CH.

5 - Tax liabilities are based on nominal income:

o (rnom)(1-t; t is tax rate)-1 = (rreal + i)(1-t)-I = (rreal)(1-t)(i*t)
- Future prices is the expected return ▪ The after-tax real rate falls by the tax rate times the inflation
o More important than past return rate
- Rate of return on zero-coupon bond over a holding period: - Tax liabilities: are based on nominal income
o r=(100/Price) – 1 - Tax rate: determined by the investor’s tax bracket
- Effective annual rate (EAR): o After-tax interest rate = rnom (1-t; t is tax rate)
o Defined as the percentage increase in funds per year o Real after-tax rate = After-tax interest rate – inflation rate
o 1+EAR = [1+(APR/n)]^n o rnom(1-t)-1 = (rreal + i)(1-t)-i = rreal(1-t)-it
o (1+EAR)^year = [1 + r(T)] o After-tax real return = after tax interest rate – inflation rate
- Continuous compounding (r): = [rnom(1-t)]-inflation
o Ln(1+EAR)=rcc - Fisher equation:
- r(T); holding period = [100/P(T)] – 1 o Predicts the nominal rate of interest should track the inflation rate, leaving the
- Holding period; r(T) = [(Price increase + Income) / P(T)] = [100 – P(T) + 0] / P(T) real rate somewhat stable
- If you are willing to invest your money for longer periods, you should expect to earns higher o Appears to work far better when inflation is more predictable, and investors
total returns can more accurately gauge the nominal interest rate they require to provide an
- The zero-coupon bond with longer maturity will have a lower present value and a lower price, acceptable real rate of return
therefore, providing a higher total return o Predicts that the nominal rate of interest should track the inflation rate,
- EAR (effective annual rate): leaving the real rate somewhat stable
o Explicitly account for compound interest - Sources of investment risk:
o Express an investment return o Macroeconomic fluctuations
o Defined as the percentage increase in funds per year o Changing fortunes of various industries
o Will always want to use this # b/c it does not take in account of compounding, o Firm-specific unexpected developments
and b/c it make less assumption - Holding period return (HPR), or realized rate of return: is based on the price per share at
▪ Ex. Yield year’s end and any cash dividends collected
o Help in term of comparing different investment years from now. You can tell o You are considering investing in a mutual fund
which investment is better HPR = (Ending price of a share – Beginning price + Cash Dividend) / Beginning price
o Make reasonable assumption in term of your investment Capital gain = Ending price of a share – Beginning price
- Q. what make interest rate fluctuate? - Risk premium: is the reward from taking risk
o The overall health of the economy o Expected reward
o Supply from savers o Expected return you will get
o Expected inflation o Risk premium = HPR; is the expected return on the fund – risk free rate
o Government can control through overnight rate (they control the amount they o Is the expected value of the excess return, and the standard deviation of the
lend to the bank; net supply from government) excess return is a measure of its risk
- Q. Main factor that determines interest rate? - Excess return: is the actual return you will get
o Inflation o Excess return = actual rate of return on a risky asset – the risk-free rate
- Annual percentage rate (APR): o The difference in any particular period between the actual rate of return on a
o Rates on short-term investments with holding periods less than a year risky asset and the actual risk-free rate
o Annualized using simple interest that ignores compounding - Risk-free rate:
o Ex. APR reported on your credit card is the monthly interest rate you pay on o Is the rate of interest that can be earned with certainty
outstanding balances multiplied by 12, with n compounding periods per year ▪ Commonly taken to be the rate on short-term T-bills
o APR = n x [[(1+EAR)^(1/n)] – 1] o The rate you would earn in risk-free assets such as T-bills, money market fund,
o APR = (%)(n) or the bank
o EAR =[ [1+(APR/n)]^n] – 1 o Return from any asset
- 1 + rnom = (1+ rreal)(1+i) o Ex. T-bills or Treasury Bills
- Fundamental factors that determine the level of interest rates: - Risk aversion: dictates the degree to which investors are willing to commit funds to stocks
1. supply of funds from savers, primarily households o The degree to which investors are willing to commit funds to stocks depends
2. demand for funds from businesses to be used to finance investments in plant, on their risk aversion
equipment, and inventories o Investors are risk averse in the sense that, if the risk premium were zero, they
3. Government’s net demand for funds as modified by actions of the Federal would not invest any money in stocks
Reserve Bank o There must also be a positive risk premium on stocks to induce risk-averse
4. Expected rate of inflation investors to hold the existing supply of stocks instead of placing all their money
- Interest Rates and Inflation Rates: in risk-free assets
o Interest rate directly determine expected returns in the fixed-income market o Risk-averse investors consider only risk-free or speculative prospects with
▪ Increases in interest rates tend to be bad news for the stock positive risk premiums
market - Systematic risk: any risk that is market wide, affects everyone in the market (is industry
o Interest rate is a promised rate return, usually denominated in a specific specific)
currency - Rates of return: single period
- Consumer price index (CPI): HPR = Dividend yield; the % return from dividends + rate of capital gain
o Measures purchasing power by averaging the prices of goods and services in - Variance (o^2):
the consumption basket of an average urban family of four o Defined as the expected value of the squared deviation from the mean (the
- Nominal interest rate (rnom): The growth rate of your money expected squared “surprise” across scenarios)
- Real interest rate (rreal): The growth rate of your purchasing power o Is a measure of volatility
o Measures the dispersion of possible outcomes around the expected value
rreal = rnom – i o Is a natural measure of uncertainty
- Square deviations are necessarily positive
