Riskreturnandportfoliotheory

RISK & RETURN
The concept and measurement of Return:
The concept of Risk:
Sources and types of risk.

Measurement of risk :
Range,
Std Deviation and
Co-Efficient of Variation.
Risk-return trade-of
Risk, Return and Portfolio Theory
Realized and Expected return.

Ex-ante and ex-post returns
01/22/16
Friday, January 22, 2016
Risk, Return &Portfolio

Theory
LEARNING OBJECTIVES
The difference among the most important types of returns

How to estimate expected returns and risk for individual
securities
What happens to risk and return when securities are
combined in a portfolio
INTRODUCTION TO RISK AND

RETURN
INTRODUCTION TO RISK AND

RETURN
Risk and return are the two most
important attributes of an
investment.
Risk isnt just the potential loss of

return, it is the potential loss of
the entire investment itself (loss
of both principal and interest).
Consequently, taking on additional
risk in search of higher returns is
a decision that should not be
taking lightly.
Return
%
Risk Premium
RF
Real Return
Research has shown that the two

are linked in the capital markets
and that generally, higher
returns can only be achieved by
taking on greater risk.
Expected Inflation Rate
Risk
RISK RETURN TRADE OFF
The concept of investment return is widely

understood. For example, a 10% per annum return on
a capital sum of $100,000 would result in $10,000
increase in value for the year. However, what exactly
is risk?.
Risk is for the most part unavoidable in life
generally as much as in investing!
In investments, the term risk is often expressed as
volatility or variations in returns.
In investment terms, the concept of volatility is the

measurement of fluctuation in the market values of
various asset classes as they rise and fall over time.
The greater the volatility the more rises and falls are
recorded by an individual asset class.
The reward for accepting greater volatility is the
likely hood of higher investment returns over mid to
longer term.
The disadvantage can mean lower returns in the
shorter term. It must also be remembered that it can
mean an increase or decrease in capital.
All investments involve some risk. In general terms
the higher the risk, the higher the potential return, or
loss. Conversely the lower the risk the lower the
potential return, or loss.
The long-term risk/return trade of between
diferent asset classes is illustrated in the

following graph:
01/22/16
01/22/16

MEASURING RETURNS
MANY DIFFERENT MATHEMATICAL DEFINITIONS OF

"RETURNS"...
01/22/16
CHAPTER 9 LECTURE.
QUANTIFYING & MEASURING INVESTMENT
PERFORMANCE: "RETURNS"
RETURNS
RETURNS =
PROFITS (IN THE
INVESTMENT GAME)
RETURNS =
OBJECTIVE TO MAXIMIZE
(CET.PAR.)
RETURNS =
WHAT YOU'VE GOT
WHAT YOU
HAD TO BEGIN WITH, AS A

PROPORTION OF WHAT YOU HAD TO BEGIN WITH.
QUANTITATIVE RETURN MEASURES

NECESSARY TO:
MEASURE PAST PERFORMANCE

=> "EX POST" OR HISTORICAL RETURNS;
MEASURE EXPECTED FUTURE PERFORMANCE

=> "EX ANTE" OR EXPECTED RETURNS.
MANY DIFFERENT MATHEMATICAL DEFINITIONS OF

"RETURNS"...
TYPE 1: PERIOD-BY-PERIOD
RETURNS . . .
"PERIODIC" RETURNS
SIMPLE "HOLDING PERIOD RETURN"
(HPR)
MEASURES WHAT THE INVESTMENT
GROWS TO WITHIN EACH SINGLE
PERIOD OF TIME,
ASSUMING ALL CASH FLOW (OR
VALUATION) IS ONLY AT BEGINNING
AND END OF THE PERIOD OF TIME
(NO INTERMEDIATE CASH FLOWS).
TYPE 1: PERIOD-BY-PERIOD RETURNS

(CONTD)
RETURNS MEASURED SEPARATELY OVER
EACH OF A SEQUENCE OF REGULAR AND
CONSECUTIVE (RELATIVELY SHORT)
PERIODS OF TIME.
SUCH AS: DAILY, MONTHLY, QUARTERLY, OR
ANNUAL RETURNS SERIES.
E.G.: RETURN TO IBM STOCK IN: 1990, 1991,
1992, ...
PERIODIC RETURNS CAN BE AVERAGED
ACROSS TIME TO DETERMINE THE "TIMEWEIGHTED" MULTI-PERIOD RETURN.
TYPE 1: PERIOD-BY-PERIOD
RETURNS (CONTD)
THE PERIODS USED TO DEFINE PERIODIC
RETURNS SHOULD BE SHORT ENOUGH THAT
THE ASSUMPTION OF NO INTERMEDIATE CASH
FLOWS DOES NOT MATTER.
TYPE 2: MULTIPERIOD RETURN

MEASURES
PROBLEM: WHEN CASH FLOWS OCCUR AT

MORE THAN TWO POINTS IN TIME, THERE IS
NO SINGLE NUMBER WHICH UNAMBIGUOUSLY
MEASURES THE RETURN ON THE
INVESTMENT.

MEASURES (CONTD)
NEVERTHELESS,
MULTI-PERIOD
RETURN MEASURES GIVE A SINGLE
RETURN NUMBER (TYPICALLY QUOTED
PER ANNUM) MEASURING THE
INVESTMENT PERFORMANCE OF A
LONG-TERM (MULTI-YEAR) INVESTMENT
WHICH MAY HAVE CASH FLOWS AT
INTERMEDIATE POINTS IN TIME
THROUGHOUT THE "LIFE" OF THE
INVESTMENT.

MEASURES (CONTD)
THERE ARE MANY DIFFERENT MULTI-PERIOD

RETURN MEASURES, BUT THE MOST FAMOUS
AND WIDELY USED (BY FAR) IS:
THE "INTERNAL RATE OF

RETURN" (IRR).
THE IRR IS A "DOLLAR-WEIGHTED" RETURN

BECAUSE IT REFLECTS THE EFFECT OF
HAVING DIFFERENT AMOUNTS OF DOLLARS
INVESTED AT DIFFERENT PERIODS IN TIME
DURING THE OVERALL LIFETIME OF THE
INVESTMENT.
ADVANTAGES OF PERIOD-BY-PERIOD
(TIME-WEIGHTED) RETURNS:
1)ALLOW YOU TO TRACK PERFORMANCE OVER
TIME, SEEING WHEN INVESTMENT IS DOING
WELL AND WHEN POORLY.
(TIME-WEIGHTED) RETURNS (CONTD)
2)ALLOW YOU TO QUANTIFY RISK (VOLATILITY)
AND CORRELATION (CO-MOVEMENT) WITH
OTHER INVESTMENTS AND OTHER PHENOMENA.
(TIME-WEIGHTED) RETURNS (CONTD)
3)
ARE FAIRER FOR JUDGING
INVESTMENT PERFORMANCE WHEN THE
INVESTMENT MANAGER DOES NOT HAVE
CONTROL OVER THE TIMING OF CASH
FLOW INTO OR OUT OF THE INVESTMENT
FUND (E.G., A PENSION FUND).
ADVANTAGES OF MULTI-PERIOD
RETURNS:
1)DO NOT REQUIRE KNOWLEDGE OF MARKET
VALUES OF THE INVESTMENT ASSET AT
INTERMEDIATE POINTS IN TIME (MAY BE
DIFFICULT TO KNOW FOR REAL ESTATE).
RETURNS (CONTD)
2)
GIVES A FAIRER (MORE COMPLETE)
MEASURE OF INVESTMENT
PERFORMANCE WHEN THE
INVESTMENT MANAGER HAS CONTROL
OVER THE TIMING AND AMOUNTS OF
CASH FLOW INTO AND OUT OF THE
INVESTMENT VEHICLE (E.G., PERHAPS
SOME "SEPARATE ACCOUNTS" WHERE
MGR HAS CONTROL OVER CAPITAL
FLOW TIMING, OR A STAGED
DEVELOPMENT PROJECT).
RETURNS (CONTD)
NOTE: BOTH HPRs AND IRRs ARE WIDELY

