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The holding period return is the rate of return during a period that the asset is held
It is the difference in the price sold and the price purchased divided by the price purchased
There are some stocks that pay dividend, the dividend is part of the return so it is added
- +
HPR = P 1 P 0 D 1
P0
P0 – price in period 0
P1 – price in period 1
D1 – the dividend paid during the period
The investor purchased a stock at £48 and sold it at £50, the dividend was £2
There are capital gains which is the return of the stock without the dividend
The dividend amount of the return paid in dividend
𝑃1−𝑃0
𝐶𝐺 =
𝑃0
𝐷1
𝐷𝑌 =
𝑃0
The HPR is not known before P1 because the P1 can not be predicted with certainty
When a person buys a stock at P0 then he does not known what P1 is
Probabilities are used to estimate the return which is the expected return
𝐸(𝑟) = Σ𝑝𝑖𝑟𝑖
pi = probability of i
ri = return of i
𝑉𝑎𝑟(𝑟) = Σpi(ri − 𝐸(𝑟))2
The estimating of returns in period 2 from probabilities of different states of the economy
is the scenario analysis
The scenario returns are the returns found with the scenario analysis
The state pi ri
1 0.1 -0.05
2 0.2 0.05
3 0.4 0.15
4 0.2 0.25
5 0.1 0.35
= 0.011990.5
= 0.01095
The reward in the investment in stocks is measured by the difference between the
expected returns of the stock and the risk free rate. The difference is the risk premium.
The risk premium is the extra return needed to compensate for the extra risk.
Risk free rate – the rate of return on the risk free asset such as government bonds
The difference in any particular period between the actual rate of return on an asset and
the actual risk-free rate is called the excess return.
The degree to which investors are willing to commit funds depends on risk aversion.
Investors are mostly risk averse so the risk premium is greater than 0
Assets are risky and the investors are rewarded for holding them
In theory, there must always be a positive risk premium on stocks in order to induce risk
averse investors to hold the existing supply of stocks.
Investors, or the market, price risky asset so that the risk premium is proportionate to the
risk of the expected excess return
Trade off between reward and risk is captured by the Sharpe Ratio
The trade off between risk premium, E(er) and risk, the of the er is the Sharpe ratio
It measures the attractiveness of the portfolio.
The higher the Sharpe ratio the more attractive the portfolio is.
𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝜎 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛
E(R) − 𝑟𝐹
𝑆𝑅 =
𝜎𝐸(𝑅)
XR = E(R) – i
√Σ(XR−𝐸(𝑋𝑅)2
𝜎(𝑋𝑅) = 𝑛
Risk, speculation and gambling:
Investors have declining marginal utility of wealth so they prefer the less risky asset
Risk aversion can be shown if the second derivative of the utility function is below 0
URA’ = MURA
URA’’ < 0
URN’ = MURN
URN’’ = 0
URS’ = MURS
URS’’ > 0
EP – expected payoff
EU – expected utility
UEP – utility of expected payoff
Risk aversion:
There is a gamble
EP = 0.6(1000) + 0.4(0)
EP = 600
EU = 0.6(100) + 0.4(0)
EU = 60
UEP > EU
If U’’(X) is less than 0 then the investor is risk averse so his UEP is greater than EU
The UEP eliminates the risk but the EU has risk
The risk averse investor is willing to pay an amount to eliminate the risk
If U’’(X) is more than 0 then the investor is risk seeking so his UEP is less than EU
The UEP eliminates the risk but the EU has risk
The risk seeking investor is willing to pay an amount to play the risky gamble
The expected value does not take the risk preferences of a person into account
There is a prize A of £10000000 at 10% chance and there is B of £1000000 at 100% chance
The expected value of both is £1000000 but a risk averse person will value the B more
The risk seeking person will value A more
EP = 0.50(100) + 0.50(36)
EP = 68
U = P0.5
U1 = 1000.5
U1 = 10
U2 = 360.5
U2 = 6
EU = pU1 + pU2
EU = 0.50(10) + 0.50(6)
EU = 8
The UEP is found
UEP = 680.5
UEP = 8.26
The certain income that will give person the same utility as EU can be found
P = EU2
P = 82
P = 64
Person A is willing to give up £4 to eliminate risk and have a certain income of £64
The £64 is the certainty equivalent
The £4 is the risk premium
RP = EP – CE
Risk premium:
The degree of risk aversion can be shown with the curvature of the utility curve
The less the curve, the less risk averse the person is
The more the curve, the more risk averse the person is
The utility curve shows the person is less risk averse as it is not very curved
The utility curve shows that even though income increases, the MU does not change much
The utility curve shows the person is more risk averse as it is very curved
The utility curve shows that as income increases, the MU increases by less than before
The E represents the income needed for the expected utility which is the certainty
equivalent
The C represents the expected income and the utility it brings the person
The distance between E and C is the risk premium
The risk premium is the amount a person is willing to give up to eliminate uncertainty
The more risk averse person will pay a higher risk premium than a less risk averse person
Person A has utility function
There is probability a storm will strike
If the storm strikes the house is destroyed and it costs £4000000
U = 0.4W0.5
PS = 0.01
PN = 0.99
UEW = 0.4x39600000.5
UEW = 795.99
W = (U/0.4)2
W = (792/0.4)2
W = 3920400
The risk premium is the difference between expected wealth and the certainty equivalent
Mean variance preferences:
If there are 2 portfolios then the investor prefers the portfolio with higher E(r) and lower P
The portfolio mean variance dominates the other if it has a higher E(r) and lower
wi = 1
E(ri’) = ri’
E(rp’) = wiri’
The household decides to invest 15% of its wealth in hedge fund X with E(r) of 10% and 85%
in risk free asset Y with E(r) of 3%
Uncertainty in returns implies risk which can be quantified variance or standard deviation
The existence of a risk premium in returns of risky assets imply that agents are risk averse
Risk averse agents will pay a premium to insure their wealth against loss
There is a trade off between returns and risk
Mean variance preferences allow the ranking of risky assets