= [rnom – i(inflation)] / (1 +i) o The higher the dispersion of outcomes, the higher will be the average value of
these squared deviations
o Future inflation is uncertain, the real rate of return that you will earn is risky - The standard deviations of the rate of return does not distinguish between good or bad
even if the nominal rate is risk-free surprises; it treats both simply as deviations from the mean
- The government and the central bank (Bank of Canada) can shift the supply and demand o As long as the probability distribution is more or less symmetric about the
curves either to the right or to the left through fiscal and monetary policies mean, the standard deviation (o) is a reasonable measure of risk
- The nominal interest rate = the real rate + the expected rate of inflation - Number of bonds bought = amount invested in bond / price in which bonds are sold for
- 3 basic factors: supply, demand, and government actions – determine the real interest rate - HPR = (interest + year-end bond price) / (bond selling price – 1)
- End-of-year-value = (interest + year end bond price)(# of bonds bought)
- True (future) means and variances are unobservable b/c we don’t actually know possible
scenarios
- The supply curve slopes up from left to right b/c the higher the real interest rate, the greater - (1+required rate)(1+rate of return from previous year) = 1
the supply of household savings - Sharpe ratio = risk premium / SD of excess returns
o Higher real interest rates, households will choose to postpone some current - Investment management is easier when returns are normally distributed:
consumption and set aside or invest more of their disposable income for o Standard deviation is a good measure of risk when returns are symmetric
future use o If security returns are symmetric, portfolio returns will be as well
- The demand curve slopes down from left to right b/c the lower the real interest rate, the o Only mean and standard deviation needed to estimate future scenarios
more businesses will want to invest in physical capital o Statistical relation between returns can be summarized with a single
o Interest rate moves when the supply and demand move correlation coefficient
- As the inflation rate increases, investors will demand higher nominal rates of return - When the distribution is positively skewed (skewed to the right), the standard deviation
o If E(i) denote current expectations of inflation, then we get the Fisher overestimates risk b/c extreme positive surprises nevertheless increase the estimate of
Equation: volatility
▪ rnom= rreal + E(i) ; rreal is the before-tax real rate - When the distribution is negatively skewed (skewed to the left), the standard deviation
▪ EAR = [(1 + rnom)^year] – 1 underestimates risk b/c extreme negative surprises nevertheless decrease the estimate of
- the nominal rate must rise along with inflation to maintain the expected real return offered volatility
by an investment - Kurtosis:
- The Fisher hypothesis implies that when real rates are stable, changes in nominal rates ought o Concerns the likelihood of extreme values on either side of the mean at the
to predict changes in inflation rate expense of a smaller likelihood of moderate deviations
 o High kurtosis means that there is more probability mass in the tails of the - Simplest way to control risk is to manipulate the ratio of risky assets to risk-free assets
distribution than predicted by the normal distribution - Long-term bonds have been riskier investments than Treasury bills and that stocks have been
o Measures the degree of fat tails riskier still
o The kurtosis for the normal distribution is defined as zero, so kurtosis above - The riskier investments have offered higher average returns
zero is a sign of fatter tail - The most straightforward way to control the risk of the portfolio is through the fraction of the
- Measures of downside risk: portfolio invested in Treasury bills or other safe money market securities vs. the fraction
o Value of risk (VaR or q; quantile od distribution): invested in risky assets
▪ Is the loss corresponding to a very low percentile of the entire - Risk-free and bons are in fixed income
return distribution - Only the government can issue default-free securities
▪ Is the return at the 1st percentile of the sample distribution o A security is risk-free with a guaranteed real return only if:
▪ VaR (1%, normal) = mean – 2.33SD ▪ Its price is indexed
▪ Loss that will be incurred in the event of an extreme adverse ▪ Maturity is equal to investor’s holding period
price change with some given, usually low, probability - Broad range of money market instruments are considered effectively risk-free assets in
▪ Is the most optimistic measure of bad-case outcomes as it takes practice
the highest return (smallest loss) of all the cases - The only risk-free asset in real terms would be a default-free price-indexed bond
o Expected shortfall (ES): - It is possible to create a complete portfolio by splitting investment funds between safe and
▪ Expected loss on a security conditional on returns being in the risky assets
left tail of the probability distribution - Expectation of sum is just equal to the expectation
o Lower partial standard deviation (LPSD): - Expectation is a linear equation
▪ SD computed using only the portion of the return distribution - Expectation of any asset or portfolio equals to itself (original)
below a threshold such as the risk-free rate of the sample o Ex. Expectation of risk-free is risk-free E(A) = A
average o Ex. Variance of a constant is zero V(A) = 0
▪ Is computed like the usual standard deviation, but using only o Variance of risk-free = 0
“bad” returns - Capital allocation line (CAL): graph showing all feasible risk-return combination of a risky and
▪ This measure ignores the frequency of negative excess returns risk-free asset
- Relative frequency of large, negative 3-signma returns - Reward-to-volatility ratio (Sharpe ratio): ratio of excess return to portfolio standard deviation
- T-bills are ideally considered the least risky of all assets - Higher levels of y, risk is higher, and additional allocations to the risky asset are undesirable.