USED IN REAL ESTATE INVESTMENT ANALYSIS
PERIOD-BY-PERIOD RETURNS...
"TOTAL
RETURN" ("r"):
rt=(CFt+Vt-Vt-1)/ Vt-1=((CFt+Vt)/Vt-1) -1
where: CFt= Cash Flow (net) in period "t"; Vt=Asset
Value ("ex dividend") at end of period "t".
"INCOME
RETURN" ("y", AKA "CURRENT

YIELD", OR JUST "YIELD"):
yt =
CFt / Vt-1
"APPRECIATION
RETURN" ("g", AKA

"CAPITAL GAIN", OR "CAPITAL RETURN",
OR "GROWTH"):
gt = ( Vt-Vt-1 ) / Vt-1 = Vt / Vt-1 - 1
NOTE:
rt = yt + gt
TOTAL RETURN IS MOST

IMPORTANT:
To convert y into g, reinvest the cash flow back into
the asset.
To convert g into y, sell part of the holding in the
asset.
NOTE:
This type of conversion is not so easy to do
with most real estate investments as it is with
investments in stocks and bonds.
EXAMPLE:
PROPERTY VALUE AT END OF 1994:
$100,000
PROPERTY NET RENT DURING 1995:
$10,000
PROPERTY VALUE AT END OF 1995:
$101,000
=
=
=
WHAT IS 1995 R, G, Y ?...
y1995 = $10,000/$100,000 = 10%
g1995 = ($101,000 - $100,000)/$100,000 = 1%
r1995
= 10% + 1% = 11%
A NOTE ON RETURN
TERMINOLOGY
"INCOME
RETURN" - YIELD, CURRENT

YIELD, DIVIDEND YIELD.
IS
IT CASH FLOW BASED OR ACCRUAL

INCOME BASED?
SIMILAR TO "CAP RATE".
IS A RESERVE FOR CAPITAL EXPENDITURES
TAKEN OUT?
CI TYPICALLY 1% - 2% /YR OF V.
EXAMPLE: V=1000, NOI=100, CI=10:
yt = (100-10)/1000 = 9%, cap rate = 100/1000 = 10%
"YIELD"
CAN ALSO MEAN: "TOTAL YIELD", "YIELD TO

MATURITY"
THESE
ARE IRRs, WHICH ARE TOTAL RETURNS,

NOT JUST INCOME.
"BASIS POINT" = 1 / 100th PERCENT = .0001
CONTINUOUSLY COMPOUNDED
RETURNS:
THE PER ANNUM CONTINUOUSLY

COMPOUNDED TOTAL RETURN IS:
WHERE "Y" IS THE NUMBER (OR FRACTION) OF
= LN( VBETWEEN
( V t - 1"t-1"
) Y AND
V t"t".
+ CF t = V t - 1 * EXP( Yr t )
r tYEARS
TIME
t + CF t ) - LN
EXAMPLE:
01/01/98
V = 1000
03/31/99 V = 1100 & CF = 50
PER ANNUM
r
= (LN(1150) LN(1000)) / 1.25
= 7.04752 6.90776
= 11.18%
"REAL" VS. "NOMINAL" RETURNS

NOMINAL RETURNS ARE THE "ORDINARY"
RETURNS YOU NORMALLY SEE QUOTED
OR EMPIRICALLY MEASURED. UNLESS IT
IS EXPLICITLY STATED OTHERWISE,
RETURNS ARE ALWAYS QUOTED AND
MEASURED IN NOMINAL TERMS. The
NOMINAL Return is the Return in Current
Dollars (dollars of the time when the return is
generated).
REAL RETURNS ARE NET OF INFLATION.
The REAL Return is the Return measured
in constant purchasing power dollars
("constant dollars").
EXAMPLE:
Suppose INFLATION=5% in 1992 (i.e., need
$1.05 in 1992 to buy what $1.00 purchased in
1991).
So:
$1.00 in "1992$" = 1.00/1.05 = $0.95 in
"1991$
Ifrt = Nominal Total Return, year t
it = Inflation, year t
Rt = Real Total Return, year t
Then:
Rt = (1+rt)/(1+it) - 1 = rt - (it + it
Rt ) rt - it ,
Thus: NOMINAL Return = REAL Return +
Inflation Premium
Inflation Premium = it + it Rt It
IN THE CASE OF THE CURRENT

YIELD
(Real yt)=(Nominal yt)/(1+it) (Nominal yt)
EXAMPLE:
1991 PROPERTY VALUE = $100,000
1992 NET RENT = $10,000
1992 PROPERTY VALUE = $101,000
1992 INFLATION
= 5%
WHAT IS THE REAL r, y, and g for 1992?
ANSWER:
Real g = (101,000/1.05)/100,000-1= -3.81%
-4%
(versus Nominal g=+1%)
Real y = (10,000/1.05)/100,000 = +9.52%
10%
(versus Nominal y=10% exactly)
Real r = (111,000/1.05)/100,000-1=+5.71%
6%
(versus Nominal r = 11%)
= g + y =+9.52%+(-3.81%) 10%
- 4%
RISK
INTUITIVE MEANING...
THE POSSIBILITY OF NOT MAKING THE
EXPECTED RETURN:
rt Et-j[rt]
MEASURED BY THE RANGE OR

STD.DEV. IN THE EX ANTE
PROBABILITY DISTRIBUTION OF
THE EX POST RETURN . . .
100%
A
Probability
75%
50%
25%
0%
-10%
Figure 1
C
-5%
0%
5%
C RISKER THAN B.
B RISKIER THAN A.
A RISKLESS.
10%
Returns
15%
20%
25%
30%
WHAT IS THE EXPECTED RETURN?

...
EXAMPLE OF RETURN RISK

QUANTIFICATION:
SUPPOSE 2 POSSIBLE FUTURE RETURN
SCENARIOS. THE RETURN WILLEITHER
BE:
+20%, WITH 50% PROBABILITY
OR:
-10%, WITH 50% PROBABILITY
"EXPECTED" (EX ANTE) RETURN

= (50% CHANCE)(+20%) + (50% CHANCE)(-10%)
= +5%
RISK (STD.DEV.) IN THE RETURN

= SQRT{(0.5)(20-5)2 + (0.5)(-10-5)2}
= 15%
THE RISK/RETURN TRADEOFF..

INVESTORS DON'T LIKE RISK!
SO THE CAPITAL MARKETS

COMPENSATE THEM BY PROVIDING
HIGHER RETURNS (EX ANTE) ON
MORE RISKY ASSETS . . .
Expected
Return
rf
Risk
RISK & RETURN:

TOTAL RETURN =
RISK PREMIUM
rt
=
RISKFREE RATE +
rf,t
RPt
RISK FREE RATE

RISKFREE RATE (rf,t)
= Compensation for TIME
= "Time Value of Money"
US Treasury Bill Return (For Real Estate, usually
use Long Bond)
RISK PREMIUM
RISK PREMIUM (RPt):
EX ANTE: E[RPt]
= E[rt] - rf,t
= Compensation for RISK
EX POST:
RPt
= rt - rf,t
= Realization of Risk ("Throw of Dice")
RELATION BETWEEN RISK &

RETURN:
GREATER RISK <===> GREATER RISK
PREMIUM
(THIS IS EX ANTE, OR ON AVG. EX POST,

BUT NOT NECESSARILY IN ANY GIVEN
YEAR OR ANY GIVEN INVESTMENT EX
POST)
EXAMPLE OF RISK IN REAL

ESTATE:
PROPERTY "A" (OFFICE):
VALUE END 1998 = $100,000

POSSIBLE VALUES END 1999
$110,000 (50% PROB.)
$90,000 (50% PROB.)
STD.DEV. OF g99 = 10%
EXAMPLE (CONTD)
PROPERTY "B" (BOWLING ALLEY):
VALUE END 1998 = $100,000
POSSIBLE VALUES END 1999
$120,000 (50% PROB.)
$80,000 (50% PROB.)
STD.DEV. OF g99 = 20%
EXAMPLE (CONTD)
B IS MORE RISKY THAN A.
T-BILL RETURN = 7%
EXAMPLE (CONTD)
A: Office Building
Known as of end 1998
Value = $100,000
Expected value end 99
= $100,000
Expected net rent 99 =
$11,000
Ex ante risk premium
= 11% - 7% = 4%
B: Bowling Alley
Known as of end 1998
Value = $100,000
Expected value end 99
= $100,000
Expected net rent 99 =
$15,000
Ex ante risk premium
= 15% - 7% = 8%
EXAMPLE (CONTD) SUPPOSE THE

