Investments Kapitel 5

Chapter
Risk, Return and the

5 Historical Record
Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
5.1 Rates of Return
• Holding-Period Return (HPR)

• Rate of return over given investment period
PEnding - PBeginning + DivCash

HPR =
PBeginning
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5.1 Rates of Return: Example
• What is the HPR for a share of stock that was
purchase for $25, sold for $27 and distributed
$1.25 in dividends?
$27.00 – $25.00 + $1.25

HPR = = 0.13 = 13.00%
$25.00
• The HPR is the sum of the dividend yield plus the

capital gains yield
5.1 Rates of Return: Measuring 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
• Dollar-weighted average return
• Internal rate of return on investment
Table 5.1 Annual Cash Flows & Rates of Return of a
Mutual Fund
• Arithmetic average: The sum of the returns

divided by the number of years.
r1 + r2 + ... + rn
rArithmetic =
n
10 + 25 - 20 + 20
= = .0875 = 8.75%
4
• Geometric average: Single period return that gives
the same cumulative performance as the sequence
of actual returns
rGeometric = [(1 + r1 ) ´ (1 + r2 ) ´ ... ´ (1 + rn )]1/ n - 1

= [1.10 ´1.25 ´ .80 ´1.20] - 1 = 0.0719 = 7.19%
1/4
5.1 Dollar weighted return
Find the internal rate of return for the cash flows (i.e. find the
discount rate that makes the NPV of the net cash flows equal
zero).
This measure of return considers both changes in investment
and security performance
-1.0 -.5 .8 .96
Dollar-Weighted 0 = -1.0 + + + +
1 + IRR (1 + IRR) (1 + IRR) (1 + IRR)4
2 3
IRR = 3.38%
• Initial investment is an outflow;
• Ending value is considered as an inflow;
• Additional investment is an outflow;
• Security sales are an inflow.
5.1 Rates of Return
• Dollar-weighted average return
• The internal rate of return on an investment
• Annualizing Rates of Return

• APR = Annual Percentage Rate
• Per-period rate × Periods per year
• Ignores Compounding
• EAR = Effective Annual Rate

• Actual rate an investment grows
• Does not ignore compounding
5.1 Rates of Return: EAR vs. APR
n-Periods of Compounding: Continuous Compounding:

æ APR ö
n
EAR = e APR - 1
EAR = ç1 + ÷ -1
è n ø
APR = [( EAR + 1)1/ n - 1] ´ n APR = ln( EAR + 1)

where
n = compounding per period
5.2 Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1 + rNom
1 + rReal =
1+ i
where
rReal = Real Interest Rate
rNom = Nominal Interest Rate
i = Inflation Rate
• Example: What is the real return on an investment that

earns a nominal 10% return during a period of 5% inflation?
1 + .10
1 + rReal = = 1.048
1 + .05
r = .048 or 4.8%
5.2 Inflation and The Real Rate of Interest
• Equilibrium Nominal Rate of Interest

• Fisher Equation (5.9)
rNom = rReal + E (i )
5.2 Inflation and The Real Rate of Interest
• 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
• Figure 5.1
Figure 5.1 Inflation and Interest rates (1927-2018)
5.3 Risk and Risk Premiums
• Scenario Analysis and Probability Distributions
• Scenario analysis: Possible economic scenarios;
specify likelihood and HPR
• Probability distribution: Possible outcomes with
probabilities
• Expected return: Mean value
• Variance: Expected value of squared deviation from
mean
• Standard deviation: Square root of variance
Spreadsheet 5.1 Scenario Analysis for a Stock Index Fund
It seems well described by the normal distribution ……
• The Normal Distribution
• Transform normally distributed return into

standard deviation score:
𝑟! − 𝐸(𝑟! )
𝑠𝑟! =
𝜎!
• Original return, given standard normal return:

𝑟! = 𝐸 𝑟! + 𝑠𝑟! ×𝜎!
Figure 5.3 Normal Distribution r = 10% and σ = 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
5.3 Risk and Risk Premiums: Value at Risk
• Value at risk (VaR):

