CHAPTER 5

Introduction to Risk, Return, and

the Historical Record

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Interest Rate Determinants
• Supply
– Households
• Demand
– Businesses
• Government’s Net Supply and/or
Demand
– Federal Reserve Actions

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 Real and Nominal Rates of Interest
• Nominal interest rate: Let rn = nominal rate,
Growth rate of your rr = real rate and
money
i = inflation rate. Then:
• Real interest rate:
𝑟𝑟 ≈ 𝑟𝑛 − 𝑖
Growth rate of your
purchasing power More precisely:
(how many Big Macs 1 + 𝑟𝑛
1 + 𝑟𝑟 =
can I buy with my 1+𝑖
money?)* solve
𝑟𝑛 − 𝑖
𝑟𝑟 =
*The Big Mac Index is a different thing
1+𝑖
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Fig 5.1: Real Rate of Interest Equilibrium
Determined by supply, demand, government actions,
expected rate of inflation

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 Equilibrium Nominal Rate of Interest
• As the inflation rate increases, investors will
demand higher nominal rates of return
• If E(i) denotes current expectations of
inflation, then we get the Fisher Equation:
• Nominal rate = real rate + expected inflation

R  r  E (i )

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Taxes and the Real Rate of Interest
• Tax liabilities are based on nominal income
– Given a tax rate (t) and nominal interest rate (R),
the real after-tax rate of return is:

R1  t   i  r  i 1  t   i  r 1  t   i  t

• As intuition suggests, the after-tax, real rate

of return falls as the inflation rate rises.

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 Rates of Return
for Different Holding Periods
• Zero Coupon Bond
• Par = $100
• T = maturity
• P = price
• rf(T) = total risk free return

100
rf T  
P 100
1
1  rf T  P

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 Time Does Matter
Use Annualized Rates of Return

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 Effective Annual Rate (EAR)
• Time matters → use EAR to annualize
• EAR definition: percentage increase in funds
invested over a 1-year horizon

1  rf T   1  EAR 
T


1  EAR  1  rf T   1
T

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 Equation 5.8 APR
• Annual Percentage Rate (APR): annualizing
using simple interest

1  APR  T  1  EAR 
T

APR 
1  EAR 
T
1
T
Q. You invest $1 for 30 years. Do you
prefer [A] 5% APR, or [B] 5% EAR?
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 5.00

End Value with APR=5.0%

4.50
End Value with EAR=5.0%
4.00
Investment End Value

3.50

3.00

2.50

2.00

1.50

1.00
0 5 10 15 20 25 30
(years) INVESTMENTS | BODIE, KANE, MARCUS 5-11
Table 5.1 APR vs. EAR

Hold the EAR fixed at 5.8% Hold the APR fixed at 5.8%
and solve for APR and solve for EAR
for each holding period for each holding period

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 Continuous Compounding
• Frequency of compounding matters
• At the limit to (compounding time)→0:

1  EAR  e rcc

Q. You invest $1 for 30 years. Which

interest rate do you prefer?
A. 5% EAR
B. 5% Rcc

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 5.00

End Value with APR=5.0%

4.50
End Value with EAR=5.0%
End Value with Rcc=5.0%
4.00
Investment End Value

3.50

3.00

2.50

2.00

1.50

1.00
0 5 10 15 20 25 30
(years) INVESTMENTS | BODIE, KANE, MARCUS 5-14
 How to derive Rcc
Let r=rate and
x=compounding time → T  N  x  N  T / x

End Value  1  r  x     1  r  x   1  r  x 
N
 
compounding N times

lim1  r  x  S lim e ln 1 r  x N

Make x very N
small. Then Substitute
N=T/x
use A=eln(A) x 0 x 0

T ln 1 r  x   d
     
 T ln 1 r x 
 lim e 
x Looks like 0/0.  dx 
Use de l’Hôpital  d 
x 0  x 
1
 lim e  dx 

T r x 0
1 r  x
 lim e 1
e rT
Q.E.D. Checks: r=0 →End Value=1
x 0 T=0 →End Value=1
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Table 5.2 Statistics for T-Bill Rates, Inflation
Rates and Real Rates, 1926-2012