FOLLOWING OCCURRED IN 1999
A: Office Building
Not known until end
1999
End 99 Value =
$110,000
99 net rent = $11,000
99 Ex post risk
premium = 21% - 7% =
14%
(The Dice Rolled
Favorably)
B: Bowling Alley
Not known until end
1999
End 99 Value =
$80,000
99 net rent = $15,000
99 Ex post risk
premium = -5% - 7% =
-12%
(The Dice Rolled
Unfavorably)
SUMMARY:
THREE USEFUL WAYSTO BREAK
TOTAL RETURNINTO TWO
COMPONENTS...
1)TOTAL RETURN = CURRENT YIELD

+ GROWTH
r=y+g
2)
TOTAL RETURN = RISKFREE RATE +

RISK PREMIUM
r = rf + RP
3)
TOTAL RETURN = REAL RETURN +

INFLATION PREMIUM
r = R + (i+iR) R + I
"TIME-WEIGHTED
INVESTMENT". . .
SUPPOSE THERE ARE CFs AT INTERMEDIATE
POINTS IN TIME WITHIN EACH PERIOD
(E.G., MONTHLY CFs WITHIN QUARTERLY
RETURN PERIODS).
THEN THE SIMPLE HPR FORMULAS ARE NO
LONGER EXACTLY ACCURATE.
"TIME-WEIGHTED
INVESTMENT". . .
A WIDELY USED SIMPLE ADJUSTMENT IS
TO APPROXIMATE THE IRR OF THE
PERIOD ASSUMING THE ASSET WAS
BOUGHT AT THE BEGINNING OF THE
PERIOD AND SOLD AT THE END, WITH
OTHER CFs OCCURRING AT
INTERMEDIATE POINTS WITHIN THE
PERIOD.
THIS APPROXIMATION IS DONE BY
SUBSTITUTING A TIME-WEIGHTED
INVESTMENT IN THE DENOMINATOR
INSTEAD OF THE SIMPLE BEGINNING-OFPERIOD ASSET VALUE IN THE
DENOMINATOR.
"TIME-WEIGHTED
INVESTMENT". . .
r
EndVal BegVal CFi
BegVal wi CFi
where:
= sum of all net cash flows occurring
CF
in
period t,
wi
= proportion of period t remaining at
the time when net cash flow "i" was
received by the investor.
(Note: cash flow from the investor to the
investment is negative; cash flow from the
investment to the investor is positive.)
i
EXAMPLE . . .
CF:
- 100
+ 10
+100
Simple HPR:
TWD HPR:
(11/12)10)
IRR:
Date:
12/31/98
01/31/99
12/31/99
(10 + 100-100) / 100
= 10 / 100
= 10.00%
(10 + 100-100) / (100
= 10 / 90.83
= 11.01%
= 11.00% . . .
EXAMPLE(CONTD)
11
10
0
100
0 100
1 IRR / mo j 2 1 IRR / mo j 1 IRR / mo 12
IRR / yr (1.0087387)12 1 11.00%
IRR / mo 0.87387%
THE DEFINITION OF THE "NCREIF"

PERIODIC RETURN FORMULA . . .
THE
MOST WIDELY USED INDEX OF

PERIODIC RETURNS IN COMMERCIAL
REAL ESTATE IN THE US IS THE
"NCREIF PROPERTY INDEX" (NPI).
NCREIF =
"NATIONAL COUNCIL
OF REAL ESTATE INVESTMENT
FIDUCIARIES
INSTITUTIONAL QUALITY R.E.
QUARTERLY INDEX OF TOTAL
RETURNS
PROPERTY-LEVEL
APPRAISAL-BASED
NCREIF FORMULA
FORMULA INCLUDES A TIME-WEIGHTED

INVESTMENT DENOMINATOR, ASSUMING:
ONE-THIRD OF THE QUARTERLY PROPERTY
NOI IS RECEIVED AT THE END OF EACH
CALENDAR MONTH;
PARTIAL SALES RECEIPTS MINUS CAPITAL
IMPROVEMENT EXPENDITURES ARE
RECEIVED MIDWAY THROUGH THE
QUARTER...
EndVal BegVal PS CI NOI

rNPI (1/3)NOI = (2/3)(1/3)NOI+(1/3)(1/3)NOI+(0)
[Note:
BegVal
1 2 PS CI 1 3 NOI
(1/3)NOI
]
MULTI-PERIOD RETURNS
SUPPOSE YOU WANT TO KNOW WHAT
IS THE RETURN EARNED OVER A
MULTI-PERIOD SPAN OF TIME,
EXPRESSED AS A SINGLE AVERAGE
ANNUAL RATE?...
YOU COULD COMPUTE THE

AVERAGE OF THE HPRs ACROSS
THAT SPAN OF TIME.
THIS WOULD BE A "TIMEWEIGHTED" AVERAGE RETURN.
(CONTD)
IT WILL:
=>Weight a given rate of return more if it
occurs over a longer interval or more frequently
in the time sample.
=>Be independent of the magnitude of

capital invested at each point in time; Not
affected by the timing of capital flows into or out
of the investment.
(CONTD)
YOU CAN COMPUTE THIS AVERAGE USING
EITHER THE ARITHMETIC OR
GEOMETRIC MEAN...
Arithmetic average return over 1992-94:

= (r 92+ r93+ r94)/3
Geometric average return over 1992-94:

= [(1+r 92)(1+r93)(1+r94)](1/3) 1
ARITHMETIC VS. GEOMETRIC

MEAN
Arithmetic Mean:
=> Always greater than geometric mean.
=> Superior statistical properties:
* Best "estimator" or "forecast" of "true"
return.
=> Mean return components sum to the mean
total return
=> Most widely used in forecasts & portfolio
analysis.

MEAN (CONTD)
Geometric Mean:
=> Reflects compounding ("chain-linking") of
returns:
* Earning of "return on return".
=> Mean return components do not sum to
mean total return
* Cross-product is left out.
=> Most widely used in performance evaluation.

MEAN (CONTD)
The two are more similar:
The less volatility in returns
across time
The more frequent the return
interval
Note: "continuously compounded" returns
(log differences) side-steps around this
issue. (There is only one continuouslycompounded mean annual rate: arithmetic
& geometric distinctions do not exist).
TIME-WEIGHTED RETURNS:
NUMERICAL EXAMPLES
An asset that pays no dividends . . .
Year:
End of year asset

value:
HPR:
1992
$100,000
1993
$110,000
(110,000 - 100,000) / 100,000 = 10.00%
1994
$121,000
(121,000 - 110,000) / 110,000 = 10.00%
1995
$136,730
(136,730 - 121,000) / 121,000 = 13.00%
THREE-YEAR AVERAGE ANNUAL

RETURN (1993-95):
Arithmetic mean:
= (10.00 + 10.00 + 13.00) / 3
= 11.00%
Geometric mean:
= (136,730 / 100,000)(1/3) - 1
= ((1.1000)(1.1000)(1.1300))(1/3) - 1
= 10.99%
Continuously compounded:
= LN(136,730 / 100,000) / 3
= (LN(1.1)+LN(1.1)+LN(1.13)) / 3
= 10.47%
ANOTHER EXAMPLE
End of year
asset value:
HPR:
Year:
1992
$100,000
1993
$110,000
(110,000 - 100,000) / 100,000 = 10.00%
1994
$124,300
(124,300 - 110,000) / 110,000 = 13.00%
1995
$140,459
(140,459 - 124,300) / 124,300 = 13.00%

