade Bond Fund Risky $96 600
invests primarily in U.S.
Total Market Value of portfolio $300 000 Treasury securities
Vanguard fund (V) is a passive equity fund that replicates the S&P 500 portfolio.
Fidelity Investment Grade Bond Fund (IG) invests primarily in corporate bonds with high safety ratings
and also in Treasury bonds.
Source: Vanguard Group site for personal investors
https://personal.vanguard.com
Source: Vanguard Group site for personal investors
https://personal.vanguard.com
Source: fundresearch.fidelity.com
Composition of the risky portfolio (P)
Weights within the risky portfolio. The holdings of the Vanguard and Fidelity shares make
up the risky portfolio, with 54% in V and 46% in IG.
wV = 113’400/210’000 = 0.54 (Vanguard)
wIG = 96’600/210’000 = 0.46 (Fidelity)

The weight of the risky portfolio, P, in the complete portfolio (the entire portfolio including
risky and risk-free assets) is denoted by y, and so the weight of the MMF is 1-y.
y = 210’000/300’000 = 0.7 (risky asset, portfolio P)
1-y = 90’000/300’000 = 0.3 (risk-free assets, F)
The weights of the individual assets in the complete portfolio (C) are:
Vanguard 113'400/300'000 = 0.378
Fidelity 96'600/300'000 = 0.322
Portfolio P 210'000/300'000 = 0.700
Ready Assets F 90'000/300'000 = 0.300
Portfolio C 300'000/300'000 = 1.000

Suppose the investor decides to decrease risk by reducing the exposure to the risky portfolio
from 70% to 56%.
•What would be the new composition of a portfolio? As a form you may use the table above.
•What dollar amount of Vanguard and Fidelity shares we need to sell and what dollar amount
of Ready Assets should we purchase to obtain this portfolio?
•What would be the new composition of a portfolio? As a form you may use the table above.

Asset________ $ Amount % Weight Calculations:

Vanguard $90 720 0,302 •Portfolio P = $300’000 × 0.56
•Ready Assets F = $300’000 × 0.44
Fidelity $77 280 0,258
•$ Amount Vanguard = $168’000 × 0.54
Portfolio P $168 000 0,560 •$ Amount Fidelity = $168’000 × 0.46
Ready Assets F $132 000 0,440 •% Weight Vanguard = $90’720/$300’000
Portfolio C $300 000 1,000 •% Weight Fidelity = $77’280/$300’000

•What dollar amount of Vanguard and Fidelity shares we need to sell and what dollar amount of
Ready Assets should we purchase to obtain this portfolio?
Calculations:
• Vanguard shares to be sold = 113’400 – 90’720 = $22’680
$42’000
• Fidelity shares to be sold = 96’600 – 77’280 = $19’320
• Ready Assets shares to be purchased = 132’000 – 90’000 = $42’000

The key point is that we leave the proportion of each asset in the risky portfolio unchanged.

Concept Check 5.6

What will be the dollar value of your
position in Vanguard and its proportion in
your complete portfolio if you decide to
hold 50% of your investment budget in
Ready Assets?
Concept Check 5.6
What will be the dollar value of your position in Vanguard and its proportion in your
complete portfolio if you decide to hold 50% of your investment budget in Ready
Assets?
Answer:
• $ value of the risky portfolio, P = 0.50 × $300’000 = $150’000
• $ value of our position in Vanguard = 0.54 × $150’000 = $81’000
• % proportion of Vanguard in complete portfolio = $81’000/$300’000
= 0.27 = 27%
 Let’s proceed to examine the risk-return combinations that result from various investment
allocations between the risky and risk-free assets.
Since we assume the composition of the optimal risky portfolio (P) already has been
determined, the concern here is with the proportion of the investment budget (y) to be
allocated to it. The remaining portion, (1-y), will be invested in the risk-free asset.
Assume that:
• Rate of return on risky asset = rP
• Expected rate of return on risky asset = E(rP) = 15%
• Standard deviation of risky asset = σP = 22%
• Rate of return on the risk-free asset = rf = 7%
=>Risk premium on risky asset = E(rP) - rf = 15% - 7% = 8%
First of all let’s draw a graph with E(r) on the vertical axis and σP on the horizontal axis.
Now let’s identify two extreme cases:
1. If you invest all of your funds into risky
assets
i. y = 1.0
ii. E(rC) = 15%
iii. σC = 22%
2. If you invest all of your funds into risk-
free asset
i. y=0
ii. E(rC) = 7%
iii. σC = 0%
Now consider more moderate
choices
3. You invest equally in risky
and risk-free assets
i. y = 0.5
ii. E(rC) = 0.5× 15% +
0.5×7% = 11%
iii. σC = 0.5×22% + 0.5×0%
= 11%

