Chapter 2

Measuring Return and Risk

Measuring Returns
Measuring Risk
Distributions

Chapter 2 All Rights Reserved 1

 Learning Objectives
Sources of Investment Returns
Measures of Investment Returns
Sources of Investment Risk
Measures of Investment Risk
Monte Carlo Simulation
Investment Performance and Margin

Chapter 2 All Rights Reserved 2

 Sources of Investment returns
Dividends, Interest
Cash dividends on common, preferred stock
Interest (coupons) on Bills and Bonds
Capital gains/losses (Realized vs. Paper)
Increases/decreases in price
Other
Stock Dividends
Rights and Warrants

Chapter 2 All Rights Reserved 3

 Returns on Investment
Ex Ante Returns
Returns derived from a probability distribution
Based on expectations about future cash flows
Ex Post Returns
Returns based on a time series of historical data
Investment decisions largely based on ex
post analysis modified by ex ante
expectations

Chapter 2 All Rights Reserved 4

 Measuring Returns
Holding Period Returns (HPR) [Eq. 2-1]

Pt Pt 1 CFt
HPR t
Pt 1
Where: Pt = current price
Pt-1 = purchase price
CFt = cash flow received in time t
HPR normally computed on monthly basis
Chapter 2 All Rights Reserved 5
 Measuring Returns
Holding Period Return Relative (HPRR) [Eq. 2-2]

Pt CFt
HPRR t
Pt 1
HPR = HPRR - 1

Chapter 2 All Rights Reserved 6

 Measuring Returns
Per-Period Return (PPR) [Eq. 2-3]
Return earned for particular period (for example,
annual return)
Per-Period Return = (Periods Income + Price Change)
Beginning Period Value
Per-Period Return Relative (PPRR) [Eq. 2-3a]
Per-Period Return Relative = (Periods Income + End
of Period Value) Beginning Period Value
PPR = PPRR - 1

Chapter 2 All Rights Reserved 7

 Compounding
Computing Future Values given a ROR
FV = Begin Value * (1 + ROR)t [Eq. 2-4]
Where: t = number of periods
ROR = assumed Rate of Return
(1 + ROR)t = Future Value Interest Factor (FVIF)
FV is also termed Ending Value
Example: What is the future value of $10,000
invested for 10 years if the ROR is 8%?
FV = 10,000 * (1.08)10 = $21,589.25

Chapter 2 All Rights Reserved 8

 Compounding
Computing the Effective Annual Rate
Rear = (1 + HPR)12/n -1

Example: You realize a 6.5% return over a 4

month period. What is the EAR
(1.065)12/4 - 1 = 0.2079 = 20.79 % per annum

Chapter 2 All Rights Reserved 9

 Measuring Average Returns
Average Rate of Return (AROR) as
Arithmetic Average:
T
AROR HPR t / T
t 1

Chapter 2 All Rights Reserved 10

 Measuring Geometric Returns
Geometric Returns as Product (P)*
T
GHPR (1 HPR t ) 1/T
1
t 1

*GHPR as a mean geometric holding period return

Arithmetic Average Returns upwardly biased

Chapter 2 All Rights Reserved 11

 Expected Returns
Probability Distributions
Normal
Leptokurtic
Platykurtic
Skewed
Expected Returns are State of Nature
specific probability assignments

Chapter 2 All Rights Reserved 12

 Portfolio Expected Returns
Weighted Average Rate of Return
WARR = W1 x E(R1) + W2 x E(R2) + . . . + Wn x E(Rn)
where Wi = % of portfolio invested in security i
E(Ri) = expected per-period return for security i
Subject to: W1 + + Wn = 1

Chapter 2 All Rights Reserved 13

 Risk and return:
What is risk?
Uncertainty - the possibility that the actual
return may differ from the expected return
Probability - the chance of something occurring
Expected Returns - the sum of possible returns
times the probability of each return

Chapter 2 All Rights Reserved 14

 Types of Risk
Pure Risk
Involves only chance of loss or no loss
Casualty insurance is a good example
Moral Hazard Problem
Adverse Selection
Speculative Risk
Associated with speculation in which there is
some chance of gain and some chance of loss

