Risk and Return: Past and

Prologue
Chapter 5
Real and Nominal Rates of Interest
Nominal interest rate:
Growth rate of your money
Real interest rate:
Growth rate of your purchasing power

(1 + r
nom
)= (1 + r
real
) x (1 + i)

r
nom
~ r
real +
i


Real and Nominal Rates of Interest
Fisher Equation:
r
nom
= r
real
+ E(i)
Rates of Return
Holding-period return (HPR):



Example: Suppose an investor wants to invest in a
stock-index fund, which sells for $100 per share
today. Suppose also that this fund is expected to
pay a $4 cash dividend and sell for $110 one year
later. What is the expected HPR? Capital gains
yield? Dividend yield?
t
t t t
P
D P P
HPR
1 1 + +
+
=
Rates of Return
Measuring returns over multiple periods:

Arithmetic average:

Geometric average: Single per-period return that gives
the same cumulative performance as the sequence of
actual returns.



Dollar weighted return: The IRR of an investment.

=
n
s
s r
n
1
) (
1
| | 1 ) 1 )...( 1 )( 1 (
/ 1
2 1
+ + + =
n
n
r r r g
Rates of Return
Example: Consider a fund that starts with $1 million
under management at the beginning of the year. This
fund receives both additional funds to invest and
redemptions from existing shareholders as given below.
Find the arithmetic and geometric averages, and the
dollar-weighted return.
1
st

Quarter
2
nd

Quarter
3
rd

Quarter
4
th

Quarter
AUM at the start of the
quarter
1.0 1.2 2.0 0.8
HPR (%) 10.0 25.0 (20.0) 25.0
Net Inflow ($ million) 0.1 0.5 (0.8) 0.0
AUM at the end of the
quarter
1.2 2.0 0.8 1.0
Expected Returns and Standard
Deviation
Scenario analysis: What HPRs are possible and how
likely are they?
Expected return:

Variance (Var):

Standard Deviation (Std):


( ) ( ) ( )
s
E r p s r s =

| |
2
2
( ) ( ) ( )
s
p s r s E r o =

2
o = STD
Expected Returns and Standard
Deviation
Example: Suppose that, over the next year, there are
four possible scenarios with their probabilities and
HPRs. Find the expected return and the standard
deviation of returns.

Scenario Probability HPR (%)
Severe
Recession
0.05 -37
Mild
Recession
0.25 -11
Normal
Growth
0.40 14
Boom 0.30 30
The Normal Distribution
The Normal Distribution
Suppose that r
i
is normally distributed with expected
return E(r
i
) and standard deviation o
i
.
Then, the standardized return:

is normally
distributed with a mean of zero and a standard deviation of
1. Therefore,

is a standard normal variable.

Deviation from Normality and Value at
Risk
Value at Risk (VaR): Attempts to answer the following
question:
How many dollars can I expect to lose on my portfolio in a
given time period at a given level of probability?

The typical probability used is 5%.
We need to know what HPR corresponds to a 5% probability.
If returns are normally distributed then we can use a standard normal
table or Excel to determine how many standard deviations below the
mean represents a 5% probability:
From Excel: =Norminv (0.05,0,1) = -1.64485 standard deviations
From the standard deviation we can find the
corresponding
level of the portfolio return:
VaR = E[r] + -1.64485o

Deviation from Normality and Value at
Risk
Example: A $500,000 stock portfolio has an annual
expected return of 12% and a standard deviation
of 35%. What is the portfolio VaR at a 5%
probability level?
Using Time Series of Return

=
t t
r
n
r
1
2
) (
1
1
) (

=
t t t
r r
n
r Var
) (
t
r Var STD =
Risk Premium and Risk Aversion
Risk-free rate:
Risk premium:
Speculation vs. Gamble
Excess return:
Risk Aversion:
Risk averse investors reject investment portfolios that are
fair games or worse
These investors are willing to consider only risk-free or
speculative prospects with positive risk premiums
Intuitively one would rank those portfolios as more attractive
with higher expected returns

The Sharpe (Reward-to-Volatility Ratio)
=


=

Utility Function
Where
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
o
2
= variance of returns
Types of investors:
1. Risk Averse
2. Risk Neutral
3. Risk lover (risk seeking)

2
1
( )
2
U E r Ao =
Utility Values of Possible Portfolios for an Investor
with Risk Aversion, A = 4
The Trade-off Between Risk and Returns of a
Potential Investment Portfolio, P
The Indifference Curve
Indifference Curves
Given A, there is one indifference curve for each level of utility.
Curve 1
Curve 2
Increasing
Utility
E(r)
o
Mean-Variance Criterion

A dominates B if E(r
A
) > E(r
B
) and o
A
s o
B
, with
at least one strict inequality.

Goal of Risk-Averse Investors: Either
(i) Maximize expected return for a given level of
risk (o), or
(ii) Minimize risk (o) for a given expected return.

Mean-Variance Dominance
Expected Return
Variance or Standard Deviation
B
A
Risky
C
D
RF
A dominates B
A dominates D
C dominates D
Asset Allocation Across Risky and Risk-free
Portfolios
Asset Allocation: Portfolio choice among broad
investment classes.

John Bogle of the Vanguard Group of Investment
Companies:
The most fundamental decision of investing is the
allocation of your assets: how much should you hold in
stock? how much in bonds? how much in cash reserves.
That decision can account for an astonishing 94% of the
differences in total returns achieved by institutionally
managed pension funds.

Asset Allocation Across Risky and Risk-free
Portfolios
Example: Assume that the total market value of an
investors portfolio is $300,000. Of that $90,000 is
invested in shares of Ready Asset money market fund
(a risk-free asset). The remaining $210,000 is in risky
securities, say, $113,400 in shares of Vanguards S&P
500 Index Fund and $96,000 in shares of Fidelitys
Investment Grade Bond Fund.
Portfolio Expected Return and Risk
Example: Suppose that, in the previous example,
E(r
p
) = 15%, o
p
= 22%, and r
f
= 7%. Draw the Capital
Allocation Line and calculate the Sharpe ratio.