RETURN (1993-95):
Arithmetic mean:
= (10.00 + 13.00 + 13.00) / 3
= 12.00%
Geometric mean:
= (140,459 / 100,000)(1/3) - 1
= ((1.1000)(1.1300)(1.1300))(1/3) - 1
= 11.99%
Continuously compounded:
= LN(140,459 / 100,000) / 3
= (LN(1.1)+LN(1.13)+LN(1.13)) / 3
= 11.32%
ANOTHER EXAMPLE
Year:
End of year
asset value:
HPR:
1992
$100,000
1993
$110,000
(110,000 - 100,000) / 100,000 = 10.00%
1994
$121,000
(121,000 - 110,000) / 110,000 = 10.00%
1995
$133,100
(133,100 - 121,000) / 121,000 = 10.00%

RETURN (1993-95):
Arithmetic mean:
= (10.00 + 10.00 + 10.00) / 3
= 10.00%
Geometric mean:
= (133,100 / 100,000)(1/3) - 1
= ((1.1000)(1.1000)(1.1000))(1/3) - 1
= 10.00%
Continuously comp'd:
= LN(133,100 / 100,000) / 3
= (LN(1.1)+LN(1.1)+LN(1.1)) / 3 = 9.53%
ANOTHER MULTI-PERIOD
RETURN MEASURE: THE IRR...
CANT COMPUTE HPRs IF YOU DONT
KNOW ASSET VALUE AT
INTERMEDIATE POINTS IN TIME (AS
IN REAL ESTATE WITHOUT REGULAR
APPRAISALS)
SO YOU CANT COMPUTE TIMEWEIGHTED AVERAGE RETURNS.
You need the IRR.
IRR
SUPPOSE YOU WANT A RETURN
MEASURE THAT REFLECTS THE
EFFECT OF THE TIMING OF WHEN
(INSIDE OF THE OVERALL TIME SPAN
COVERED) THE INVESTOR HAS
DECIDED TO PUT MORE CAPITAL
INTO THE INVESTMENT AND/OR
TAKE CAPITAL OUT OF THE
INVESTMENT.
You need the IRR.
IRR
FORMAL DEFINITION OF IRR
"IRR" (INTERNAL RATE OF RETURN) IS

THAT SINGLE RATE THAT DISCOUNTS ALL
THE NET CASH FLOWS OBTAINED FROM
THE INVESTMENT TO A PRESENT VALUE
EQUAL TO WHAT YOU PAID FOR THE
INVESTMENT AT THE BEGINNING:
IRR
0 = CF 0 +
CF N
CF 1
CF 2
+
+ ... +
(1 + IRR)
(1 + IRR )2
(1 + IRR )N
CFt = Net Cash Flow to Investor in Period "t

CF0 is usually negative (capital outlay).
Note: CFt is signed according to the convention:
cash flow from investor to investment is
negative,
cash flow from investment to investor is positive.
Note also: Last cash flow (CFN) includes two
components:
The last operating cash flow plus
The (ex dividend) terminal value of the asset
("reversion").
WHAT IS THE IRR?...

(TRYING TO GET SOME INTUITION
HERE . . .)
A SINGLE ("BLENDED") INTEREST

RATE, WHICH IF ALL THE CASH IN
THE INVESTMENT EARNED THAT
RATE ALL THE TIME IT IS IN THE
INVESTMENT, THEN THE INVESTOR
WOULD END UP WITH THE TERMINAL
VALUE OF THE INVESTMENT (AFTER
REMOVAL OF CASH TAKEN OUT
DURING THE INVESTMENT):
WHAT IS THE IRR? (CONTD)

PV 1 IRR CF1 1 IRR
CFN 1 1 IRR CFN

where PV = -CF0, the initialcash
"deposit" in the
"account" (outlay to purchase the investment).
IRR is "internal" because it includes only the
returns earned on capital while it is invested in
the project.
Once capital (i.e., cash) is withdrawn from the
investment, it no longer influences the IRR.
This makes the IRR a "dollar-weighted"
average return across time for the investment,
because returns earned when more capital is in
the investment will be weighted more heavily
in determining the IRR.
N
N 1
THE IRR INCLUDES THE EFFECT OF:

1. THE INITIAL CASH YIELD RATE
(INITIAL LEVEL OF CASH PAYOUT AS A
FRACTION OF THE INITIAL
INVESTMENT;
2. THE EFFECT OF CHANGE OVER TIME
IN THE NET CASH FLOW LEVELS (E.G.,
GROWTH IN THE OPERATING CASH
FLOW);
3. THE TERMINAL VALUE OF THE ASSET
AT THE END OF THE INVESTMENT
HORIZON (INCLUDING ANY NET
CHANGE IN CAPITAL VALUE SINCE THE
INITIAL INVESTMENT WAS MADE).
IRR
THE IRR IS THUS A TOTAL RETURN
MEASURE (CURRENT YIELD PLUS GROWTH
& GAIN).
NOTE ALSO:
THE IRR IS A CASH FLOW BASED RETURN

MEASURE...
DOES NOT DIFFERENTIATE BETWEEN
"INVESTMENT" AND "RETURN ON OR
RETURN OF INVESTMENT".
INCLUDES THE EFFECT OF CAPITAL
INVESTMENTS AFTER THE INITIAL OUTLAY.
DISTINGUISHES CASH FLOWS ONLY BY
THEIR DIRECTION: POSITIVE IF FROM
INVESTMENT TO INVESTOR, NEGATIVE IF
FROM INVESTOR TO INVESTMENT (ON
SAME SIDE OF "=" SIGN).
IRR
In general, it is not possible to algebraically
determine the IRR for any given set of cash flows.
It is necessary to solve numerically for the IRR,
in effect, solving the IRR equation by "trial &
error". Calculators and computers do this
automatically.
ADDITIONAL NOTES ON THE

IRR . . .
TECHNICAL PROBLEMS:
IRR MAY NOT EXIST OR NOT BE
UNIQUE (OR GIVE MISLEADING RESULTS)
WHEN CASH FLOW PATTERNS INCLUDE
NEGATIVE CFs AFTER POSITIVE CFs.
BEST TO USE NPV IN THESE
CASES. (SOMETIMES FMRR IS USED.)
ADDITIONAL NOTES ON THE IRR

(CONTD)
THE IRR AND TIME-WEIGHTED RETURNS:
IRR = TIME-WTD GEOMEAN HPR
IF (AND ONLY IF) THERE ARE NO
INTERMEDIATE CASH FLOWS (NO CASH
PUT IN OR TAKEN OUT BETWEEN THE
BEGINNING AND END OF THE
INVESTMENT).

(CONTD)
THE IRR AND RETURN COMPONENTS:
IRR IS A "TOTAL RETURN"
IRR DOES NOT GENERALLY
BREAK OUT EXACTLY INTO A SUM OF:
y + g: INITIAL CASH YIELD + CAPITAL
VALUE GROWTH COMPONENTS.
DIFFERENCE BETWEEN THE
IRR AND THE INITIAL CASH YIELD IS
DUE TO A COMBINATION OF GROWTH
IN THE OPERATING CASH FLOWS
AND/OR GROWTH IN THE CAPITAL
VALUE.
THE IRR AND RETURN

COMPONENTS (CONTD)
IF THE OPERATING CASH FLOWS

GROW AT A CONSTANT RATE, AND IF THE
ASSET VALUE REMAINS A CONSTANT
MULTIPLE OF THE CURRENT OPERATING
CASH FLOWS, THEN THE IRR WILL INDEED
EXACTLY EQUAL THE SUM OF THE INITIAL
CASH YIELD RATE PLUS THE GROWTH
RATE (IN BOTH THE CASH FLOWS AND THE
ASSET CAPITAL VALUE), AND IN THIS CASE
THE IRR WILL ALSO EXACTLY EQUAL BOTH
THE ARITHMETIC AND GEOMETRIC TIMEWEIGHTED MEAN (CONSTANT PERIODIC
RETURNS): IRRt,t+N=rt,t+N=yt,t+N+gt,t+N.