Chapter 2 All Rights Reserved 15

 Sources of Risk
Investment Theory: Market Risk
Diversifiable vs. Non-Diversifiable (CAPM)
Purchasing Power impact of inflation
Real vs. Nominal Returns
Interest Rate Risk
Changes in market values when rates change
Price risk vs. Reinvestment Rate Risk

Chapter 2 All Rights Reserved 16

 Sources of Investment Risk
Business Risk (non-systematic)
Financial Risk
Default, Liquidity, Marketability, Leverage
Exchange Rate Risk Political Risk
Tax Risk (changes in code, treatment)
Investment Manager Risk
Additional Commitment Risk
Chapter 2 All Rights Reserved 17
 Measures of Risk
Standard Deviation
Coefficient of Variation CV = SD / Mean
Beta (CAPM relative risk market)
Range: highest to lowest expected values
Semi-Variance (trimmed mean)
n

Pi xmin R i ER ,0
2

i 1

Chapter 2 All Rights Reserved 18

 Measuring Risk
Finance
Standard Deviation (SD)

1/2
1 T
2
SD [ ]
T 1 t 1
(HPR t AROR)

R t R
n
1
Variance [ ]
2 2

n 1 t 1

Chapter 2 All Rights Reserved 19

 Risk and Return
Fundamental Relationship
The greater the risk, the greater the expected
return (positively related)
Investors assumed to be risk averse:
The will want the same return with less risk.
Assume greater risk only for greater returns.
Risk and Return relationship varies over
time.

Chapter 2 All Rights Reserved 20

 Monte Carlo Simulation
Dealing with random nature of returns
Use of random numbers (probabilities) to vary
expected future outcomes.
Computer programs will generate numbers
between 0 and 1. Output range can be set:
Example: only values between 0 and .25
Random effects may be positive or negative
(requires two draws)

Chapter 2 All Rights Reserved 21

 Investment Leverage Buying on
Margin
Buying on Margin
Margin rate: percentage of securities purchase
that must come from investors funds rather
than from borrowing
Initial margin rate: used when determining cash
needed for new purchase
Maintenance margin rate: used when
determining if margin call is needed

Chapter 2 All Rights Reserved 22

 Investment Leverage Buying on
Margin
Margin Rates
Federal Reserve Board vs. In-house rule
Regulation T
50% initial margin rate
NYSE's Rule 431 & FINRA's Rule 2520
25% maintenance margin rate [MMR]
30% on short positions
In-house requirements may be higher, never lower

Chapter 2 All Rights Reserved 23

 Investment Leverage Buying on
Margin
Buying Power
Dollar value of additional securities that can be
purchased on margin with current equity in
margin account
BP a function of Net Equity position
E = MV Loan
BP = (E / IMR) MV
See examples 1 and 2 on page 2.44-.45

Chapter 2 All Rights Reserved 24

 Investment Leverage Buying on
Margin
Margin Calls
M/C Threshold = Loan Value / (1 MMR)
Example: MMR = 25%, Loan = $50,000
M/C T = 50,000 / (.75) = $66,667.
If value of portfolio drops below $66,667 broker calls
for $$$: Cash Required = Loan [MV*(1-MMR)]
Meeting Margin calls
Deposit (or transfer additional funds)
Liquidate a portion of portfolio proceeds to pay down

Chapter 2 All Rights Reserved 25

 Investment Leverage Buying on
Margin
Effects of Margin Buying on Investment
Returns
ROI = (Sell Buy) / Buy
ROI = (50000 40000) / 40000 = 25%
50% Margin: (50000 40000) / 20000 = 50%
ROI = (50000 60000) / 60000 = - 16.66%
ROI = (50000 60000) / 30000 = - 33.33%

Chapter 2 All Rights Reserved 26

 Investment Leverage Buying on
Margin
Broker Call-Loan Rate
Interest rate charged by banks to brokers for
loans that brokers use to support their margin
loans to customers
Usually scaled up for margin loan rate

Chapter 2 All Rights Reserved 27

 Take-Home Exercise
Mini-case starting page 2.54

Chapter 2 All Rights Reserved 28