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Chapter 5

Risk, Return, and the Historical

Record
INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

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Course administration

• We again expect to be fully in-person this semester.

Attendance and participation will be important.

• We have 3 TAs for this course

• All are very familiar with the course and content.
• Stephen Agawu [email protected]
• Nick Liu [email protected]
• Zeyu He [email protected]

• There will be some in-class exercises (these will count toward

class participation).

• Please put “BUS 205a-1”, “BUS 105a”, or “BUS 205a-2”

somewhere in subject line of emails to any member of the
teaching group.

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Our textbook

• Textbook Bodie et al (13th edition)

• It is okay to have earlier editions

• It is important to read the

corresponding chapters before
class

• Prerequisites: some knowledge

in statistics, calculus

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Professor Li:

• My research spans trading, financial market microstructure,

high-frequency trading, exchange-traded funds (ETFs), and
machine learning.
• E.g., how to build a liquid, efficient stock exchange that
supports the economy
• I did my undergrad in Physics, M.S. in Actuarial Science,
and Ph.D. in Finance with a minor in Statistics
• Also published some papers in computational physics &
material sciences back in the days
• I also taught BUS/FIN-241A-1: Machine Learning and Data
Analysis for Business and Finance and BUS 71a:
Introduction to Finance

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Philosophy of Finance

• Learning finance is like learning a foreign language

• Terms / jargon must be learned
• If you are going to lean more in investments, a lot of
courses in the future will build on the languages learned
here
• The only way you learn finance is by practicing finance:
• You will have regular homework
• The only way to appreciate how to use finance is to see how it
applies in realistic settings
• Wherever possible, we will link what we are learning in the
textbook to real life examples

• Syllabus
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 Chapter Overview
Present tools for estimating expected returns and risk from
the historical record.
Interest rates and investments in safe assets.
• History of risk-free investments in the United States.

Scenario analysis of risky investments and the data inputs

necessary to conduct it.
Develop statistical tools needed to make inferences from
historical time series of portfolio returns.

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 Measuring Returns Over Different Holding
Periods
Holding period return measures the total return expressed as
a percent change from the initial investment:
Price Change + Income
Holding Period Return r (T ) 
Initial Price

For example, a zero-coupon bond’s price, P(T), will be less

than its face value (here 100):

Price Change + Income 100  P(T )  0 100

r (T )    1
P(T) P(T ) P(T )

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 Effective Annual Rate (EAR) and Annual
Percentage Rate (APR)
Effective annual rates (EAR) explicitly account for compound
interest.
n
 APR 
1  EAR  1  
 n 
Annual percentage rates (APR) are annualized using simple
rather than compound interest.
APR n [(1  EAR)1/ n  1]

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 Table 5.1 Annualized Rates of Return

In the following table, read ‘(1 + .0271)2 − 1 = .0549’ as (1 + .0271) squared minus 1 = .0549; ‘(1 + 3.2918)1/25 − 1 = .060’ as (1 + 3.2918) to the power 1 over 25, minus 1 = .060.

Horizon, T Price, P(T) r(T) = (100 ÷ P(T)) − 1 EAR over Given Horizon
Half–year $97.36 100/97.36 − 1 = 0.0271 = 2.71% (1 + .0271)2 − 1 = .0549

1 Year $95.52 100/95.52 − 1 = 0.0469 = 4.69% (1 + .0469) − 1 = .0469

25 Years $23.30 100/23.30 − 1 = 3.2918 = 329.18% (1 + 3.2918)1/25 − 1 = .060

Table 5.1
Annualized rates of return. Prices and returns on zero-
coupon bonds with face value of $100 and different
maturities.

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 Effective Annual Rate (EAR) and
Continuous Compounding
As the frequency of compounding (n) increases, the
relationship between EAR and the continuously compounded
rate rcc  becomes:

1  EAR e r
CC

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 Figure 5.2 APR, EAR, and Compounding
Frequency

Figure 5.2
Annual percentage rates (APR) and effective annual rates (EAR). In the first set
of columns, we hold the equivalent annual rate (E AR) fixed at 5.8% and find APR
for each holding period. In the second set of columns, we hold A PR fixed at 5.8%
and solve for EAR.

Access the text alternative for slide images.

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 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.

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 Real and Nominal Rates of Interest
A nominal interest rate is the growth rate of your money.
A real interest rate is the growth rate of your purchasing
power.
rnom  Nominal Interest Rate
rreal  Real Interest Rate
i Inflation Rate
r i
rreal  nom
1 i
Note : rreal rnom  i

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 Figure 5.1 Determination of the Equilibrium Real
Rate of Interest

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 Interest Rates and Inflation
We expect higher nominal interest rates when inflation is
higher.
If E of (i) denotes current expectations of inflation, the Fisher
hypothesis is:

rnom rreal  E i 

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 Taxes and the Real Interest Rate
Tax liabilities are based on nominal income and the tax rate
determined by the investor’s tax bracket.
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

After-tax return falls by the tax rate times the inflation rate.

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 Bills and Inflation, 1926 to 2021
Fisher equation.
• 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.

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 Table 5.3 T-Bills, Inflation, and Real Rates,
1926 to 2021

Average Annual Rates Standard Deviation

T-Bills Inflation Real T-Bill T-bills Inflatio Real T-Bill
n
Full sample 3.30 3.02 0.38 3.10 3.98 3.78
1927–1951 0.95 1.80 −0.48 1.24 6.06 6.34
1952–2021 4.14 3.46 0.68 3.14 2.84 2.27
Source: Annual rates of return from rolling over 1-month T-bills: Kenneth French;
annual inflation rates: Bureau of Labor Statistics.

