Risk and Returns

&
Historical Record

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W. Suo

Objective
How to calculate return
portfolio
Quantitative description of stocks
Mean, variance, standard deviation
Covariance, correlation
Skewness, kurtosis,
Estimation from historical data
Download data, histogram, regression
Different type of risks
Historical returns
Average return and risk from various class of securities

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W. Suo

Rate of Returns
Ways to calculate one-period rate of return

Unmargined returns

Reflects price change and any cash flow income

runmargined
Margined returns

P1 P0 CF
P0

Reflects price change, any cash flows and interest paid on borrowed funds

rmargined

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P1 P0 CF Int
Margin * P0

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Transaction Costs
Transaction costs (TC) can include

Interest on borrowed funds

Taxes
Commissions
rmargined

P1 P0 CF Int - TC
Margin * P0

Short sale

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Rate of Returns: Examples

Unmargined return:
Margined return: margin=50%, cost of borrowing=4%,

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Rate of Returns: Portfolio

of capital in
Assume investing proportions
assets with returns . The return on the
investment is
Example: total investment $10,000
T-Bill

1000

2.50%

Stock X

4000

5.20%

Stock Y
3000
Return of
the portfolio:

7.00%

Stock Z

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2000

-3%

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The Investors Goal

Goal is to maximize what is earned relative to the
amount put into an investment

Maximize

Rate of return
rate of return

Terminal Value of Invested Funds - PV of Investment

PV of Investment

Investments terminal value

Terminal Value Present Value 1 rate of return

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Uncertainty
One period rate of return is called a random variable

Returns tend to fluctuate randomly from period to period

How to describe a random variable:

Distribution
Expected return
Variance, skew, kurtosis
Standard deviation

Several variables

Slide 8

Covariance
Correlation
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Historical Estimation
How to download historical data?
Spreadsheet example

Slide 9

Mean, variance, skew, kurtosis

Histograpm
Regression

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Sources of Risk
Market risk

arises from alternating bull and bear market forces

Interest rate risk

caused by changes in market interest rates

Purchasing power risk

results from inflation (or deflation)

Management risk

caused by alternating profitable decisions and management errors

Credit risk

results from possibility of default or bankruptcy

Liquidity risk

Slide 10

results from price discounts or sales commissions incurred to quickly sell

an asset
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Sources of Risk
Margin risk

created by using borrowed funds

Callability risk

caused by the fact that callable securities may be redeemed prior to

the scheduled maturity date

Convertibility risk

caused by the fact that a convertible security may be converted into

the issuers common stock

Foreign exchange risk

caused by the fluctuation of exchange rates

Domestic political risk

caused by changes in environmental regulations, fees, licenses,

taxes, etc

Industry risk

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caused by events that affect competing firms

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Wealth Indices for Average U.S. Investments in Different Asset

Classes Compared to Inflation, 1925-2006

If you had invested $1 on December 31, 1925 in each of the following,

you would have

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Average Annual Rate of Return and Risk Statistics for Asset Classes
and Inflation in the U.S., 1926-99

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Combining Risk Premiums To

Compute Required Rate of Return
Required Rate of Return (k)

Sum of appropriate risk premiums

For T-bills, k=4.5%

4.5% = Risk-free rate (RFR)

For T-notes, k = 5.5%

4.5% = Risk-free rate (RFR)

+1.0% = + Intermediate Horizon Premium
5.5%= Total = Required rate of return

For T-bonds, k = 5.9%

4.5% = Risk-free rate (RFR)

+ 1.4% = + Long Horizon premium
5.9% = Total = Required rate of return

For Corporate bonds, k = 6.3%

4.5% =
+ 1.4% =
+0.4% =
6.3% =

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Risk-free rate (RFR)

+ Long Horizon Premium
+ Default Premium
Total = Required rate of return

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Combining Risk Premiums To

Compute Required Rate of Return
Required Rate of Return (k)

Sum of appropriate risk premiums

For Large Cap Stocks, k = 13.0%

4.5% =
+1.4% =
+7.1% =
13.0% =

Risk-free rate (RFR)

+ Long Horizon Premium
+Equity Risk Premium
Total = Required rate of return

For Small Cap Stocks, k = 14.5%

4.5% =
+1.4% =
+7.1% =
+ 1.5% =
14.5% =

Risk-free rate (RFR)

+ Long Horizon Premium
+Equity Risk Premium
+ Size Premium
Total = Required rate of return

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The Investment Pyramid

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