FINS5513 Lecture 2A

Risk and Return; Risk Aversion

 Risk & Return
Lecture Outline
❑ Rates of return for different holding periods
➢ Holding Period Return (HPR), Annualised Percentage Rate
(APR), Effective Annual Rate (EAR), T-Bill discounts
❑ Measuring reward (return) and risk (volatility)
➢ Expected Return
➢ Variance and Standard Deviation
➢ Sharpe Ratio

❑ Mean-variance criterion and asset dominance

❑ Risk aversion and risk premiums
❑ Normal distribution
➢ Deviation from normality and risk estimation

Lecture 2A FINS5513 2
 Holding Period Return
❑ Holding Period Return is given by:
P1 − P 0 + D1
HPR =
P0
HPR = Holding period return
P0 = Beginning price
P1 = Ending price
D = Total income received over Holding Period (eg coupons, dividends)

❑ Example: P0 = $100 P1 = $110 D = $4

$110 − $100 + $4
HPR = = .14, or 14%
$100

BKM 5.4
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 EAR & APR
❑ The HPR gives the total return over the period an investment is held,
without regard to the time period
❑ We can annualise the HPR in two ways:
➢ Assuming simple interest - Annualised Percentage Rate (APR)
➢ Assuming compound interest – Effective Annual Rate (EAR)

Assume: T = holding period expressed in years (eg T=2 for 2 year

hold; T=0.25 for 3 month; T=5.5 for 5 years and 6 months)
❑ Annualized percentage rate (APR)
APR = HPR / T
❑ EAR: Percentage increase in funds invested over a 1-year horizon
1
1+ EAR = éë1+ HPRùû T

BKM 5.4
Lecture 2A FINS5513 4
 HPR, EAR, APR
Example
❑ Q2.1
Compound Frequency
Calculation 1 Month 3 month 6 month 1 year
APR (given) Given 6.0% 6.0% 6.0% 6.0%
Hold M 1 month 3 months 6 months 12 months
T T = M / 12 0.083 0.25 0.5 1

Holding Period Return HPR = APR*T

(1/T)
EAR EAR = (1 + HPR) -1

❑ See file “L2 HPR, APR, EAR & T-Bill Discounts”

BKM 5.2
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 US T-Bill Pricing
❑ Treasury bills: prices quoted on an annualised discount percentage

➢ E.g: Maturity Days Bid Ask Chg Asked Yield

to Mat (APR)
Oct 27, 2020 171 2.60 2.58 0.00 2.65

➢ The Ask price for the Bill is 2.58% with 171 days till maturity
➢ Discount (for the holding period) is 2.58%*171/360=1.226%*
➢ A bill with face value $10,000 could be bought from the dealer
at $10,000*(1-0.01226)= $9,877.45
➢ Bid price is calculated similarly
* Note the discount for the holding period is slightly different from the APR because the denominator is FV not purchase price

BKM 2.1
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 US T-Bill Pricing
❑ If the investor buys the bill and holds it until maturity, the
annualised interest or APR is:
(10,000 / 9877.45 – 1) * 365/171 = 0.02648
= 2.65%
❑ This APR is the final column – the “Asked yield”
➢ The “Asked Yield” is often call the bond-equivalent yield
which in this instance is the same as an APR
➢ T-bill rates are quoted as discount yields (“Bid” and “Ask”
columns) not as bond-equivalent yields (APRs)

BKM 2.1
Lecture 2A FINS5513 7
 HPR, EAR, APR and
T-Bill Discount Yield
❑ Q2.2

Maturity
Calculation 1 month T-Bill 3 month T-Bill 6 month T-Bill 1 year T-Bill
Face value P1 $1,000 $1,000 $1,000 $1,000
Maturity M 1 month 3 months 6 months 12 months
Annualised Discount Yield (DY - given) Given 6.0% 6.0% 6.0% 6.0%

T T = M / 12 0.083 0.25 0.5 1

Discount to FV (from Discount Yield DY) Disc = T*Annualised DY
Price of T-bill P 0 = P 1*(1-Disc)

Holding Period Return HPR = (P 1 - P 0) / P 0

APR APR = HPR / T

(1/T)
EAR EAR = (1 + HPR) -1

❑ See file “L2 HPR, APR, EAR & T-Bill Discounts”

BKM 5.2
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 Market Conventions
❑ The EAR accounts for compounding interest, not just simple
interest (ie “interest on interest”)
➢ If compounding is annual: EAR = APR
➢ If compounding is more frequent then annually: EAR > APR