(CONTD)
THE IRR AND TERMINOLOGY:
IRR OFTEN CALLED "TOTAL YIELD"
(APPRAISAL)
"YIELD TO MATURITY" (BONDS)
EX-ANTE IRR = "GOING-IN IRR".
DOLLAR-WEIGHTED & TIME-WEIGHTED

RETURNS:A NUMERICAL EXAMPLE . . .
"OPEN-END" (PUT) OR (CREF).
INVESTORS BUY AND SELL "UNITS" ON

THE BASIS OF THE APPRAISED VALUE
OF THE PROPERTIES IN THE FUND AT
THE END OF EACH PERIOD.
SUPPOSE THE FUND DOESN'T PAY OUT

ANY CASH, BUT REINVESTS ALL
PROPERTY INCOME. CONSIDER 3
CONSECUTIVE PERIODS. . .
INVESTMENT PERIODIC
RETURNS: HIGH, LOW, HIGH . . .
YR END UNIT VALUE
1996
1997
1998
1999
$1000
$1100
$990
$1089
+10.00%
-10.00%
GEOM MEAN TIME-WTD RETURN
=
(1.089)+10.00%
(1/3)-1 = 2.88%
PERIODIC RETURN
INVESTOR #1, "MR. SMART" (OR

LUCKY): GOOD TIMING . . .
END OF YEAR:
1996
1997
1998
1999
UNITS BOUGHT
UNITS SOLD
$1089
IRR
= IRR(-2000,1100,0,1089)
= 4.68%
CASH FLOW
-$2000
+$1100
INVESTOR #2, "MR. DUMB" (OR

UNLUCKY): BAD TIMING . . .
END OF YEAR:
1996
1997
1998
1999
UNITS BOUGHT
UNITS SOLD
IRR = IRR(-1000,-1100,990,1089) = -0.50%

CASH FLOW
-$1000
-$1100
+$990
$1089
EXAMPLE (CONTD)
DOLLAR-WTD RETURN BEST FOR
MEASURING INVESTOR PERFORMANCE
IF INVESTOR CONTROLLED TIMING OF
CAP. FLOW.
TIME-WTD RETURN BEST FOR

MEASURING PERFORMANCE OF THE
UNDERLYING INVESTMENT (IN THIS
CASE THE PUT OR CREF), AND
THEREFORE FOR MEASURING INVESTOR
PERFORMANCE IF INVESTOR ONLY
CONTROLS WHAT TO INVEST IN BUT
NOT WHEN.
MEASURING RETURNS
INTRODUCTION
Ex Post Returns
Return calculations done after-the-fact, in order
to analyze what rate of return was earned.
Ex Ante Returns
Return calculations may be done before-the-fact,
in which case, assumptions must be made about
the future
MEASURING RETURNS
INTRODUCTION
According to the constant growth DDM can be decomposed into the

two forms of income that equity investors may receive, dividends and
capital gains.
D1
kc
g Income / Dividend Yield Capital Gain (or loss) Yield
P0
WHEREAS
Fixed-income investors (bond investors for example) can expect to
earn interest income as well as (depending on the movement of
interest rates) either capital gains or capital losses.
MEASURING RETURNS
INCOME YIELD
Income yield is the return earned in the form of a

periodic cash flow received by investors.
The income yield return is calculated by the
periodic cash flow divided by the purchase price.
Income yield
CF1
P0
Where CF1 = the expected cash flow to be received

P0 = the purchase price
[8-1]
INCOME YIELD
STOCKS VERSUS BONDS
Figure 8-1 illustrates the income yields for both bonds and stock in Canada from
the 1950s to 2005
The dividend yield is calculated using trailing rather than

forecast earns (because next years dividends cannot be
predicted in aggregate), nevertheless dividend yields have
exceeded income yields on bonds.
Reason risk
The risk of earning bond income is much less than the risk
incurred in earning dividend income.
(Remember, bond investors, as secured creditors of the first have a
legally-enforceable contractual claim to interest.)
(See Figure 8 -1 on the following slide)
EX POST VERSUS EX ANTE

RETURNS
MARKET INCOME YIELDS
8-1 FIGURE
Insert Figure 8 - 1
MEASURING RETURNS
COMMON SHARE AND LONG CANADA BOND YIELD

GAP
Table 8 1 illustrates the income yield gap between stocks and bonds over
recent decades
The main reason that this yield gap has varied so much over time is that the
return to investors is not just the income yield but also the capital gain (or
loss) yield as well.
MEASURING RETURNS
DOLLAR RETURNS
Investors in market-traded securities (bonds or stock)

receive investment returns in two different form:
The investor will receive dollar returns, for example:

$1.00 of dividends
Share price rise of $2.00
Income yield
Capital gain (or loss) yield
To be useful, dollar returns must be converted to percentage returns as a

function of the original investment. (Because a $3.00 return on a $30
investment might be good, but a $3.00 return on a $300 investment
would be unsatisfactory!)
MEASURING RETURNS
CONVERTING DOLLAR RETURNS TO PERCENTAGE

RETURNS
An investor receives the following dollar returns a stock

investment of $25:
The capital gain (or loss) return component of total return is calculated:
ending price minus beginning price, divided by beginning price
[8-2]
P1 P0 $27 - $25
Capital gain (loss) return
.08 8%
P0
$25
$1.00 of dividends
Share price rise of $2.00
MEASURING RETURNS
TOTAL PERCENTAGE RETURN
Total return Income yield Capital gain (or loss) yield
[8-3]
CF1 P1 P0
P0
CF1 P1 P0

P0 P0
$1.00 $27 $25
0.04 0.08 0.12 12%
$25
$25
The investors total return (holding period

return) is:
MEASURING RETURNS
TOTAL PERCENTAGE RETURN GENERAL FORMULA
The general formula for holding period return is:
[8-3]
CF1 P1 P0
P0
CF1 P1 P0
P
P
0
0
Total return Income yield Capital gain (or loss) yield
MEASURING AVERAGE RETURNS

EX POST RETURNS
Measurement of historical rates of return that have

been earned on a security or a class of securities allows
us to identify trends or tendencies that may be useful
in predicting the future.
There are two different types of ex post mean or
average returns used:
average
Geometric mean
Arithmetic

ARITHMETIC AVERAGE
Arithmetic Average (AM)
r
i 1
Where:
ri = the individual returns

n = the total number of observations
Most commonly used value in statistics

Sum of all returns divided by the total number of
observations
[8-4]

GEOMETRIC MEAN
[8-5]
1
n
Geometric Mean (GM) [( 1 r1 )( 1 r2 )( 1 r3 )...( 1 rn )] -1
Measures the average or compound growth rate

over multiple periods.
GEOMETRIC MEAN VERSUS ARITHMETIC AVERAGE
If the return values are volatile the geometric mean <

arithmetic average
If all returns (values) are identical the geometric mean =

arithmetic average.
The greater the volatility of returns, the greater the difference

between geometric mean and arithmetic average.
(Table 8 2 illustrates this principle on major asset classes 1938 2005)
AVERAGE INVESTMENT RETURNS AND STANDARD

DEVIATIONS
The greater the difference,

the greater the volatility of
annual returns.
MEASURING EXPECTED (EX ANTE)

RETURNS
While past returns might be interesting, investors are
most concerned with future returns.
Sometimes, historical average returns will not be
realized in the future.
Developing an independent estimate of ex ante returns
usually involves use of forecasting discrete scenarios
with outcomes and probabilities of occurrence.
ESTIMATING EXPECTED RETURNS

ESTIMATING EX ANTE (FORECAST) RETURNS
The general formula
Expected Return (ER) (ri Prob i )
[8-6]
i 1
Where:
ER = the expected return on an investment

Ri = the estimated return in scenario i
Probi = the probability of state i occurring

ESTIMATING EX ANTE (FORECAST) RETURNS
Example:
This is type of forecast data that are required to make
an ex ante estimate of expected return.
ESTIMATING EX ANTE (FORECAST) RETURNS USING A

SPREADSHEET APPROACH
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.
ESTIMATING EX ANTE (FORECAST) RETURNS USING A FORMULA

APPROACH
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.
n
Expected Return (ER) (ri Prob i )

i 1
(r1 Prob1 ) (r2 Prob 2 ) (r3 Prob 3 )

