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    Chapter Five: Risk, Return, and The Historical Record

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    zauqi
    This document summarizes key concepts around risk, return, and the historical record of investments. It discusses nominal and real interest rates, how inflation affects returns, and how taxes impact the real rate of return. It also covers effective annual rates, holding period returns, expected returns and standard deviation as a measure of risk. The document discusses how returns are estimated and different types of distributions like the normal distribution. Finally, it touches on risk aversion and how investors consider risk versus return in building an optimal portfolio.

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    Chapter Five: Risk, Return, and The Historical Record

    Uploaded by

    zauqi
    51 views30 pages
    This document summarizes key concepts around risk, return, and the historical record of investments. It discusses nominal and real interest rates, how inflation affects returns, and how taxes impact the real rate of return. It also covers effective annual rates, holding period returns, expected returns and standard deviation as a measure of risk. The document discusses how returns are estimated and different types of distributions like the normal distribution. Finally, it touches on risk aversion and how investors consider risk versus return in building an optimal portfolio.

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    This document summarizes key concepts around risk, return, and the historical record of investments. It discusses nominal and real interest rates, how inflation affects returns, and how taxes impact the real rate of return. It also covers effective annual rates, holding period returns, expected returns and standard deviation as a measure of risk. The document discusses how returns are estimated and different types of distributions like the normal distribution. Finally, it touches on risk aversion and how investors consider risk versus return in building an optimal portfolio.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    51 views30 pages

    Chapter Five: Risk, Return, and The Historical Record

    Uploaded by

    zauqi
    This document summarizes key concepts around risk, return, and the historical record of investments. It discusses nominal and real interest rates, how inflation affects returns, and how taxes impact the real rate of return. It also covers effective annual rates, holding period returns, expected returns and standard deviation as a measure of risk. The document discusses how returns are estimated and different types of distributions like the normal distribution. Finally, it touches on risk aversion and how investors consider risk versus return in building an optimal portfolio.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 30

    Chapter Five

    Risk, Return, and the


    Historical Record

    Name:
    • Devi Twi Jayanti - 123012011036
    • Afriyanti - 123012011024
    • Yudha Kusuma - 123012011072
    • Dwi Harini - 123012011090
    Real and Nominal Rates of Interest
    • Nominal interest rate (rn):

    • Growth rate of your money

    • Real interest rate (rr):

    • Growth rate of your purchasing power


    rr  rn  rn  i
    rr  1
    • Where i is the rate of inflation
    i
    i

    5-2
    Determination of the Equilibrium Real
    Rate of Interest

    5-3
    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:

    rn  rr  E

    i 
    5-4
    Taxes and the Real Rate of
    Interest
    • Tax liabilities are based on nominal income

    • Given a tax rate (t) and nominal interest rate (rn), the
    real after-tax rate is:

    • The after-tax real rate of return falls as the inflation rate


    rises

    5-5
    example
    • you are in a 30% tax bracket and your
    investments provide a nominal return of 12%
    while inflation runs at 8%,
    Nominal rate : 12%
    Inflasi : 8%
    Real rate = 12% - 8% = 4%

    = (4% + 8%) (1-30%)-8%


    = 0.0278
    = 2,8%
    But the tax code does not recognize that the first 8%.

    after-tax nominal return is 12%(1 − .3) = 8.4%, so your after-tax real


    interest rate is only 8.4% − 8% = .4%. As predicted by Equation 5.5,
    your after-tax real return has fallen by
    it = 8% × .3 = 2.4%.
    Comparing Rates of Return for Different
    Holding Periods

    • For T = 1, Equation 5.6 provides the risk-free rate for an investment horizon of 1 year.