❑ The relationship between EAR and APR is given by:

(1 +EAR)T – 1
APR =
T
❑ Q2.3

❑ For short-term securities, APRs are used as the yield

❑ EAR is used to compare returns on investments with different
time horizons to the one-year horizon
BKM 5.2
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 Expected Return:
Ex-Ante Analysis
❑ Expected return E(r) on a forward-looking basis is given by:

E (r ) =  p( s )r ( s )
s

p(s) = Probability of a state

r(s) = Return if a state occurs
s = State (Scenario)

❑ r(s) can be thought of as the expected return if a particular state

(scenario) occurs
❑ Note that this is the Expected Return equation on a forward-
looking basis (ie under uncertainty)

BKM 5.4
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 Expected Return
Ex-Ante Analysis
❑ Q2.4

❑ Distribution of return scenarios for Walmart (WMT) in different

probability weighted future scenarios

❑ See file “L2 Calculating Ex-Ante & Ex-Post ER, Var & SD”

❑ We can use the SUMPRODUCT function in Excel

BKM 5.4
Lecture 2A FINS5513 11
 Expected Return
Ex-Post
❑ Estimating future returns by placing probabilities on uncertain
future scenarios can have a high level of forecasting error
❑ Therefore, Expected Return is often estimated using the average
(or mean) historical (backward looking or ex-post) sample rates
of return, denoted 𝒓ത by using the formula:
𝒏
𝟏
𝒓ത = ෍ 𝒓𝒕
𝒏
𝒕=𝟏
❑ Q2.5

BKM 5.4
Lecture 2A FINS5513 12
 Measuring Scenario
Risk: VAR and SD
❑ We seek to maximise return because return maximises wealth
❑ However, we seek return in a world of uncertainty
❑ Under uncertainty, we face risk
❑ Think of return as the reward and risk as the cost of that reward
❑ So, how do we measure risk?
➢ Risk is really a measure of the volatility of our returns
➢ So, how do we measure volatility?
➢ Volatility is simply the amount of (squared) deviation from our
expectations. It is given by the variance* equation:

❑ To return to original units (rather than squares), we use Standard

Deviation – St.Dev*:
s= s 2

*Note: VAR and St.Dev is always +

BKM 5.4
Lecture 2A FINS5513 13
 Scenario VAR and
St.Dev: Example
❑ Step #1 – Derive E(r) – see previous slides
❑ Step #2 – Take the actual return in each state and subtract E(r)
❑ Step #3 – Square the difference
❑ Step #4 – Multiply each of the squared differences by the
probability of that state. Therefore Q2.6a):

❑ Step #5 – Sum the total to derive the variance: σ2 =

❑ The standard deviation is simply the square root of the variance:

BKM 5.4
Lecture 2A FINS5513 14
 Standard Deviation and
Risk
❑ We can also use historical data to estimate the risk
❑ When forward looking, if each future state is equally likely we
would divide by n to derive variance. However, when backward
looking we divide by n – 1 to account for estimation error as r
is only an estimation of E(r) (degrees of freedom bias)
❑ The unbiased estimated standard deviation is given by:
n 2

ˆ =
1
 r ( j ) − r 
n − 1 j =1
r(j) = the return on the jth observation
❑ Q2.6b) is shown in file “L2 Calculating Ex-Ante & Ex-Post

BKM 5.5
Lecture 2A FINS5513 15
 The Reward-to-Volatility
(Sharpe) Ratio
❑ When analyzing return, we often look at the “excess return”
above the risk-free rate, rather than the total return
➢ This is because part of the return can be earned for no risk by
investing in the risk-free asset
➢ The difference between the excess return on a risky asset and
the risk-free rate is often called the Risk Premium
❑ So, what is a good way to capture the risk/reward relationship?
➢ Divide return (+) by risk (-) and state it as a ratio
➢ This reward-to-volatility ratio is often called the Sharpe Ratio

Sharpe Ratio: Risk premium

SD of excess returns
BKM 5.5
Lecture 2A FINS5513 16
 The Reward-to-Volatility
(Sharpe) Ratio
❑ We will apply the Sharpe Ratio in coming weeks as it is a very
important ratio
➢ Widely used to evaluate the performance of fund managers

❑ Mathematically the Sharpe Ratio is given by:

E ( ri ) − rf
Sharpe Ratio: Si =
i
Q2.7a) Ex-Ante Q2.7b) Ex-Post

BKM 5.5
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 Which Fund is
Preferred?
Probability
0.2
AW =5%
0.15
AWA
0.1

TPB
0.05
TP =10%
0
Return (%)
0 5 10 15 20

E(rAW) = E(rTP) = 10%

❑ AW and TP have the same expected return E(r), but TP has a
much wider dispersion of returns - as reflected in the higher σ
❑ Q2.8a)
❑ Which would you choose?
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 Which Fund is
Preferred?
❑ Q2.8b): Probability AW will return less than 0%?