•Measure of downside risk
•Worst loss with given probability, usually 1%
or 5%
• 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
• The Sharpe (Reward-to-Volatility) Ratio
• Ratio of portfolio risk premium to 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
• Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios
Portfolio Risk Premium E (rp ) - rf

SP =
Standard Deviation of Excess Returns sP
where
E (rp ) = Expected Return of the portfolio
rf = Risk Free rate of return
s P = Standard Deviation of portfolio excess return
5.4 The Historical Record: World Portfolios
• World Large stocks: 24 developed countries,
~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
Table 5.3: Historical Return and Risk
Figure 5.4: Treasury Bills
Figure 5.4: 30-year Treasury Bonds
Figure 5.4: Common Stocks
5.5 Asset Allocation across Portfolios
• 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
• 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 Portfolio Asset Allocation: Expected Return and Risk
Expected Return of the Complete Portfolio

E (rC ) = y ´ E (rp ) + (1 - y) ´ r f
where 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
Standard Deviation of the Complete Portfolio

s C = y ´s p
where s C = Standard deviation of the complete portfolio
s P = Standard deviation of the risky portfolio
Figure 5.7 Investment Opportunity Set
• 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
Available risk premium to variance ratio
y=
Required risk premium to variance ratio
[ E (rP ) - rf ] / s P2 [ E (rP ) - rf ]
= =
A As P2
The price of risk
• How should an investor, with a given degree of risk
aversion A, allocate wealth between the risky and the risk-
free assets?
• A measures the compensation that an investor has
apparently required (per unit of variance) to be induced to
hold portfolio p.
• We can measure risk aversion assessing the risk
premium necessary to compensate an investor for
investing his entire wealth in a portfolio p with a variance
p.
• Conventional wisdom holds that plausible estimates for
the value of A lie in the range of 1,5 - 4.
The price of risk
• The ratio of portfolio risk premium to variance
E(rp ) - rf
• A = ----------------
Variancep
A = degree of risk aversion of an investor
• Conventional wisdom holds that plausible estimates for

the value of A lie in the range of 1,5-4.
Price of risk
• When the price of risk of the available risky portfolio
exactly matches the investor’s degree of risk aversion, her
entire wealth will be invested in it (y=1).
• For example, if we observe that the entire wealth of an
investor is held in a portfolio with an annual risk premium
of 10% and variance of 0,0256 (SD = 16%), investor’s
degree of risk aversion is:
E(rp ) - rf 0,10
• A = ---------------- = ------------------- = 3,91
Variancep 0,0256
If the available risk premium to variance ratio for a risky
portfolio Q is = 2, then y = 2 / 3,91= 051 (51%).
5.6 Passive Strategies and the Capital Market Line
• Passive Strategy
• Investment policy that avoids security analysis
• Capital Market Line (CML)

• Capital allocation line using market-index
portfolio as risky asset
Table 5.5: Excess Returns Statistics for the Market Index
5.6 Passive Strategies and the Capital Market Line
• 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

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Chapter

Risk, Return and the

Bodie, Kane, and Marcus

• Holding-Period Return (HPR)

PEnding - PBeginning + DivCash

$27.00 – $25.00 + $1.25

• The HPR is the sum of the dividend yield plus the

• Arithmetic average: The sum of the returns

rGeometric = [(1 + r1 ) ´ (1 + r2 ) ´ ... ´ (1 + rn )]1/ n - 1

• Annualizing Rates of Return

• EAR = Effective Annual Rate

n-Periods of Compounding: Continuous Compounding:

APR = [( EAR + 1)1/ n - 1] ´ n APR = ln( EAR + 1)

• Example: What is the real return on an investment that

• Equilibrium Nominal Rate of Interest

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

• Transform normally distributed return into

• Original return, given standard normal return:

• Normality over Time

• Value at risk (VaR):

Portfolio Risk Premium E (rp ) - rf

• The Risk-Free Asset

Expected Return of the Complete Portfolio

Standard Deviation of the Complete Portfolio

• Risk Aversion and Capital Allocation

A = degree of risk aversion of an investor

• Conventional wisdom holds that plausible estimates for

• Capital Market Line (CML)

• Cost and Benefits of Passive Investing

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