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 Bills and Inflation, 1926-2009
• Moderate inflation can offset most of the
nominal gains on low-risk investments.
• One dollar invested in T-bills from1926–2012
grew to $20.25, but with a real value of only
$1.55.
• Negative correlation between real rate and
inflation rate means the nominal rate doesn’t
fully compensate investors for increased in
inflation

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Fig 5.3: Interest Rates and Inflation
1926-2009

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 Risk and Risk Premiums

Rates of Return: Single Period

HPR 
 P1  P 0   D1

P0
HPR = Holding Period Return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one

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Rates of Return: Single Period Example
• Ending Price = 110
• Beginning Price = 100
• Dividend = 4

• HPR = (110 - 100 + 4 ) / (100) = 14%

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 Expected Return and Standard
Deviation
Expected (or mean) returns Q. What is the
expected value
E (r )   p ( s )r ( s ) of rolling a die?
s A. 1
B. Sqrt(6)
s = state
C. Pi
p(s)= probability of a state
r(s) = return if a state occurs
D. 3.5
E. 6

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 Scenario Returns: Example
State Prob. of state r for that state
Excellent 0.25 0.3100
Good 0.45 0.1400
Poor 0.25 -0.0675
Crash 0.05 -0.5200
E(r) = (0.25)(0.31)
+ (0.45)(0.14)
+ (0.25)(-0.0675)
+ (0.05)(-0.52)
= 0.0976
= 9.76% (think of a probability-weighted avg)
NOTE: use decimals instead of percentages to be safe
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Variance and Standard Deviation

Variance (VAR):

   p( s)  r ( s)  E (r ) 
2 2

Standard Deviation (STD):

STD   2

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 Scenario VARiance and STD
• Example VARiance calculation:
σ2 = 0.25(0.31 - 0.0976)2 +
0.45(0.14 - 0.0976)2 +
0.25(-0.0675 - 0.0976)2 +
0.05(-0.52 - 0.0976)2 =
= 0.038

• Example STD calculation:

  0.038  0.1949
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Time Series Analysis of Past Rates of Return

The Arithmetic Average of historical

rate of return as an estimator of the
expected rate of return
n
1 n
E (r )   p( s )r s    r s 
s 1 n s 1

Q. What assumptions are we implicitly

making?
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Geometric Average Return

TVn  (1  r1 )(1  r2 )...(1  rn )

TV = Terminal Value of the Investment
Solve for a rate g that, if compounded n
times, gives you the same TV

TV  1 g   g  TV
n 1/ n
1

g = geometric average rate of return

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 Estimating
Variance and Standard Deviation
• Estimated Variance = expected value of
squared deviations (from the mean)

   p( s)  r ( s)  E (r ) 
2 2

Recall the definition of variance

n 2

ˆ   r s   r 
2 1
n s 1

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 Geometric Variance and Standard
Deviation Formulas
Using the estimated ravg instead of the real E(r)
introduces a bias:
– we already used the n observations to estimate ravg
– we really have only (n-1) independent observations
– correct by multiplying by n/(n-1)

When eliminating the bias, Variance and

Standard Deviation become*:
n 2

ˆ 
1
 r s   r 
n  1 j 1
* More at http://en.wikipedia.org/wiki/Unbiased_estimation_of_standard_deviation
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The Reward-to-Volatility (Sharpe) Ratio
• Excess Return
• The difference in any particular period between
the actual rate of return on a risky asset and the
actual risk-free rate
• Risk Premium
• The difference between the expected HPR on a
risky asset and the risk-free rate
• Sharpe Ratio
Risk Premium

SD of Excess Returns
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 The Normal Distribution
• Investment management math is easier when
returns are normal
– Standard deviation is a good measure of risk
when returns are symmetric
– If security returns are symmetric, portfolio returns
will be, too
– Assuming Normality, future scenarios can be
estimated using just mean and standard
deviation

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Figure 5.4 The Normal Distribution

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 Normality and Risk Measures
• What if excess returns are not normally
distributed?
– Standard deviation is no longer a complete
measure of risk
– Sharpe ratio would not be a complete measure of
portfolio performance
– Need to consider higher moments, like skew and
kurtosis