- Long-term Canadian Government Treasury bonds are also certain to be repaid, but the prices - Any investor would prefer a portfolio on the higher indifference curve with a higher certainty
of these bonds fluctuate as interest rates vary, so they impose meaningful risk equivalent return (utility)
- Common stocks are the riskiest of the 3 groups of securities b/c as a part owner of the - Portfolios on higher indifference curves offer a higher expected return for any given level of
corporation, your return will depend on the success or failure of the firm risk
- Firm capitalization is highly skewed to the right: many small but a few gigantic firms - More risk-averse investors have steeper indifference curves than less risk-averse investors
- Average realized returns have generally been higher for small stocks vs. large stocks o Steeper curves mean that investors require a greater increase in expected
- The equilibrium level of real interest rate is determined by demand and supply of the funds return to compensate for an increase in portfolio risk
- The nominal rate of interest = the equilibrium real rate + expected rate of inflation o Higher indifference curves correspond to higher levels of utility
- Lognormal distribution: - Value at Risk (VaR) and Expected Shortfall (ES) assess exposure to extreme losses
o The distribution itself is not normal, but if you log it, it will become normal - Passive strategy:
o Probability distribution that characterizes a variable whose log has a normal o Avoids any direct or indirect security analysis
(bell-shaped) distribution o A natural candidate for a passively held risky asset would be a well-diversified
o Use of continuously compounded returns instead of effective annual returns portfolio of common stocks such as the S&P/TSX Composite Index
o Describe a portfolio decision that avoids any direct or indirect security analysis
CH.6 o Require that we devote no resources to acquiring information on any
individual stock or group of stocks
- Speculation: o Generate an investment opportunity set that is represented by the CML
o Taking considerable risk for a commensurate gain o Passive management entails only negligible costs to purchase T-bills and very
o Parties have heterogeneous expectations modest management fees to either an exchange traded-fund or a mutual fund
- Gambling: company that operates a market index fund
o Bet on an uncertain outcome for enjoyment o A passive strategy involves investment in 2 passive portfolios:
o Parties assign the same probabilities to the possible outcomes ▪ Virtually risk-free short-term T-bills (or alternatively, a money
o Undertaken risk for the enjoyment market fund)
o Is to bet or wager on an uncertain outcome ▪ A fund of common stocks that mimics a broad market index
- Fair game: a risky investment with a risk premium of zero - The Capital Market Line (CML):
- Portfolio is more attractive when its expected return is higher, and its risk is lower o Results when using market index as the risky portfolio
- Higher utility values are assigned to portfolios with more attractive risk-return profiles - Q. How reasonable is it for an investor to pursue a passive strategy?
- Portfolios receive higher utility scores for higher expected returns and lower scores for higher o Important considerations:
volatility ▪ Alternative active strategy is not free
- Preferred portfolio for risk aversion investors are the one with the highest utility from the ▪ Free-rider benefit
investors’ perspective
- Certainty equivalent rate of return:
o Is the rate that a risk-free investment would need to offer to provide the same
utility as the risky portfolio
o A less risk-averse investors may assign the same portfolio a certainty
equivalent rate greater than the risk-free rate and thus will prefer it to the risk-
free alternative
- Risk-averse:
o A>0; utility go down
o Investors consider risk portfolios only if they provide compensation for risk via
a risk premium
- Risk-neutral:
o A=0; judge risky prospects solely by their expected rates of return
o Investors find the level of risk irrelevant and consider only the expected return
of risk prospects
- Risk lovers:
o A<0; utility go up
o Are willing to accept lower expected returns on prospects with higher amounts
of risk
o Will always take “fair game”
o Is happy to engage in fair games and gambles; this investors adjusts the
expected return upward to take into account the “fun” of confronting the
prospects’ risk
- Equally preferred portfolios will lie in the mean-standard deviation plane on an indifference
curve, which connects all portfolio points with the same utility value
o The less risk-averse investor has a shallower indifference curve. An increase in
risk requires less increase in expected return to restore utility to the original
level
o 2 portfolio that have the same expected return and risk will have the same
utility on the indifference curve
▪ All point on the indifference curves have the same utility
- Q. how can estimate the levels of risk aversion of individual investors?
o Use questionnaires
o Observations of how portfolio composition changes over time
o Average degrees of risk aversion from groups of individuals
- Most basic asset allocation choice is risk-free money market securities versus other risky asset
classes