1 / 34

# Risk and Return: Past and Prologue - PowerPoint PPT Presentation

Risk and Return: Past and Prologue. 5. Bodie, Kane, and Marcus Essentials of Investments, 9th Edition. 5.1 Rates of Return. Holding-Period Return (HPR) Rate of return over given investment period HPR= [PS − PB + CF] / PB PS = Sale price PB = Buy price

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about ' Risk and Return: Past and Prologue' - booth

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

5

Bodie, Kane, and Marcus

Essentials of Investments, 9th Edition

• Holding-Period Return (HPR)

• Rate of return over given investment period

• HPR= [PS − PB + CF] / PB

• PS = Sale price

• CF = Cash flow during holding period

• Measuring Investment Returns over Multiple Periods

• Arithmetic average

• Sum of returns in each period divided by number of periods

• Geometric average

• Single per-period return; gives same cumulative performance as sequence of actual returns

• Compound period-by-period returns; find per-period rate that compounds to same final value

• Dollar-weighted average return

• Internal rate of return on investment

• Conventions for Annualizing Rates of Return

• APR = Per-period rate × Periods per year

• 1 + EAR = (1 + Rate per period)

• 1 + EAR = (1 + Rate per period)n= (1 + )n

• APR = [(1 + EAR)1/n– 1]n

• Continuous compounding: 1 + EAR = eAPR

APR

n

• Scenario Analysis and Probability Distributions

• Scenario analysis: Possible economic scenarios; specify likelihood and HPR

• Probability distribution: Possible outcomes with probabilities

• Expected return: Mean value of distribution of HPR

• Variance: Expected value of squared deviation from mean

• Standard deviation: Square root of variance

5.2 Risk and Risk Premiums Standard Deviation 20%

• Normality over Time

• When returns over very short time periods are normally distributed, HPRs up to 1 month can be treated as normal

• Use continuously compounded rates where normality plays crucial role

5.2 Risk and Risk Premiums Standard Deviation 20%

• Deviation from Normality and Value at Risk

• Kurtosis: Measure of fatness of tails of probability distribution; indicates likelihood of extreme outcomes

• Skew: Measure of asymmetry of probability distribution

• Using Time Series of Return

• Scenario analysis derived from sample history of returns

• Variance and standard deviation estimates from time series of returns:

Figure 5.2 Comparing Scenario Analysis to Normal Distributions with Same Mean and Standard Deviation

5.2 Risk and Risk Premiums Distributions with Same Mean and Standard Deviation

• Risk Premiums and Risk Aversion

• Risk-free rate: Rate of return that can be earned with certainty

• Risk premium: Expected return in excess of that on risk-free securities

• Excess return: Rate of return in excess of risk-free rate

• Risk aversion: Reluctance to accept risk

• Price of risk: Ratio of risk premium to variance

5.2 Risk and Risk Premiums Distributions with Same Mean and Standard Deviation

• The Sharpe (Reward-to-Volatility) Ratio

• Ratio of portfolio risk premium to standard deviation

• Mean-Variance Analysis

• Ranking portfolios by Sharpe ratios

5.3 The Historical Record Distributions with Same Mean and Standard Deviation

• World and U.S. Risky Stock and Bond Portfolios

• World Large stocks: 24 developed countries, about 6000 stocks

• U.S. large stocks: Standard & Poor's 500 largest cap

• U.S. small stocks: Smallest 20% on NYSE, NASDAQ, and Amex

• World bonds: Same countries as World Large stocks

• U.S. Treasury bonds: Barclay's Long-Term Treasury Bond Index

Figure 5.4 Rates of Return on Stocks, Bonds, Distributions with Same Mean and Standard Deviationand Bills

5.4 Inflation and Real Rates of Return Distributions with Same Mean and Standard Deviation

• Equilibrium Nominal Rate of Interest

• Fisher Equation

• R = r + E(i)

