Risk. Statistics for portfolios.

Chapter 8, 9, 10
Risk. Statistics for portfolios. Portfolio returns and the
efficient frontier. Deriving the Formula for the
Minimum Variance Portfolio. Portfolios with Three and
More Assets. Ch.8, Ch.9, Ch.10
Rates of Return

• Holding-Period Return (HPR)

• Rate of return over given investment period

PEnding  PBeginning  DivCash

HPR 
PBeginning
Rates of Return: Single Period Example

Ending Price = $110

Beginning Price = $100
Dividend = $4

5-4
Rates of Return: Example
• What is the HPR for a share of stock that was
purchase for $25, sold for $27 and distributed
$1.25 in dividends?

$27.00 – $25.00  $1.25

HPR  0.13 13.00%
$25.00

• The HPR is the sum of the dividend yield plus the

capital gains yield
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
• Dollar-weighted average return
• Internal rate of return on investment
 Rates of Return: Measuring over Multiple Periods

• Arithmetic average: The sum of the returns

divided by the number of years.
r1  r2  ...  rn
rArithmetic 
n
10  25  20  20
 .0875 8.75%
4
 Rates of Return: Measuring over Multiple Periods

• Geometric average: Single period return that gives

the same cumulative performance as the sequence
of actual returns

rGeometric [(1  r1 ) (1  r2 ) ... (1  rn )]1/ n  1

1.10 1.25 .80 1.20
1/4
 1 0.0719 7.19%
Measuring Returns
• Rate of return on zero-coupon bond over a holding
period (Zero-coupon bond: Bing Videos )
 r = (100/Price) – 1
• effective annual rate (EAR), defined as the
percentage increase in funds per year

APR - Annual percentage rate

• To find r (continuous compounding) from the
effective annual rate, we solve :

5-9
Rates of Return: EAR vs. APR
n-Periods of Compounding: Continuous Compounding:
 APR 
n
EAR e APR  1
EAR  1   1
 n 

APR [( EAR  1)1/ n  1] n APR ln( EAR  1)

where
n compounding per period
Interest Rates and Inflation Rates
• Fundamental factors that determine the level of
interest rates:
1. Supply of funds from savers, primarily
households
2. Demand for funds from businesses to be used
to finance investments in plant, equipment, and
inventories
3. Government’s net demand for funds as modified
by actions of the Federal Reserve Bank
4. Expected rate of inflation

5-11
Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1  rNom
1  rReal 
1 i
where
rReal Real Interest Rate
rNom  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  rReal  1.048
1  .05
r .048 or 4.8%
Inflation and The Real Rate of Interest

• Equilibrium Nominal Rate of Interest

• Fisher Equation (5.9)

rNom rReal  E (i )
Equilibrium Real Rate of Interest

Bodies. Investment
5-14
Figure 5.1 Inflation and Interest rates
(1927-2022)
Taxes and the Real Interest Rate
• Tax liabilities are based on nominal income

rnom Nominal Interest Rate

rreal Real Interest Rate
i Inflation Rate
t  Tax Rate
rnom 1 t   i  rreal  i  1  t   i  rreal 1  t   i t

• The after-tax real rate falls by the tax rate

times the inflation rate

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Fisher

• Predicts the nominal rate of interest should track

the inflation rate, leaving the real rate somewhat
stable
• Appears to work far better when inflation is more
predictable, and investors can more accurately
gauge the nominal interest rate they require to
provide an acceptable real rate of return
Fisher Effect:
• Bing Videos

5-17
The Bank of Canada cut its key interest rate by 25bps to 4.25% in its September
2024 meeting, as expected, to mark the third consecutive 25bps slash after having
left the hiking cycle’s terminal rate of 5% for 10 months.
Canada Interest Rate (tradingeconomics.com)

5-18
Canada Interest Rate (tradingeconomi
cs.com)

5-19
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 a Stock Index Fund
 The Normal Distribution:
• Transform normally distributed return into
standard deviation score:

ri  E ri 
sri 
i

• Original return, given standard normal

return:
ri E ri   sri  i

22
© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC.
Figure 5.3 Normal Distribution r = 10%
and σ = 20%
Excess Returns and Risk Premiums

• Risk premium is the difference between the

expected HPR and the risk-free rate
• Provides compensation for the risk of an investment
• Risk-free rate is the rate of interest that can be
earned with certainty
• Commonly taken to be the rate on short-term T-bills
• Difference between actual rate of return and risk-
free rate is called excess return
• Risk aversion dictates the degree to which
investors are willing to commit funds to stocks

5-24
Expected Return and Standard Deviation (1 of 2)

• Expected returns
E (r )  p ( s )r ( s )
s
p(s) = Probability
r(s) = Return
s = scenario