    5-7
    Effective Annual Rate (EAR)
    • In general, we can relate EAR to the total return, rf (T ), over a
    holding period of length T by using the following equation:
    Annual Percentage Rate
    (APR)
    • APR: Annualized rates on short-term
    investments (by convention, T < 1
    year) often are reported using simple
    rather than compound interest

    APR = n × rf (T ).
    n = 1/T
    Example:
    Deposit 6-month, rate of 2.71%
    APR = n × rf (T ).
    = 1/0.5 × 2.71
    = 5.42%.
    Annual Percentage Rate (APR)

    Therefore, the relationship among the compounding period, the EAR, and the APR is

    APR  1 EAR  1


    T

    T
    APR vs.
    EAR

    5-11
    Holding Period
    Return
    • Rates of return: Single period

    HPR  P1  P 0
     D1
    P0
    • HPR = Holding period
    return
    • P0 = Beginning price
    • P1 = Ending price
    • D1 = Dividend during 5-12

    period one
    HPR: Single Period
    Example
    • Ending Price = $110

    • Beginning Price = $100

    • Dividend = $4

    $110  $100  $4
    HPR  $100  .1 4 , o r 1 4 %

    5-13
    Expected Return and Standard
    Deviation
    • Expected returns

    E(r)   p(s)r(s)
    s
    • p(s) = Probability of a state

    • r(s) = Return if a state occurs

    • s = State
    5-14
    Scenario Returns: Example

    State Prob. of State r in State

    Excellent .25 0.3100


    Good .45 0.1400

    Poor .25 -0.0675

    Crash .05 -0.5200

    E(r) = (.25)(.31) + (.45)(.14) + (.25)(−.0675) + (0.05)(−


    0.52)

    E(r) = .0976 or 9.76%


    5-15
    Expected Return and Standard
    Deviation

    • Variance (VAR):

    s p s r s   E r
    2
     
    
    • Standard Deviation
    2

    (STD):

    STD   2

    5-16
    Scenario VAR and STD: Example

    • The expected rate of return on the index • The variance of the rate of return (σ2 )
    E(r) = (.25 × .31) + (.45 × .14) + [.25 × (− .0675 σ2 = .25(.31 − 0.0976)2 + .45(.14 − .0976)2
    )] + [.05 × (− .52)] = .0976 + .25(− 0.0675 − 0.0976)2 + .05(−.52 − .0976)2
    = .038

    • Standard deviation is calculated:


    5-17
    σ = √.0380  = .1949 = 19.49%
    Returns Using Arithmetic and
    Geometric Averaging
    • Arithmetic
    Average n
    n
    1 r(s)
    E(r)  
    s1
    p(s)r(s)  
    n s1

    • Geometric (Time-Weighted) Average


    g  TV 1/ n
    1
    TV n  (1  r1 )
    (1  r2 )...(1  rn )

    = Terminal value of the investment 5-18


    Estimating
    Variance and Standard Deviation

    • Estimated Variance

    • Expected value of squared deviations


    n

    1
    ˆ 
    2
     r s  r
     2
    n s1

    • Unbiased estimated standard 2


    n
    deviation 1
    ˆ n  r  s  r

     1
    j
    1 
    5-19
    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 5-20

    SD of excess returns
    The Normal
    Distribution
    • Investment management is easier when returns are normal

    • Standard deviation is a good measure of risk when returns


    are symmetric

    • Future scenarios can be estimated using only the mean and


    the standard deviation

    • The dependence of returns across securities


    can be summarized using only the pairwise correlation
    coefficients
    5-21
    The Normal
    Distribution

    Mean = 10%, SD = 20%


    5-22
    Normality and Risk
    Measures
    • What if excess returns are not normally distributed?

    • Standard deviation is no longer a complete measure of risk

    • Sharpe ratio is not a complete of portfolio


    measure
    performance
    • Need to consider skewness and kurtosis

    5-23
    Normal and Skewed
    Distributions

    Mean = 6%, SD = 17%


    5-24
    Normal and Fat-Tailed
    Distributions

    Mean = .1, SD = .2
    5-25
    Historic Returns on Risky
    Portfolios

    5-26
    Risk Aversion

    The investment process .includes two major tasks:

    • The first task is securities and market analysis, in


    which we assess the risks and expected returns
    of all available investment instruments.

    • The second task is the formation of an optimal


    asset portfolio.
    Speculation and Gambling

    Speculation is "taking a large enough


    investment risk to earn a commensurate return.“

    gamble is "betting or betting on an uncertain


    outcome".
    Risk and Risk Aversion

    • Investors who are risk averse refuse to invest in


    a portfolio that is fair game or worse. Risk
    averse investors only consider risk-free
    portfolios or speculative prospects with a
    positive risk premium.

    But as risk increases with return, the most


    attractive portfolio becomes unclear.
    Thank You

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