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 Figure 5.2 Interest Rates and Inflation, 19 27 to 20
21

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 Risk and Risk Premiums: Holding Period
Returns
Sources of investment risk.
• Macroeconomic fluctuations.
• Changing fortunes of various industries.
• Firm-specific unexpected developments.

Holding period return (HPR) is the return realized from a

price change and any cash dividends collected:

Ending price of a share  Beginning price  Cash dividend

HPR 
Beginning price

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 Risk and Risk Premiums: Expected Return
and Standard Deviation 1

Expected returns.

E (r ) s p ( s ) r ( s )

• p(s) = probability of each scenario.

• r(s) = HPR in each scenario.
• s = scenario.

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 Risk and Risk Premiums: Expected Return
and Standard Deviation 2

Variance:

2
σ  p s  r s   E r 
2

Standard Deviation:

2
σ  Variance   p s  r s   E r 
s

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 Risk and Risk Premiums: Excess Returns
and Risk Premiums
Risk-free rate is the rate of interest that can be earned with
certainty, commonly the rate on T-bills.
Risk premium is the difference between the expected HPR
and the risk-free rate.
• Provides compensation for the risk of an investment.

Excess return is the difference between actual rate of return

and risk-free rate.
Risk aversion dictates the degree to which investors are
willing to commit funds to stocks.

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 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.

Risk premium
Sharpe ratio =
SD of excess return

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 The Normal Distribution 1

Normal distribution is a bell-shaped probability distribution

that characterizes many natural phenomena.
• For example, heights and weights of newborns, test
scores, and so on .tera

Investment management is more manageable when returns

can be well approximated by the normal distribution.
• Symmetric.
• Stable.
• Only mean and standard deviation are needed to estimate
future scenarios.
• Statistical relation between returns can be summarized
with a single correlation coefficient.
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 Figure 5.4 The Normal Distribution 2

Figure 5.4 The normal distribution with mean 10% and standard deviation 20%.

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 Figure 5.3 Frequency Distribution, Broad
Market Index Monthly Return, 1927 to 2021

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 Figure 5.5 Deviations From Normality and
Tail Risk 1

Skewness: Standard measure of asymmetry in the

probability distribution of returns.

  R  R 3 
Skew Average  3

 ˆ 
 

Figure 5.4 Normal and skewed

distributions (mean = 6%, SD = 17%).

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 Figure 5.5 Deviations From Normality and
Tail Risk 2

Kurtosis: The likelihood of extreme values on either side of the mean 

smaller likelihood of moderate deviations.
• Measures the degree of fat tails.

 R R 4
Kurtosis Average 
  3
 ˆ 4 
 

Figure 5.4 Normal and fat-tailed

distributions (mean = .1, SD = .2).
Access the text alternative for slide images.

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 Normality and Risk Measures: Downside
Risk 1

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.

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 Normality and Risk Measures: Downside
Risk 2

Measures of downside risk.

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.
• Sortino Ratio: Measures average excess returns to LPSD
(compare to Sharpe Ratio).

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 Arithmetic Average
Expected Returns and the Arithmetic Average.
• When using historical data, each observation is treated as an equally likely
“scenario.”

• Expected return, E r , is estimated by arithmetic average of sample rates of

sample rates of return.

n 1 n
E (r )   p ( s) r ( s )   r ( s )
s 1 n s 1
Arithmetic average of historic rates of return

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 Geometric Average
Geometric Average Return.
• Time-weighted rate of return.
• Intuitive measure of performance: the sample period
annual HPR that would compound to the same terminal
value obtained from the sequence of actual returns in the
time series:

(1  g ) n Terminal value
g Terminal value1/n  1

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 Learning From Historical Returns: Variance
and Standard Deviation
Estimated variance.
• Expected value of squared deviations.

1 n
ˆ   [r ( s )  r ]2
2
n s 1

Unbiased estimated standard deviation.

1 n 2
ˆ   [r ( s)  r ]
n  1 j 1

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 Figure 5.7 Frequency Distribution of Annual
Returns: Treasury Bills

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 Figure 5.7 Frequency Distribution of Annual
Returns: 30-Year Treasury Bonds

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 Figure 5.7 Frequency Distribution of Annual
Returns: Common Stocks

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 Table 5.4 Historic Returns on Risky
Portfolios, 1927 to 2021

T–Bills T–Bonds Stocks

Average 3.30% 5.96% 12.17%
Risk premium N/A 2.66 8.87
Standard deviation 3.10 11.58 19.89
Max 14.71 41.6803 57.35
Min −0.02 −25.96 −44.04

Table 5.4
Risk and return of investments in major asset classes; estimates from
annual data, 1927 to 2021.

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 Historic Returns on Risky Portfolios: A Global
View of the Historical Record
Century-plus-long history (1900–2020) of average excess
returns in 20 stock markets.
• Mean annual excess return across these countries was
5.3% versus the United States mean excess return of
7.7%.
• Sharpe ratio across these countries was .29 versus U.S.
Sharpe ratio of .40.
Tremendous variability in year-by-year returns.

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 Figure 5.10 Average Excess Returns in 21
Countries, 1900 to 2020

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 Figure 5.10 Sharpe Ratio in 21 Countries,
1900 to 2020

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 Normality and Long-Term Investments

Lognormal distribution.
• Probability distribution that characterizes a variable whose
log has a normal (bell-shaped) distribution.
• Use of continuously compounded returns instead of
effective annual returns.
Short-run versus long-run risk.

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