(30% 0.25) (12% 0.5) (-25% 0.25)
7.25%

MEASURING RISK
RISK
If
investors require a 10% rate of return on a given

investment, then any return less than 10% is considered
harmful.
Probability of incurring harm

For investors, risk is the probability of earning an
inadequate return.
RISK
ILLUSTRATED
Probability
Outcomes that produce harm
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
The range of total possible returns

on the stock A runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
RANGE
The difference between the maximum and minimum
values is called the range
Canadian
common stocks have had a range of annual

returns of 74.36 % over the 1938-2005 period
Treasury bills had a range of 21.07% over the same period.
As a rough measure of risk, range tells us that

common stock is more risky than treasury bills.
DIFFERENCES IN LEVELS OF RISK

ILLUSTRATED
Probability
A is a much riskier investment than B
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
The wider the range of probable

outcomes the greater the risk of the
investment.
Outcomes that produce harm
HISTORICAL RETURNS ON
DIFFERENT ASSET CLASSES
Figure 8-2 illustrates the volatility in annual returns on

three different assets classes from 1938 2005.
Note:
Treasury bills always yielded returns greater than 0%

Long Canadian bond returns have been less than 0% in some
years (when prices fall because of rising interest rates), and
the range of returns has been greater than T-bills but less
than stocks
Common stock returns have experienced the greatest range of
returns
(See Figure 8-2 on the following slide)
MEASURING RISK
ANNUAL RETURNS BY ASSET CLASS, 1938 - 2005

FIGURE 8-2
REFINING THE MEASUREMENT OF

RISK
STANDARD DEVIATION ()
Standard
Range measures risk based on only two observations

(minimum and maximum value)
Standard deviation uses all observations.
deviation can be calculated on forecast or possible

returns as well as historical or ex post returns.
(The following two slides show the two different formula used for Standard
Deviation)
MEASURING RISK
EX POST STANDARD DEVIATION
[8-7]
Ex post
2
(
r
r
)
i
i 1
n 1
Where :
the standard deviation
_
r the average return

ri the return in year i
n the number of observations
MEASURING RISK
EXAMPLE USING THE EX POST STANDARD DEVIATION

Problem
Estimate the standard deviation of the historical returns on investment
A that were: 10%, 24%, -12%, 8% and 10%.
Step 1 Calculate the Historical Average Return
n
Arithmetic Average (AM)
i 1
10 24 - 12 8 10 40
8.0%
5
5
Step 2 Calculate the Standard Deviation

n
Ex post
(r r )
i 1
n 1
(10 - 8) 2 ( 24 8) 2 (12 8) 2 (8 8) 2 (14 8) 2
5 1
2 2 16 2 20 2 0 2 2 2
4 256 400 0 4
664
166 12.88%
4
4
4
EX POST RISK
STABILITY OF RISK OVER TIME

Figure 8-3 (on the next slide) demonstrates that the relative riskiness of
equities and bonds has changed over time.
Until the 1960s, the annual returns on common shares were about four
times more variable than those on bonds.
Over the past 20 years, they have only been twice as variable.
Consequently, scenario-based estimates of risk (standard deviation) is
required when seeking to measure risk in the future. (We cannot safely
assume the future is going to be like the past!)
Scenario-based estimates of risk is done through ex ante estimates and
calculations.
RELATIVE UNCERTAINTY
EQUITIES VERSUS BONDS
FIGURE 8-3
MEASURING RISK
EX ANTE STANDARD DEVIATION
A Scenario-Based Estimate of Risk
Ex ante
2
(Prob
)
(
r
ER
)
i
i
i
i 1
[8-8]
SCENARIO-BASED ESTIMATE OF RISK

EXAMPLE USING THE EX ANTE STANDARD DEVIATION
RAW DATA
GIVEN INFORMATION INCLUDES:
- Possible returns on the investment for different
discrete states
- Associated probabilities for those possible returns
SCENARIO-BASED ESTIMATE OF
RISK
EX ANTE STANDARD DEVIATION SPREADSHEET

APPROACH
The following two slides illustrate an approach to

solving for standard deviation using a spreadsheet
model.

FIRST STEP CALCULATE THE EXPECTED RETURN
Determined by multiplying
the probability times the
possible return.
Expected return equals the sum of

the weighted possible returns.
SECOND STEP MEASURE THE WEIGHTED AND SQUARED
DEVIATIONS
Now multiply the square deviations by

First calculate the deviation of
their probability of occurrence.
possible returns from the expected.
Second, square those deviations

The sum of
thestandard
weighted
and
square
deviations
from the
mean.
The
deviation
is the
square root
is the variance
percent (in
squared
terms.
of theinvariance
percent
terms).
SCENARIO-BASED ESTIMATE OF
RISK
EXAMPLE USING THE EX ANTE STANDARD DEVIATION

FORMULA
(Prob ) (r ER )
i 1
P1 (r1 ER1 ) 2 P2 (r2 ER2 ) 2 P1 (r3 ER3 ) 2

.25(22 10.3) 2 .5(14 10.3) 2 .25(35 10.3) 2
.25(32.3) 2 .5(3.8) 2 .25(24.8) 2
.25(.10401) .5(.00141) .25(.06126)
.0420
.205 20.5%
Ex ante

MODERN PORTFOLIO
THEORY
PORTFOLIOS
The risk-return characteristics of the portfolio is demonstrably

different than the characteristics of the assets that make up that
portfolio, especially with regard to risk.
Combining different securities into portfolios is done to achieve
diversification.
A portfolio is a collection of different securities such as stocks and

bonds, that are combined and considered a single asset
DIVERSIFICATION
Diversification has two faces:
2.
Diversification results in an overall reduction in

portfolio risk (return volatility over time) with little
sacrifice in returns, and
Diversification helps to immunize the portfolio from
potentially catastrophic events such as the outright
failure of one of the constituent investments.
(If only one investment is held, and the issuing firm
goes bankrupt, the entire portfolio value and returns
are lost. If a portfolio is made up of many different
investments, the outright failure of one is more than
likely to be offset by gains on others, helping to make
the portfolio immune to such events.)
1.
EXPECTED RETURN OF A
PORTFOLIO
MODERN PORTFOLIO THEORY
[8-9]
ER p ( wi ERi )
i 1
The portfolio weight of a particular security is the

percentage of the portfolios total value that is invested
in that security.
The Expected Return on a Portfolio is simply the

weighted average of the returns of the individual assets
that make up the portfolio:
EXPECTED RETURN OF A
PORTFOLIO
EXAMPLE
ER p ( wi ERi ) (.286 14%) (.714 6% )

i 1
4.004% 4.284% 8.288%
Portfolio value = $2,000 + $5,000 = $7,000

rA = 14%, rB = 6%,
wA = weight of security A = $2,000 / $7,000 = 28.6%
wB = weight of security B = $5,000 / $7,000 = (1-28.6%)= 71.4%
RANGE OF RETURNS IN A TWO

ASSET PORTFOLIO
Because the expected return on the portfolio is a simple

weighted average of the individual returns of the assets, you
can achieve portfolio returns bounded by the highest and the
lowest individual asset returns.
In a two asset portfolio, simply by changing the weight of the

constituent assets, different portfolio returns can be achieved.