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 Skew and Kurtosis

this is zero for symmetric distributi ons

 
 R  R 3 
skew  average 
 ˆ
3

 R  R   4

kurtosis  average  3
 ˆ
4

 
this equals 3 for a Normal distributi on

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Fig.5.5A Normal and Skewed Distributions
Mean = 6%
SD = 17%

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Fig 5.5B Normal & Fat-Tailed Distributions
Mean = 0.1
SD = 0.2

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 Value at Risk (VaR)
• A measure of loss most frequently associated
with extreme negative returns
• VaR is the quantile of a distribution below
which lies q% of the possible values of that
distribution
– The 5% VaR, commonly estimated in practice, is
the return at the 5th percentile when returns are
sorted from high to low.
Also referred to as 95%-ile (depends on
perspective)

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 Normal Distribution and VaR
2.5

2
The area is
the percentile
1.5

0.5
VaR

0
-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
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 Expected Shortfall (ES)
• a.k.a. Conditional Tail Expectation (CTE)
• More conservative measure of downside risk
than VaR:
– VaR = highest return from the worst cases
– Real life distributions are asymmetric and have
fat tails
– ES = average return of the worst cases

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 Normal Distribution, VaR, and Expected Shortfall
2.5

2
The area is
the percentile
1.5

Expected
0.5 Shortfall VaR

0
-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
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 A game with a coin
• Let’s play a game: flip one coin, and receive
$1 if heads
• Assume Pr[Heads]= p (for example p=50%)

• Q. What is the game’s expected outcome?

• Q. What is the Variance?
• Q. What is the St.Dev?

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 A game with two coins
• Let’s play a game: flip 2 fair coins, and
receive $1 for each head

• Q. What is the portfolio expected return?

• Q. What is the portfolio Variance?
• Q. What is the portfolio St.Dev?

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 A lot more coins
• Let’s play a game: flip 30 fair coins, and
receive $1 for each head.

• Q. What is the portfolio expected return?

• Q. What is the portfolio Variance?
• Q. What is the portfolio St.Dev?

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 A Portfolio of 2 stocks
• Portfolio = 0.5 * A + 0.5 * B
• A: rA = 0.08 StDevA = 0.1
• B: rB = 0.10 StDevB = 0.1

• Q. What is the portfolio Expected Return?

• Q. What is the portfolio Variance?
• Q. What is the portfolio Standard Deviation?

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 A Portfolio of 3 stocks
• Portfolio = 𝑤𝐴 × 𝐴 + 𝑤𝐵 × 𝐵 + 𝑤𝐶 × 𝐶

• Q. What is the portfolio expected return?

• Q. What is the portfolio Variance?
• Q. What is the portfolio Standard Deviation?

• Q. What is if you have N stocks?

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 (A)

Q. Which
portfolio
has best
(B) (C) Sharpe?

30% (A)
50% (B)
20% (D)
(D) (E)

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Historic Returns on Risky Portfolios
• Normal distribution is generally a good
approximation of portfolio returns
– VaR indicates no greater tail risk than is
characteristic of the equivalent normal
– The ES does not exceed 0.41 of the monthly SD,
presenting no evidence against the normality
• However
– Negative skew is present in some of the
portfolios some of the time, and positive kurtosis
is present in all portfolios all the time
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Figure 5.7 Nominal and Real Equity Returns
Around the World, 1900-2000

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Figure 5.8 Standard Deviations of Real Equity and
Bond Returns Around the World, 1900-2000

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Figure 5.9 Probability of Investment Outcomes
After 25 Years with a Lognormal Distribution

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Terminal Value with Continuous Compounding

When the continuously compounded rate of

return on an asset is normally distributed, the
effective rate of return will be lognormally
distributed. Remember:
E Geom. Avg  E Arithm. Avg  0.5 2

so m  g  0.5 2

The Terminal Value will then be:

𝑇
𝑇 𝑔+0.5 𝜎 2 𝑇𝑔+0.5𝑇𝜎 2
1 + 𝐸𝐴𝑅 = 𝑒 =𝑒

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