TRANG CHAP 2 (9-11)

9. Calculate and interpret major return measures and describe their appropriate uses.
Return Measures
1) Holding period return (HPR)
• the percentage increase in the value of an investment over a given time period:
𝑒𝑛𝑑−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒
• Holding period return = 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒 – 1
2) Average returns
Arithmetic mean returns
 the average of a series of periodic returns.
𝑅1 +𝑅2 +𝑅3 +⋯+ 𝑅𝑛
 Arithmetic mean returns =
𝑛
Geometric mean return
𝑛
• Geometric mean return = √(1 + 𝑅1 ) ∗ (1 + 𝑅2 ) ∗ (1 + 𝑅3 ) ∗ … (1 + 𝑅𝑛 ) – 1
• a compound annual rate. Generally, for time series data or to evaluate the performance
or the annualized return over time.
3) Money-weighted rate of return (IRR)
the internal rate of return on a portpolio based on all of its cash inflows and outflows. IRR is
the interest rate at which the cash outflow equal to the cash inflow.

4) Annualized return
Annualized returns are returns over a period scaled down to a 12-month period. This scaling
process allows investors to objectively compare the returns of any assets over any period.
𝟑𝟔𝟓
Annualized return = (𝟏 + 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒓𝒆𝒕𝒖𝒓𝒏)𝒅𝒂𝒚𝒔 𝒉𝒆𝒍𝒅 - 1
5) Portfolio return
Expected Return=WA×RA+WB×RB+WC×RC
where:
WA = Weight of security A
RA = Expected return of security A
WB = Weight of security B
RB = Expected return of security B
WC = Weight of security C
RC = Expected return of security C
6) Other return measures
Gross return Gross return refers to the total return on For example, a portfolio manager
a security portfolio prior to deducting earn for investor 20% return at the
management fees and taxes first place. The gross return will be:
 20%
Net return Net return refers to the return after In this case is 2%, therefore the net
deducting management fees return will be
20%-2% = 18%
Pre-tax Pre-tax nominal return is the return So Pre-tax nomital return is 18%
nominal return before paying taxes
After tax Is return after tax liability is deducted Let say, it is 30%. As the result, after
nominal return tax nominal return will be
18%(1-0.3)= 12.6%
Real return is the nominal return adjusted for In this case, the inflation is 3%.
inflation Real return will be
12.6%- 3% = 9.6%

10.Calculate and interpret the mean, variance, and covariance (or correlation) of asset
returns based on historical data.
1) MEAN
Arithmetic mean returns
 the average of a series of periodic returns.
𝑅1 +𝑅2 +𝑅3 +⋯+ 𝑅𝑛
 Arithmetic mean returns = 𝑛
Geometric mean return
𝑛
• Geometric mean return = √(1 + 𝑅1 ) ∗ (1 + 𝑅2 ) ∗ (1 + 𝑅3 ) ∗ … (1 + 𝑅𝑛 ) – 1
• a compound annual rate. Generally, for time series data or to evaluate the performance
or the annualized return over time.

2) VARIANCE
• The variance is a measure of the volatility of the asset returns. The returns fluctuate
significantly over the period of time. That means the risk related to the asset is high.
Sample variance:
∑(𝑥 − ̅̅̅
𝑥)2
𝒔𝟐 =
𝒏−𝟏
Population variance
𝟐
(𝒙 − 𝝁)𝟐
𝝈 =
𝑵
where:
µ: the mean of expected value of the population’s distribution

𝑥̅ : the mean of the observations

x: the return for each period.

N: the total number periods.

3) Covariance and correlation

Covariance is a measure of how two variables move together over time.
- Positive covariance means that the variables tend to move together.
- Negative covariance means that the two variables tends to move in opposite
directions.
- A covariance of zero means there is no linear relationship between two variables.
Population Covariance:
̅̅̅̅̅̅̅̅̅̅̅̅̅̅
∑(𝒙𝒊 − 𝒙)(𝒚 ̅̅̅
𝒊 − 𝒚)
𝐂𝐨𝐯(𝐱, 𝐲) =
𝑵
Sample Covariance:
∑(𝒙𝒊 − 𝒙 ̅)(𝒚𝒊 − 𝒚 ̅)
𝐂𝐨𝐯(𝐱, 𝐲) =
𝑵−𝟏
CORRELATION
• a standardized measure of the linear relationship between two variables with values
ranging between -1 and +1. Correlation 1 means that there is perfect positive
correlation between two variables, they move up and down together.
• A correlation of 0 means that there is no correlation between two variables.
• A correlation of -1 means that there is perfect negative correlation between two
variables.
Cov(𝑅 , 𝑅 )
𝑖 𝑗
𝜌(𝑅𝑖 , 𝑅𝑗 ) = 𝜎(𝑅 )𝜎(𝑅
𝑖 𝑗)

11. Calculate and interpret portfolio standard deviation and return of two assets.
Portfolio expected return:
E(𝑅𝑝 ) = 𝑊1 𝑅1 + 𝑊2 𝑅2
Risk of portfolio:
𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜌𝜎1 𝜎2