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

2
• Standard Deviation (STD): STD  

5-25
Deviation from Normality and Tail Risk
• What if excess returns are not normally
distributed?
• STD is no longer a complete measure of risk
 Skewness:


R R
Skew  Average 
 
3

3
 σ̂ 
 Kurtosis:

R R
Kurtosis  Average 
   3
4

4
 σ̂ 

• Sharpe ratio is not a complete measure of portfolio

performance

5-26
Scenario Returns: Example
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%

5-27
Scenario VAR and STD: Example
• Example VAR calculation

σ 2 .25 .31  0.0976   .45 .14  .0976 

2 2

 .25  0.0675  0.0976   .05  .52  .0976 

2 2

.038

• Example STD calculation:

σ  .038
.1949

5-28
 Risk and Excel

Watch "Expected return, standard deviation, and covariance in Excel / Principles

of finance / Episode 6" on YouTub:
https://youtu.be/p_2gM4RPugs?si=s8exKlNh08-XHJX8

Watch "How to calculate Sharpe ratio in Excel / Analyzing stock returns / Episode
10" on YouTube
https://youtu.be/4oEeY8mmRX8?si=6aEGtaFZ84fMx4Sn

Watch "Combining two stocks in a portfolio in Excel / Analyzing stock returns /

Episode 8" on YouTube
https://youtu.be/FDZAM2Jhfyg?si=imJgv8MQiXda0hNV
Learning from Historical Record

• Arithmetic Average
n n
1
E r    ps  r s    r s 
s 1 n s 1

• Geometric (Time-Weighted) Average

• Terminal value of the investment:

TVn  1  r1 1  r2  ... 1  rn 

• Geometric Average:
1n
g TV n  1

5-30
Learning from Historical Record
(continued)
Estimating Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations
2
1 n
σ 2
ˆ 
n
 r s   r 
s 1
• Unbiased estimated standard deviation

n 2
1
ˆ
σ
n -1
 r s   r 
j 1

5-31
Learning from Historical Record:
The Reward-to-Volatility (Sharpe) Ratio
• Investors price risky assets so that the risk
premium will be commensurate with the risk of
expected excess returns
• Best to measure risk by the standard deviation
of excess, not total, returns
• Sharpe ratio
• Evaluates performance of investment managers

5-32
The Normal Distribution (continued)
• Investment management is easier when returns
are normally distributed:
• Standard deviation is a good measure of risk
when returns are symmetric
• If security returns are symmetric, portfolio
returns will be as well
• Only mean and standard deviation needed to
estimate future scenarios
• Statistical relation between returns can be
summarized with a single correlation coefficient

5-33
Skewness and Kurtosis

5-34
Normality and Risk Measures:
Downside Risk

• Measures of downside risk

• Value at risk (VaR)
 Loss that will be incurred in the event of an extreme
adverse price change with some given, usually low,
probability
• Expected shortfall (ES)
 Expected loss on a security conditional on returns
being in the left tail of the probability distribution
• Lower partial standard deviation (LPSD)
 SD computed using only the portion of the return
distribution below a threshold such as the risk-free
rate of the sample average
• Relative frequency of large, negative 3-sigma returns

5-35
Historical Returns on Risky Portfolios

5-36
Figure 5.5 Frequency distribution of
annual returns on U.S. Treasury bills,
Treasury bonds, and common stocks

5-37
Table 5.3: Historical Return and Risk
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

 C  y  p
where  C Standard deviation of the complete portfolio
 P Standard deviation of the risky portfolio
Figure 5.7 Investment
Opportunity Set
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
Available risk premium to variance ratio
y
Required risk premium to variance ratio
[ E (rP )  rf ] /  P2 [ E (rP )  rf ]
 
A A P2
5.6 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
Excess Returns Statistics for the Market Index
 Standard Deviation & Variance in Finance - Video | Study.co
m

The stress test is a forward-looking quantitative evaluation of bank capital that

demonstrates how a hypothetical macroeconomic recession scenario would
affect firm capital ratios. Federal Reserve Board - Stress Tests

Investment Pyramid
https://www.viddler.com/embed/7014c0b1/?f=1&player=arpe
ggio&secret=100923560&make_responsive=0

5-45
Efficient Frontier

Efficient Frontier - Overview, How It Works, Example, Sign

ificance | Wall Street Oasis
Correlation of Returns
Plot the graph
Portfolio Returns
Formulas
Portfolio Statistics

You don’t need to do an

extensive calculation of
annual portfolio returns—
it’s enough to know the
return statistics for each
stock, the portfolio
proportions, and the
covariance of the stock
returns.
Graphing all possible Portfolios