20/08/2022

CHAPTER 3
RISK, RETURN, AND
HISTORICAL RECORDS

School of Economics

Content

• Nominal and real interest rate

• Rates of return for different holding periods
• Estimations of return and risk
• Historical record

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Reading materials

• Bodie, Merton, & Cleeton (2012) – Chapter 10

• Fabozzi & cộng sự (2011) - Chapter 11

• Ross & cộng sự (2018) – Chapter 10

Real and Nominal Interest Rates

• Nominal interest rate (rn):

• Growth rate of money

• Real interest rate (rr):

• Growth rate of purchasing power

rn − i
rr = rr  rn − i
1+ i
Where i is the rate of inflation
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Real and Nominal Interest Rates

• 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 )

Rates of Return for Different Holding Periods

lợi suất nhận dc trong kì đầu tư của mình
• Zero Coupon Bond:
+ Par = $100 sau khi đáo hạn nhận FV
+ Maturity = T
+ Price = P
100
rf (T ) = −1
P(T )
Total risk-free return
giá trị cuối kì - đầu kì/ đầu kì
HPR= Pt-(Pt-1)/ (Pt-1)

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Rates of Return for Different Holding Periods

Example 1

HPR

2,7%
4.69% 100/95.52 -1
329.18%

How to compare securities with

various maturities?
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Rates of Return for Different Holding Periods

người ta thường đưa tỉ suất sinh lợi về cùng 1 năm
Effective Annual Rate (EAR)

• EAR: Percentage increase in funds invested over a 1-year horizon

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1 + EAR = 1 + rf (T )  T

t luôn có đơn vị tính là năm EAR1= (1+2,7%)^1/0,5 - 1= 5.47%

vd: 1 tháng thì T=1/12 EAR2= (1+4.69%)^1/1 -1 = 4,69%
EAR3= (1+329.18%)^1/25 -1=5,99%

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Rates of Return for Different Holding Periods

P1 return nhận dc từ chênh lệch giá -> capital gain/loss
• Rates of return: Single period
P2 dividend yield: lợi nhuận nhận dc từ cổ tức

− +
HPR = P1 P 0 D1
chia làm 2 phần:
p1= (P1-P0)/P0
p2= D1/P0
P0

HPR = Holding period return đầu tư trong dài hạn thì muốn nhận dividend yield
đối với nhà đầu tư nc ngoài vì giá ko quá chênh lệch
P0 = Beginning price
-> đối với thị trường đang phát triển
P1 = Ending price đầu tư trong ngắn hạn thì muốn nhận dc sự chênh
D1 = Dividend during period one lệch giá-> áp dụng cho những nhà dầu tư ở thị trường
mới, VD như Việt Nam 10

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Rates of Return for Different Holding Periods

Example 2

Ending Price = $110

Beginning Price = $100
Dividend = $4

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

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Rates of Return for Different Holding Periods

Annual Percentage Rate (APR)

• APR: Annualizing using simple interest

(1 + EAR )
T
−1
APR =
T

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Rates of Return for Different Holding Periods

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Expected Return and Standard Deviation

lợi nhuận mong muốn và độ lệch chuẩn
• Expected returns

E (r ) =  p( s)r ( s)
s
p(s) = Probability of a state độ lệch càng lớn thì high uncertainty
r(s) = Return if a state occurs
s = State

Return/risk -> xác định dc

risk đo lường sự ko chắc chắn đối với sự việc xảy ra-> uncertainty
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Expected Return and Standard Deviation

Example 3

State Prob. of State r in State

Excellent 0.25 0.31
Good 0.45 0.14
Poor 0.25 -0.0675
Crash 0.05 -0.52

E(r) = (.25)(.31) + (.45)(.14) + (.25)(−.0675) + (0.05)(− 0.52)

E(r) = .0976 or 9.76%
ow^2= 25% * (31%-9.76%)^2 + 45%*(14%-9.76%)^2
+ 25% *(-6.75%-9.76%)^2 + 5%*(-52%-9.76%)^2 = 0.0379 -> phương sai
ow= SD= căn của 0.0379= 19.46% 15

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Expected Return and Standard Deviation

Example 4
Considering the following cases. What is the expected return for a project
with initial investment of USD100.