• E(i): Current expected inflation

• R: Nominal interest rate

• r: Real interest rate

5.4 Inflation and Real Rates of Return Distributions with Same Mean and Standard Deviation

• U.S. History of Interest Rates, Inflation, and Real Interest Rates

• Since the 1950s, nominal rates have increased roughly in tandem with inflation

• 1930s/1940s: Volatile inflation affects real rates of return

5.5 Asset Allocation across Portfolios Rates 1926-2010

• Asset Allocation

• Portfolio choice among broad investment classes

• Complete Portfolio

• Entire portfolio, including risky and risk-free assets

• Capital Allocation

• Choice between risky and risk-free assets

5.5 Asset Allocation across Portfolios Rates 1926-2010

• The Risk-Free Asset

• Treasury bonds (still affected by inflation)

• Price-indexed government bonds

• Money market instruments effectively risk-free

• Risk of CDs and commercial paper is miniscule compared to most assets

5.5 Asset Allocation Across Portfolios Rates 1926-2010

• Portfolio Expected Return and Risk

P: portfolio composition

y: proportion of investment budget

rf: rate of return on risk-free asset

rp: actual rate of return

E(rp): expected rate of return

σp: standard deviation

E(rC): return on complete portfolio

E(rC) = yE(rp) + (1 − y)rf

σC = yσrp+ (1 − y)σrf

5.5 Asset Allocation across Portfolios Rates 1926-2010

• Capital Allocation Line (CAL)

• Plot of risk-return combinations available by varying allocation between risky and risk-free

• Risk Aversion and Capital Allocation

• y: Preferred capital allocation

5.6 Passive Strategies and the Capital Market Line Rates 1926-2010

• Passive Strategy

• Investment policy that avoids security analysis

• Capital Market Line (CML)

• Capital allocation line using market-index portfolio as risky asset

5.6 Passive Strategies and the Capital Market Line Rates 1926-2010

• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple

• Expense ratio of active mutual fund averages 1%

• Expense ratio of hedge fund averages 1%-2%, plus 10% of returns above risk-free rate

• Active management offers potential for higher returns

Selected Problems Rates 1926-2010

5-28

Problem 1 Rates 1926-2010

\$140,710.04

• V(12/31/2004) = V (1/1/1998) x (1 + GAR)7

= \$100,000 x (1.05)7 =

5-29

Problem 2 Rates 1926-2010

(50 – 40 + 2)/40 = 0.30 = 30.00%

(43 – 40 + 1)/40 = 0.10 = 10.00%

(34 – 40 + 0.50)/40 = –0.1375 = –13.75%

[(1/3) x 30%] + [(1/3) x 10%] + [(1/3) x (–13.75%)] = 8.75%

0.031979

a. The holding period returns for the three scenarios are:

Boom:

Normal:

Recession:

E(HPR) =

2(HPR)

5-30

Problem 2 Cont. Rates 1926-2010

Risky E[rp] = 8.75%Risky p = 17.88%

(0.5 x 8.75%) + (0.5 x 4%) = 6.375%

0.5 x 17.88% = 8.94%

b. E(r) =

 =

5-31

Problems 3 & 4 Rates 1926-2010

3. For each portfolio: Utility = E(r) – (0.5  4 2 )

We choose the portfolio with the highest utility value, which is Investment 3.

5-32

Problems 3 & 4 Cont. Rates 1926-2010

0

highest expected return

Investment 4

4. When an investor is risk neutral, A = _ so that the portfolio with the highest utility is the portfolio with the _______________________.

So choose ____________.

5-33

Problem 5 Rates 1926-2010

Time

Cash flow

Explanation

0

1

2

3

b. DWR

a. TWR

Year

Return = [(capital gains + dividend) / price]

a. TWR

2002-2003

(110 – 100 + 4)/100 = 14.00%

-300

Purchase of three shares at \$100 per share

2003-2004

(90 – 110 + 4)/110 = –14.55%

-208

Purchase of two shares at \$110,

plus dividend income on three shares held

2004-2005

(95 – 90 + 4)/90 = 10.00%

3.15%

110

Dividends on five shares,

plus sale of one share at \$90

396

Dividends on four shares,

plus sale of four shares at \$95 per share

2.33%

-0.1661%

5-34