ASSET PORTFOLIO
Assume ERA = 8% and ERB = 10%
Example 1:
(See the following 6 slides based on Figure 8-4)
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE

WEIGHTS IN A AND B
8 - 4 FIGURE
10.50
ERB= 10%
Expected Return %
10.00
9.50
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

WEIGHTS IN A AND B
8 - 4 FIGURE
A portfolio manager can select the relative weights of the two
assets in the portfolio to get a desired return between 8%
(100% invested in A) and 10% (100% invested in B)
10.50
ERB= 10%
Expected Return %
10.00
9.50
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

WEIGHTS IN A AND B
8 - 4 FIGURE
10.50
ERB= 10%
Expected Return %
10.00
9.50
The potential returns of

the portfolio are
bounded by the highest
and lowest returns of
the individual assets
that make up the
portfolio.
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

WEIGHTS IN A AND B
8 - 4 FIGURE
10.50
ERB= 10%
Expected Return %
10.00
9.50
9.00
The expected return on

the portfolio if 100% is
invested in Asset A is
8%.
8.50
8.00
ER p wA ERA wB ERB (1.0)(8%) (0)(10%) 8%
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

WEIGHTS IN A AND B
8 - 4 FIGURE

invested in Asset B is
10%.
10.50
Expected Return %
10.00
ERB= 10%
9.50
9.00
8.50
ER p wA ERA wB ERB (0)(8%) (1.0)(10%) 10%

8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

WEIGHTS IN A AND B
8 - 4 FIGURE

invested in Asset A and
50% in B is 9%.
10.50
Expected Return %
10.00
9.50
ERB= 10%
ER p wA ERA wB ERB
9.00
(0.5)(8%) (0.5)(10%)
4% 5% 9%
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

ASSET PORTFOLIO
Assume ERA = 14% and ERB = 6%
Example 1:
(See the following 2 slides )
RANGE OF RETURNS IN A TWO ASSET

PORTFOLIO
E(R)A= 14%, E(R)B= 6%
A graph of this
relationship is
found on the
following slide.
RANGE OF RETURNS IN A TWO ASSET

PORTFOLIO
E(R)A= 14%, E(R)B= 6%
EXPECTED PORTFOLIO RETURNS

EXAMPLE OF A THREE ASSET PORTFOLIO
K. Hartviksen

RISK
IN PORTFOLIOS
MODERN PORTFOLIO THEORY - MPT
Prior to the establishment of Modern Portfolio Theory (MPT),

most people only focused upon investment returnsthey ignored
risk.
With MPT, investors had a tool that they could use to

dramatically reduce the risk of the portfolio without a significant
reduction in the expected return of the portfolio.
EXPECTED RETURN AND RISK FOR

PORTFOLIOS
STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING

COVARIANCE
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COV A, B )
Risk of Asset A
adjusted for weight
in the portfolio
Risk of Asset B
adjusted for weight
in the portfolio
[8-11]
Factor to take into

account comovement
of returns. This factor
can be negative.
EXPECTED RETURN AND RISK FOR

PORTFOLIOS
STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING

CORRELATION COEFFICIENT
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )( A, B )( A )( B )
Factor that takes into

account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.
[8-15]
GROUPING INDIVIDUAL ASSETS

INTO PORTFOLIOS
The riskiness of a portfolio that is made of different risky

assets is a function of three different factors:
the riskiness of the individual assets that make up the

portfolio
the relative weights of the assets in the portfolio
the degree of comovement of returns of the assets making
up the portfolio
The standard deviation of a two-asset portfolio may be

measured using the Markowitz model:
p w w 2 wA wB A, B A B
2
A
2
A
2
B
2
B
RISK OF A THREE-ASSET
PORTFOLIO
We need 3 (three) correlation coefficients between A and B; A and

C; and B and C.
a,b
B
a,c
b,c
The data requirements for a three-asset portfolio grows

dramatically if we are using Markowitz Portfolio selection formulae.
p A2 wA2 B2 wB2 C2 wC2 2 wA wB A, B A B 2 wB wC B ,C B C 2wA wC A,C A C
RISK OF A FOUR-ASSET PORTFOLIO
We need 6 correlation coefficients between A and B; A and C; A

and D; B and C; C and D; and B and D.
a,b
B
a,c
b,d
b,c
a,d
D
c,d
C
The data requirements for a four-asset portfolio grows dramatically

if we are using Markowitz Portfolio selection formulae.
COVARIANCE
[8-12]
COV AB Prob i (k A,i ki )(k B ,i - k B )

i 1
A statistical measure of the correlation of the

fluctuations of the annual rates of return of
different investments.
CORRELATION
The degree to which the returns of two stocks comove is measured by the correlation coefficient ().
The correlation coefficient () between the returns
on two securities will lie in the range of +1 through
- 1.
[8-13]
AB
COV AB
A B
+1 is perfect positive correlation

-1 is perfect negative correlation
COVARIANCE AND CORRELATION

COEFFICIENT
[8-14]
COVAB AB A B
Solving for covariance given the correlation

coefficient and standard deviation of the two
assets:
IMPORTANCE OF CORRELATION
Correlation is important because it affects the

degree to which diversification can be achieved
using various assets.
Theoretically, if two assets returns are perfectly
positively correlated, it is possible to build a
riskless portfolio with a return that is greater than
the risk-free rate.
AFFECT OF PERFECTLY NEGATIVELY

CORRELATED RETURNS
ELIMINATION OF PORTFOLIO RISK
Returns
%
20%
15%
10%
Returns on Stock A
Returns on Stock B
5%
Time 0
Returns on Portfolio
1
If returns of A and B are

perfectly negatively correlated,
a two-asset portfolio made up of
equal parts of Stock A and B
would be riskless. There would
be no variability
of the portfolios returns over
time.
EXAMPLE OF PERFECTLY POSITIVELY

CORRELATED RETURNS
NO DIVERSIFICATION OF PORTFOLIO RISK
Returns
%
20%
15%
10%
Returns on Stock A
Returns on Stock B
5%
Time 0
1

perfectly positively correlated, a
two-asset portfolio made up of
would be risky. There would be
no diversification (reduction of
portfolio risk).

CORRELATED RETURNS
ELIMINATION OF PORTFOLIO RISK
Returns
%
20%
15%
10%
Returns on Stock A
Returns on Stock B
5%
Time 0
1

perfectly negatively correlated,
a two-asset portfolio made up of
would be riskless. There would
be no variability
of the portfolios returns over
time.

CORRELATED RETURNS
NUMERICAL EXAMPLE
ER p ( wi ERi ) (.5 5%) (.5 15% )

i 1
2.5% 7.5% 10%

n
ER p ( wi ERi ) (.5 15%) (.5 5% )

i 1
7.5% 2.5% 10%
Perfectly Negatively
Correlated Returns
over time
DIVERSIFICATION POTENTIAL
In a simple, two-asset case, if the returns of the two assets are

perfectly negatively correlated it is possible (depending on the
relative weighting) to eliminate all portfolio risk.
This is demonstrated through the following series of
spreadsheets, and then summarized in graph format.
The potential of an asset to diversify a portfolio is dependent

upon the degree of co-movement of returns of the asset with
those other assets that make up the portfolio.
EXAMPLE OF PORTFOLIO
COMBINATIONS AND CORRELATION
Perfect
Positive
Correlation
no
diversification
Both
portfolio
returns and
risk are
bounded by
the range set
by the
constituent
assets when
=+1
Positive
Correlation
weak
diversification
potential
When =+0.5
these portfolio
combinations
have lower
risk
expected
portfolio return
is unaffected.
No
Correlation
some
diversification
potential
Portfolio
risk is
lower than
the risk of
either
asset A or
B.
Negative
Correlation
greater
diversification
potential
Portfolio risk
for more
combinations
is lower than
the risk of
either asset
Perfect
Negative
Correlation
greatest
diversification
potential
Risk of the
portfolio is
almost
eliminated at
70% invested in
asset A
Diversification of a Two Asset Portfolio

Demonstrated Graphically
The Effect of Correlation on Portfolio Risk:
The Two-Asset Case
Expected Return
AB = -0.5
12%
AB = -1
AB = 0
8%
AB= +1
4%
0%
0%
10%
20%
30%
Standard Deviation
40%
IMPACT OF THE CORRELATION

COEFFICIENT
The
Figure 8-7 (see the next slide) illustrates the

relationship between portfolio risk () and the
correlation coefficient
slope is not linear a significant amount of

diversification is possible with assets with no correlation (it
is not necessary, nor is it possible to find, perfectly
negatively correlated securities in the real world)
With perfect negative correlation, the variability of portfolio
returns is reduced to nearly zero.
EXPECTED PORTFOLIO
RETURN
IMPACT OF THE CORRELATION

COEFFICIENT
8 - 7 FIGURE
Standard Deviation (%)

of Portfolio Returns
15
10
0
-1
-0.5
0
Correlation Coefficient ()
0.5
ZERO RISK PORTFOLIO

