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RETURNS
LEARNING ABOUT RISK & RETURNS FROM THE HISTORICAL RECORD
Recap: Supply, Demand & Government Policy Originates from the Money Supply diagram in Macroeconomics
Open Market Operation, Lending to Financial Institutions, Increasing/Decreasing the Reserve Requirement
Nominal Rate, R
% growth rate of your money % growth rate of your purchasing power Take into account inflation rate: r R i
Real rate, r
1+ R 1+ r = 1+ i
Inverse relationship between real rate and inflation rate 30% tax bracket; 12% investment yield; 8% inflation rate
Example:
A bank offers you two alternative interest schedules for a savings account of RM100,000 locked in for 3 years. You are asked to choose either
A monthly rate of 1%; OR An annually , continuously compounded rate of 12%. EAR = 12.68% EAR = 12.75%
(1 + EAR ) APR =
T
100 rf (T ) = 1 P(T )
with P(T) = the price of a Treasury bond with par value 100, maturity of T years.
1 + rf (T ) = (1 + EAR )
1 + rf (T ) = (1 + EAR ) = 1 + APR * T
T
P P0 + D1 1 HPR = P0
E(r) Probability-weighted average of the returns in each scenario measure of risk (uncertainty of returns)
E (r ) = p (s )r (s )
s 2 s
= p (s )[r (s ) E (r )]
The rate we can earn if we leave our money in riskless assets Riskless asset: T-bills, cash deposit account, money market fund
Difference between actual return and risk free rate Expected reward for the risk tolerated in investing money Expected excess return
1 n E (r ) = r (s ) n s =1
Geometric Average, (1 + g)
Time weighted
(1 + g )
Risk Estimate
Risk: How disperse will the future return be from the expected return Since we cant observe the whole population of expectations, we estimate the average, denoted as r Hence, the estimated variance is given as
1 n 2 s = r (s ) r n 1 s =1
Trade off between reward (risk premium) and risk (standard deviation) How much reward can we earn for each unit of risk borne
Least likely to obtain extreme outcomes, mid range outcome more likely Stable distribution: Sum of assets with Normal returns = Normal distribution of portfolio returns (apply iid assumptions) Simplified scenario analysis as there are only 2 parameters that need to be estimated
Measures of Normality
|Skewness| > 0: Skewed distribution Kurtosis > 3: Fat tail distribution Jarque-Bera test statistics
Measure of departure from normality based on sample kurtosis & skewness, good for n > 2000.
n 2 K2 2 S + ~ 2, JB = 6 4
There is 5% chance/probability that the value of the portfolio will fall by more than RM K million over a one day period, assuming markets are normal and there is no trading In other words, this portfolio is expected to lose RM K million or more on 1 day in 20.
Historical VaR and simulation approaches are often not comparable Normal VaR interpretation is uninformative about the extreme tail losses beyond VaR
It cannot answer the question of the potential loss exceeding VaR So, well need complex global optimization techniques to find the optimal weight of each portfolios component, as opposed to the mean-variance risk-measures
Assuming the terminal value of the portfolio in the bottom 5% of possible outcomes, what is its Expected Value? Accounts for the entire tail of the distribution (or worst case scenario) A measure of risk for non-normal distribution Computes the standard deviation only from the values below the expected return the downside risk
Exercises
CFA problems:
BRAINTEASER
You have 100kg of grapes. 99% of the weight of grapes is water. Time passes and some amount of water evaporates, so our grapes are now 98% of water. What is the weight of grapes now? (No calculator allowed. Do this one in your head)