Chapter 5
5.1 Rates of Return
→ The holding-period return (HPR) on a share of stock reflects both the increase (or decrease)
in the price of the share over the investment period as well as any dividend income the share has
provided.
Dividend yield = cash dividend/beginning price
Capital gains yield = ending price – beginning price/beginning price
Dividend yield + capital gains yield = HPR
Measuring investment returns over multiple periods
Arithmetic average
The arithmetic average of the annual returns is just the sum of the returns divided by the number
of years: (10 + 25 − 20 + 20)/4 = 8.75%.
Geometric average
r G =[(1 + .10) × (1 + .25) × (1 − .20) × (1 + .20)] ^ ¼ − 1 = .0719, or 7.19%
Dollar weighted return
IRR=3.38%
Conventions for annualizing rates of return
APR= Annual percentage rate
APR = Per-period rate × Periods per year
→ APR ignores compounding
EAR=Effective annual rate
→ actual rate an investment grows
→ EAR doesn't ignore compounding
5.2 Inflation and the real rate of interest
→ Nominal interest rate: The interest rate in terms of nominal (not adjusted for purchasing
power) dollars.
→ Real interest rate: The growth rate of purchasing power derived from an investment.
→ Inflation rate: The rate at which prices are rising, measured as the rate of increase of the CPI.
r real ≅r nom − i
→ Fisher Equation:
E(i) is the expected inflation rate
5.3 Risk and risk premiums
Scenario analysis and probability distributions
→ Standard deviation is the measure of risk/uncertainty
→ The larger the standard deviation, the more risk
The Normal Distribution
→ Transform normally distributed return into standard deviation score:
→ Original return, given standard normal return:
Deviation from normality and tail risk
→ Standard deviation measures the dispersion of possible asset returns.
→ Value at risk (VaR): Measure of downside risk. The worst loss that will be suffered with a
given probability, often 1% or 5%.
→ Kurtosis: Measure of the fatness of the tails of a probability distribution relative to that of a
normal distribution. Indicates likelihood of extreme outcomes.
- The kurtosis of normal distribution is zero
→ Skew: Measure of the asymmetry of a probability distribution.
- Positive skewness indicates that an investor may expect frequent small losses and a few
large gains
- Negative skewness indicates that an investor may expect frequent small gains and few
large losses
Risk premiums and risk aversion
→ Higher risk, higher return
→ Risk-free rate: The rate of return that can be earned with certainty, often measured by the
rate on Treasury bills.
→ Risk premium: An expected return in excess of that on risk-free securities.. It is the
difference between the expected HPR on the index fund and the risk-free rate
- If the risk-free rate in the example is 4% per year, and the expected index fund return is
10%, then the risk premium is 6% per year.
→ Excess return: Rate of return in excess of the risk-free rate.
→ Risk aversion: reluctance to accept risk
- The degree to which investors are willing to commit funds to stocks depends in part on
their risk aversion.
- Investors are risk averse in the sense that, without the expectation of earning a positive
risk premium, they would not be willing to invest in stocks.
Investors degree of risk aversion:
We call the ratio of a portfolio’s risk premium to its variance the price of risk. Based on this
price of risk (A= 3.91), we allocate wealth between the risky and risk-free assets.
The Sharpe Ratio
→ Risk aversion implies that investors will demand a higher reward (as measured by their
portfolio risk premium) to accept higher portfolio volatility. A statistic commonly used to rank
portfolios in terms of this risk-return trade-off is the Sharpe ratio
→ A risk-free asset would have a risk premium of zero and a standard deviation of zero.
→ Therefore, the Sharpe ratio of a risky portfolio quantifies the incremental reward (the increase
in risk premium) for each increase of 1% in the portfolio standard deviation (SD).
→ Standard deviation is a useful risk measure for diversified portfolios, it is not a useful way to
think about the risk of individual securities.
→ The Sharpe ratio is a valid statistic only for ranking portfolios; it is not appropriate for
comparing individual assets.
→ Higher risk tolerance, lower risk premium
5.5 Asset allocation across risky and risk free portfolios
→ Asset allocation: Portfolio choice among broad investment classes.
→ Capital allocation to risky assets: The choice between risky and risk-free assets.
→ Complete portfolio: The entire portfolio including risky and risk-free assets.
→ Capital allocation line (CAL): Plot of risk-return combinations available by varying
portfolio allocation between a risk-free asset and a risky portfolio.
→ The risk premium of the complete portfolio, C, equals the risk premium of the risky asset
times the fraction of the portfolio invested in the risky asset:
E(rc) = Expected Return of the complete portfolio
E(rp) = Expected Return of the risky portfolio
rf = Return of the risk free asset
y = Percentage assets in the risky portfolio
→ The standard deviation of the complete portfolio equals the standard deviation of the risky
asset times the fraction of the portfolio invested in the risky asset:
→ The risk premium and the standard deviation of the complete portfolio increase in proportion
to the investment in the risky portfolio.
Investor’s preferred capital allocation(y):
→ More risk-averse investors will choose portfolios near point F on the capital allocation line .
More risk-tolerant investors will choose points closer to P, with higher expected return and
higher risk. The most risk-tolerant investors will choose portfolios to the right of point P.