❑ Probability TP will return less than 0%?

❑ Q2.8c)

BKM 6.1
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 Mean-Variance Criterion
❑ If asset returns are normally distributed
➢ Mean and variance of returns (“the first two moments”) are
sufficient to describe return and risk
➢ Mean-variance analysis requires only the mean and standard
deviation of stock returns
➢ Expected return (y-axis) and standard deviation (x-axis)

❑ The Mean-Variance (M-V) Criterion states:

Portfolio A dominates portfolio B if:
E (rA )  E (rB )
and* * At least one inequality must be
A B strict to rule out indifference

BKM 6.1
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 Asset Dominance
Expected Return
4
2 3
1
Variance or Standard Deviation
• 2 dominates 1; has a higher return
• 2 dominates 3; has a lower risk
• 4 dominates 3; has a higher return
BKM 6.1
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 Risk and Risk Aversion
❑ Portfolio theory rests on the assumption investors are Risk Averse:
➢ That is, they follow the mean-variance criterion – for the same level
of E(r), investors will choose the asset with the lowest risk
➢ Risk neutral investors judge assets solely by their E(r) and are
indifferent to risk while risk seekers prefer higher levels of risk
❑ Individual investors have different degrees of risk aversion
❑ Market returns show there is a risk premium (indicates risk aversion):
➢ Risk-free assets (1 month T-bills returned ~3.5% since 1926)
➢ Risky assets have a + risk premium (stocks returned ~11.8%p.a in
total since 1926 ie 8.3% risk premium with 20% St.Dev)
➢ Market takes additional risk only for a commensurate gain

❑ Portfolio attractiveness increases with E(r) and decreases with risk

❑ What happens when return increases with risk?
➢ Depends on each investor’s risk-reward trade-off (next lecture)

BKM 6.1
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 The Normal Distribution
❑ Investment management is more straight forward when returns
(which are uncertain) are approximated as a normal distribution:
➢ Normal distribution allows for symmetry of returns
➢ Standard deviation is a good measure of risk when returns
are symmetric
➢ If security returns are symmetric, portfolio returns will be as
well
➢ Importantly, this means that: future scenario probabilities can
be estimated using only the mean and the standard deviation
• We can assess the likelihood of certain events based
solely on the mean and standard deviation
➢ The dependence of returns across securities can be
summarized using only the pairwise correlation coefficients
BKM 5.6
Lecture 2A FINS5513 23
 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 measure of portfolio
performance
➢ Need to consider skewness and kurtosis

BKM 5.7
Lecture 2A FINS5513 24
 Skewed Distributions

❑ When a distribution is negatively skewed: Mean < Median eg

human longevity
❑ When a distribution is positively skewed: Median < Mean eg
Sydney house prices

BKM 5.7
Lecture 2A FINS5513 25
 Kurtosis

Source: BKM Figure 5.4B

❑ Still symmetric but with “fat tails” – more chance of extreme

events (known as “black swans”) – eg we underestimate the risk
of market crashes
BKM 5.7
Lecture 2A FINS5513 26
 This lecture
❑ Focuses on Return and Risk
❑ Rates of return for different holding periods
➢ Holding Period Return (HPR), Annualised Percentage Rate
(APR), Effective Annual Rate (EAR), T-Bill discounts
❑ Measuring reward (return) and risk (volatility)
➢ Expected Return
➢ Variance and Standard Deviation
➢ Sharpe Ratio

❑ Mean-variance criterion and asset dominance

❑ Risk aversion and risk premiums
❑ Normal distribution
➢ Deviation from normality and risk estimation
Lecture 2 FINS5513 27
 Next Lecture
❑ BKM Chapter 6 and 7, including end-of-chapter questions

❑ Complete Case Study II Questions

❑ Focus on understanding utility function, uncorrelated returns and

the efficient frontier

Lecture 2A FINS5513 28