We can calculate the portfolio that removes all risk.
When = -1, then
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )( A, B )( A )( B )
Becomes:
[8-16]
p w A (1 w) B
[8-15]
AN EXERCISE TO PRODUCE
THE EFFICIENT FRONTIER
USING THREE ASSETS
AN EXERCISE USING T-BILLS,

STOCKS AND BONDS
Historical
averages for
returns and risk for
three asset
Each achievable
classes
portfolio
combination is
Historical
plotted correlation
on
expected
return,
coefficients
the asset
risk between
() space,
classes
found on the
following slide.
Portfolio
characteristics for
each combination
of securities
ACHIEVABLE PORTFOLIOS
RESULTS USING ONLY THREE ASSET CLASSES
The plotted points are

attainable portfolio
combinations.
The efficient set is that set of

achievable portfolio
combinations that offer the
highest rate of return for a
given level of risk. The solid
blue line indicates the efficient
set.
ACHIEVABLE TWO-SECURITY
PORTFOLIOS
MODERN PORTFOLIO THEORY
8 - 9 FIGURE
13
12
Expected Return %
This line
represents
the set of
portfolio
combinations
that are
achievable by
varying
relative
weights and
using two
noncorrelated
securities.
11
10
9
8
7
6
10
20
30
40
50
60
DOMINANCE
It is assumed that investors are rational, wealthmaximizing and risk averse.

If so, then some investment choices dominate others.
INVESTMENT CHOICES
THE CONCEPT OF DOMINANCE ILLUSTRATED
10%
5%
A dominates C
because it offers a
higher return but
for the same risk.
5%
A dominates B
because it offers
the same return
but for less risk.
20%
Risk
To the risk-averse wealth maximizer, the choices are clear, A dominates B,

A dominates C.
Return
%
EFFICIENT FRONTIER
THE TWO-ASSET PORTFOLIO COMBINATIONS

8 - 10 FIGURE
A is not attainable
B,E lie on the
Expected Return %
efficient frontier and

are attainable
E is the minimum
B
C
variance portfolio
(lowest risk
combination)
C, D are
E
D
attainable but are

dominated by
superior portfolios
that line on the line
above E
EFFICIENT FRONTIER
THE TWO-ASSET PORTFOLIO COMBINATIONS
B
C
D
Rational, risk
averse
investors will
only want to
hold portfolios
such as B.
Expected Return %
8 - 10 FIGURE
The actual
choice will
depend on
her/his risk
preferences.

DIVERSIFICATION
DIVERSIFICATION
This is illustrated in Figure 8 -11 and Table 8 -3 found

on the following slides.
As the portfolio is divided across more and more securities,

the risk of the portfolio falls rapidly at first, until a point is
reached where, further division of the portfolio does not
result in a reduction in risk.
Going beyond this point is known as superfluous
diversification.
We have demonstrated that risk of a portfolio can be

reduced by spreading the value of the portfolio across,
two, three, four or more assets.
The key to efficient diversification is to choose assets
whose returns are less than perfectly positively
correlated.
Even with random or nave diversification, risk of the
portfolio can be reduced.
DIVERSIFICATION
DOMESTIC DIVERSIFICATION
8 - 11 FIGURE
Average Portfolio Risk

January 1985 to December 1997
14
12
10
8
6
4
2
0
50
100
150
200
Number of Stocks in Portfolio
250
300
DIVERSIFICATION
DOMESTIC DIVERSIFICATION
TOTAL RISK OF AN INDIVIDUAL

ASSET
EQUALS THE SUM OF MARKET AND UNIQUE RISK
Diversifiable
(unique) risk
[8-19]
Nondiversifiable
(systematic) risk
Number of Stocks in Portfolio
[8-19]
This graph illustrates

that total risk of a stock
is made up of market
risk (that cannot be
diversified away
because it is a function
of the economic
system) and unique,
company-specific risk
that is eliminated from
the portfolio through
diversification.
Total risk Market (systematic) risk Unique (non - systematic) risk
Average Portfolio Risk
INTERNATIONAL DIVERSIFICATION
Clearly, diversification adds value to a portfolio
by reducing risk while not reducing the return on
the portfolio significantly.
Most of the benefits of diversification can be
achieved by investing in 40 50 different
positions (investments)
However, if the investment universe is expanded
to include investments beyond the domestic
capital markets, additional risk reduction is
possible.
(See Figure 8 -12 found on the following slide.)
DIVERSIFICATION
INTERNATIONAL DIVERSIFICATION
8 - 12 FIGURE
Percent risk
100
80
60
40
U.S. stocks
20
International stocks
11.7
0
10
20
30
Number of Stocks
40
50
60
SUMMARY AND CONCLUSIONS

In this chapter you have learned:
to measure different types of returns

How to calculate the standard deviation and
interpret its meaning
How to measure returns and risk of portfolios
and the importance of correlation in the
diversification process.
How the efficient frontier is that set of
achievable portfolios that offer the highest rate
of return for a given level of risk.
How

CONCEPT REVIEW
QUESTIONS
CONCEPT REVIEW QUESTION 1

EX ANTE AND EX POST RETURNS
What is the difference between ex ante and ex

post returns?
COPYRIGHT
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons
Canada, Ltd. The purchaser may make
back-up copies for his or her own use
only and not for distribution or resale.
The author and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.

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RISK & RETURN

The concept and measurement of Return:

The concept of Risk:

Sources and types of risk.

Risk, Return and Portfolio Theory

Realized and Expected return.

Friday, January 22, 2016

Risk, Return &Portfolio

The difference among the most important types of returns

Risk, Return and Portfolio Theory

Friday, January 22, 2016

INTRODUCTION TO RISK AND

Risk, Return and Portfolio Theory

INTRODUCTION TO RISK AND

Risk isnt just the potential loss of

Risk, Return and Portfolio Theory

Research has shown that the two

Expected Inflation Rate

RISK RETURN TRADE OFF

The concept of investment return is widely

volatility or variations in returns.

In investment terms, the concept of volatility is the

diferent asset classes is illustrated in the

Risk, Return and Portfolio Theory

Risk, Return and Portfolio Theory

Friday, January 22, 2016

MANY DIFFERENT MATHEMATICAL DEFINITIONS OF

HAD TO BEGIN WITH, AS A

QUANTITATIVE RETURN MEASURES

MEASURE PAST PERFORMANCE

MEASURE EXPECTED FUTURE PERFORMANCE

MANY DIFFERENT MATHEMATICAL DEFINITIONS OF

TYPE 1: PERIOD-BY-PERIOD RETURNS

TYPE 2: MULTIPERIOD RETURN

PROBLEM: WHEN CASH FLOWS OCCUR AT

TYPE 2: MULTIPERIOD RETURN

TYPE 2: MULTIPERIOD RETURN

THERE ARE MANY DIFFERENT MULTI-PERIOD

THE "INTERNAL RATE OF

THE IRR IS A "DOLLAR-WEIGHTED" RETURN

NOTE: BOTH HPRs AND IRRs ARE WIDELY

RETURN" ("y", AKA "CURRENT

RETURN" ("g", AKA

TOTAL RETURN IS MOST

WHAT IS 1995 R, G, Y ?...

y1995 = $10,000/$100,000 = 10%

g1995 = ($101,000 - $100,000)/$100,000 = 1%

RETURN" - YIELD, CURRENT

IT CASH FLOW BASED OR ACCRUAL

yt = (100-10)/1000 = 9%, cap rate = 100/1000 = 10%

CAN ALSO MEAN: "TOTAL YIELD", "YIELD TO

ARE IRRs, WHICH ARE TOTAL RETURNS,

THE PER ANNUM CONTINUOUSLY

"REAL" VS. "NOMINAL" RETURNS

IN THE CASE OF THE CURRENT

WHAT IS THE REAL r, y, and g for 1992?

MEASURED BY THE RANGE OR

WHAT IS THE EXPECTED RETURN?

EXAMPLE OF RETURN RISK

"EXPECTED" (EX ANTE) RETURN

RISK (STD.DEV.) IN THE RETURN

THE RISK/RETURN TRADEOFF..

SO THE CAPITAL MARKETS