State of Probability Year –end price Cash dividend HPR

economy
Boom 0.3 129.5 4.5
Normal growth 0.5 110 4
Recession 0.2 80.5 3.5

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Expected Return and Standard Deviation

• Variance (VAR):

 2 =  p(s )r (s ) − E (r )2

s

• Standard Deviation (STD):

STD =  2

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Expected Return and Standard Deviation

Example 4

Bear Normal Bull Market

market market
Probability 0.2 0.5 0.3
Stock X -20% 18% 50%
Stock Y -15% 20% 10%
a. Expected rate of return for stocks X and Y. -7%, 19%, 18%
b. Standard deviation of returns on stocks X and Y a
Investors normally don’t buy only 1 stock. They have a
portfolio with many stocks. Assume that of $10,000
portfolio, $9,000 in stock X and $1,000 in stock Y. What is
the expected return and risk of this portfolio?
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Historical Records

• True means and variances are unobservable because we don’t actually know possible
scenarios like the one in the examples
• So we must estimate them (the means and variances, not the scenarios)
• One way: analyzing time series of past rates of return

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Historical Records

• Arithmetic Average
𝑛
1
𝐸 𝑟 = 𝑟ҧ = ෍ 𝑟
𝑛
𝑠=1

• Geometric (Time-Weighted) Average

g = TV 1/ n − 1
TVn = (1 + r1 )(1 + r2 )...(1 + rn )
= Terminal value of the investment
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Historical Records

• Estimated Variance
• Expected value of squared deviations
𝑛
1
𝜎ො 2 = ෍ 𝑟 − 𝑟lj 2
𝑛
𝑠=1

• Unbiased estimated standard deviation

𝑛 2
1
𝜎ො = ෍ 𝑟 − 𝑟lj
𝑛−1
𝑗=1
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Historical Records
Example 5
Stock A and B have the historical closing prices as follow:
Date P(A) Div(A) P(B) Div(B)
Q4-2015 50 5 60 Calculate the expected return
Q3-2015 55 62 and standard deviation of the
Q2-2105 52 59 two stocks.
Q1-2015 54 57 9
Q4-2014 56 6 57
Q3-2014 49 60

Again: Investors normally don’t buy only 1 stock. They have

a portfolio with many stocks. Assume that of his budget, a
person invests 30% on A and 70% on B. What is the
11/12/2017 expected return and risk of this portfolio? 22

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Expected Return and Standard Deviation of Portfolio

đa dạng hóa danh mục đầu tư
n
E ( R p ) =  wi E ( Ri )
i

Where E(Rp): Expected return of a portfolio

wi: Percentage of asset i in the portfolio
E(Ri): Expected return of asset i
n: numbers of assets in the portfolio

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Expected Return and Standard Deviation of Portfolio

𝑛 𝑛 𝑛

𝜎𝑝2 = ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )

𝑖=1 𝑖=1 𝑗=1
𝑗≠𝑖
For a portfolio with 2 assets D and E

▪ Portfolio variance:  p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )

Cov ( rD , rE ): Covariance of returns for D and E

Cov ( rD , rE ) = DEDE
D,E : Correlation coefficient of returns
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Expected Return and Standard Deviation of Portfolio

Cov ( rD , rE ) = ෍ 𝑝(𝑠) [𝑅𝐷(𝑠) − 𝐸(𝑅𝐷 )][(𝑅𝐸(𝑠) − 𝐸(𝑅𝐸 )]

𝑠
or

σ(𝑟𝐴,𝑖 −𝑟ഥ𝐴 )((𝑟𝐵,𝑖 −𝑟ഥ𝐵 )

Cov ( rD , rE ) =
𝑛

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Expected Return and Standard Deviation of Portfolio

Cov ( rD , rE ) = DEDE

DE : Correlation coefficient of returns

▪ Range of values for 
−1 ≤ 𝜌 ≤ 1
If  = 1.0, the securities are perfectly positively correlated
If  = - 1.0, the securities are perfectly negatively correlated
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Expected Return and Standard Deviation of Portfolio

Guessing sign of 𝜌 of pairs of

securities?
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Expected Return and Standard Deviation

Now you can come

back Example 4 and 5

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