We may see that when you

reduce the fraction of the
complete portfolio allocated
to the risky asset by half, The standard deviation of the complete
you reduce both the risk and portfolio will equal the standard deviation
the risk premium by half (8% of the risky asset times the fraction of the
VS 4%) portfolio invested in the risky asset.
To generalize, the risk premium of the
complete portfolio, C, will equal the risk
σC = yσP
premium of the risky asset times the The slope of the F-P line will be the Sharpe
fraction of the portfolio invested in the ratio.
risky asset.
Concept Check 5.6
What are the expected return, risk premium, standard deviation, and ratio of risk
premium to standard deviation for a complete portfolio with y = 0.75?

Answer:
• E(rC) = 0.75× 15% + 0.25×7% = 11.25% + 1.75% = 13%
• Risk premium = E(rC) – rf = 13% - 7% = 5%
• σC = 0.75×22% + 0.25×0% = 16.5% = 0.75×22%

Note: don’t forget that what we were talking about in this section was devoted to trade-off
between a risky and a risk-free portfolios. The issue with a trade-off between two risky
portfolios is a different thing.
 Capital allocation line
Plot of risk-return
combinations available by
varying portfolio allocation
between a risk-free asset
and a risky portfolio.

We can rewrite our

calculations for CAL as

What about points on the line

to the right of portfolio P in the
investment opportunity set?

Example 5.7 Levered Complete Portfolio

Suppose the investment budget is $300’000, and our investor borrows an additional
$120’000 at a risk-free rate, investing the $420’000 in the risky asset.
• what will be the “y”?
• what will be the expected return, risk premium, standard deviation, and ratio of risk
premium to standard deviation for a complete portfolio with the new “y”
Example 5.7 Levered Complete Portfolio
Suppose the investment budget is $300’000, and our investor borrows an additional
$120’000 at a risk-free rate, investing the $420’000 in the risky asset.
• what will be the “y”?
• what will be the expected return, risk premium, standard deviation, and ratio of risk
premium to standard deviation for a complete portfolio with the new “y”

• y = $420’000/$300’000 = 1.4
• E(rC) = 1.40 × 15 – 0.4 × 7= 18.2% = (420’000×0.15-120’000×0.07)/300’000
• Risk premium = E(rC) – rf = 18.2% - 7% = 11.2%
• σC = 1.40×22% = 30.8%

As you might have expected, the levered portfolio has both a higher expected return and a
higher standard deviation than an unlevered position in the risky asset.
 eat well VS sleep well

•More risk averse investors The investor’s asset One role of the professional
will choose portfolios near F allocation choice also financial adviser is to
on the CAL above. depends on the trade-off 1. present investment
between risk and return. opportunity alternatives
•More risk-tolerant investors • If the Sharpe ratio to clients
will choose portfolios near P. increases, investors might 2. obtain an assessment of
well decide to take on riskier the client’s risk tolerance
•Even more Risky investors positions. 3. help determine an
will choose portfolios to he appropriate complete
right of the point P portfolio
Passive strategy – investment policy based on the philosophy that securities are fairly priced
and it avoids the costs involved in undertaking security analysis.

To avoid the costs of acquiring information on any individual stock or a group of stocks, we
may follow a “neutral” diversification approach.
Here we select a portfolio which mirrors a broad market indices, such as S&P 500 or Russell
2000.
Thus, such strategies are also called indexing.
The rate of return on portfolio then replicates the return on the index.

We call the capital allocation line (CAL) provided by one-month T-bills and a broad index of
common stocks the capital market line (CML).
• Passive strategy is cheaper. Constructing an active portfolio is more expensive
than constructing a passive one. Ex: index funds usually have the lowest
operating expenses.
• Free-rider benefit. Based on the efficient market hypothesis.
• “Diversification is protection against ignorance.” Warren Buffett.

To summarize,
• A passive strategy involves investment in two passive portfolios:
• Virtually risk-free short-term T-bills (or a MMF), and
• Fund of common stocks that mimics a broad market index
• Recall that the CAL representing such a strategy is called a CML
• Using Table 5.5, we see that using 1926-2006 data, the passive risky portfolio has
offered an average excess return of 8.4% with a standard deviation of 20.4%, resulting in
a reward to volatility ratio of 0.41.
• But might we expect the same numbers for the future?
HW:
1. Read Chapters 5 and 6 of the Investments_11e_-_Zvi_Bodie.pdf, be prepared for
selective oral questions.

LOSs covered:
40.a. (excl diversification ratio)
40.b.
40.c.
40.d.
40.e.