Risk and Returns b (1)

Chapter
Risk, Return and the

5 Historical Record
Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
Background
∙ Constructing a portfolio involves choosing variety of asset classes
∙ each security or asset class contribute to both the expected return and risk
characteristics of the overall portfolio.
∙ evaluating different portfolio construction choices needs calculation expected
return and risk/volatility
∙ Scenario analysis helps quantify these metrics by outlining possible future
outcomes.
∙ Historical performance data provides empirical evidence on how different asset
classes and portfolios have balanced risk and return over time.
∙ Simple diversification across asset classes helps control risk.
∙ control comes from allocating between risky and risk-free assets through the
capital allocation decision.
∙ Capital allocation determines the overall portfolio's expected return, risk and
risk-reward tradeoff.
∙ Different allocations suit different investor risk tolerances.
Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. 2
5.1 Rates of Return
•Holding-Period Return (HPR)
• Rate of return over given investment period
•What is the HPR for a share of stock that was purchased

for $25, sold for $27, and distributed $1.25 in dividends?
Data on Fund’s Returns
• How would we characterize fund performance over the entire period,

given that the fund experienced both cash inflows and outflows?
5.1 Rates of Return: Measuring over Multiple
Periods
Annualized return: It allows for meaningful comparisons of performance
across investments with different holding periods.
• Arithmetic average
• Sum of returns in each period divided by number of periods
• ignores timing of cash flows.
• Geometric average
• Single per-period return
• Gives same cumulative performance as sequence of actual returns
• accounts for cash flow timing and adjusts for the impact of cash flows (both inflows
and outflows)
• Known as the time-weighted average return
• Dollar-weighted average return

• Internal rate of return on all cash flows into and out of the fund over the period.
• reflects investor experience.
5.1 Rates of Return: Measuring over Multiple
Periods
•Arithmetic average: The sum of the returns
divided by the number of years.
• Geometric average: Single period return that gives the

same cumulative performance as the sequence of actual
returns
Compare AA V GA
• Three Cases Investment Start with $100
• two years of zero returns (0, 0)
• up 10% in the first year and down 10% in the second (+10, -10)
• up 20% in the first year and down 20% in the second (+20, -20).
• AA each of these scenarios is 0% per annum (over-weighting the effect of

gains and under-weighting the effect of losses).
• The geometric mean of each is different, being:
• 0% per annum
• minus 0.5% per annum (your capital goes from 100 at the start to 110 in year one to 99 in
year two, so you have lost money)
• minus 2.0% per annum (you have lost even more money).
the greater the dispersion, the greater the spread between the two means.
Volatility in Returns
Compare AA V GA
• The geometric mean will always be less than the arithmetic
mean unless the values being considered are identical, an
unlikely event.
• The geometric average return takes into account the
compounding of returns over multiple periods, so it is most
sensitive to the timing of when gains and losses occur
compared to the other return measures.
• If there are gains followed by losses, or vice versa, the
geometric average will be lower than the arithmetic
average return, which simply averages all the periodic
returns without regard to timing.
• The geometric mean is a better measure of average return when
dealing with multiple periods precisely because it accounts for return
variability over time in a way the arithmetic mean does not.
Q: When should you use the GAR and when should you use the AAR?
A1: When you are evaluating PAST RESULTS (ex-post):
• Use the AAR (average without compounding) if you ARE NOT reinvesting
any cash flows received before the end of the period.
• Use the GAR (average with compounding) if you
ARE reinvesting any cash flows received before the end of the period.
A2: When you are trying to estimate an expected return (ex-ante return):
■ Use the AAR
■ The AAR provides a better estimate of the expected return for a single future period, as it
does not incorporate the compounding effect.
■ When making investment decisions or projections, the focus is typically on the expected
return for the next period, rather than the long-term annualized return.
5.1 Rates of Return: Measuring over Multiple Periods
Dollar-weighted average return
• the dollar-weighted return (IRR) is 3.38%.

• is lower than the time-weighted (geometric) return of 7.19%.
• This is because the higher returns (25% and 20%) were achieved in years 2 and 4 when
less money was under management ($1.2M and $0.8M respectively).
• The lower returns (-20% and 10%) occurred when more money was under
management ($2M and $1M).
• So the timing of returns meant higher returns came when less capital was at risk,
lowering the dollar-weighted return from the investor's perspective relative to the
purely mathematical time-weighted return.
• The difference highlighting the importance of considering dollar-weighted returns
over simple averages.
• Dollar-weighted return most accurately reflects the actual experience of investors'
dollars over time with varying cash flows into and out of the fund.
5.1 Rates of Return
•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
5.3 Risk and Risk Premiums
• A good way to organize your beliefs about possible outcomes is to devise a
list of possible economic scenarios and specify both the probability of each
scenario and the HPR the asset will realize in that scenario.
•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
Risk and Risk Premiums
Expected Return and Standard Deviation (1 of 2)
•Expected returns
• p(s) = probability of each scenario
• r(s) = HPR in each scenario
• s = scenario
Variance (VAR):
Standard Deviation (STD):
5-14
Spreadsheet 5.1 Scenario Analysis for a Stock Index Fund
Problem solving
Economic Prob (%) Initial Price End Price Dividend
Situation
Boom 35 100 140 4.5
Average 40 100 110 4.00
Recession 25 100 81 2.5
What expected holding period returns and STD?
Problem solving
Economic Prob (%) Stock Bond Mutual Fund
Situation HPR (%) HPR (%) HPR(%)
Boom 35 40 25 30
Average 40 15 10 13
Recession 25 -20 -15 -12
Risk free rate is 7%
a) What would be expected returns and Std deviation?
b) Which alternative is performing better?
We specified several economic scenarios, the likelihood of each, and the
portfolio rate of return in each scenario. These assumptions define the
probability distribution of the return on the portfolio.
How do evaluate whether our assumptions are reasonable?
Historical Returns could be reference points
r = 10% and σ = 20%
5.3 Risk and Risk Premiums: Value at
Risk
Deviation from Normality and Value at Risk
Value at risk (VaR):

•a statistical measure of the riskiness of financial security or
portfolios of assets.
•Measure of downside risk
•Worst loss with given probability, usually 1% or 5%
Parametric VaR(5%) = E(r) + z*σ
VaR(95% c i) z static= 1.64
VaR(97.5% c i) z static= 1.96
VaR(99% c i) z static= 2.34
if the 5% one-month VAR is -10% , there is 95% confidence that over the next
month the portfolio will not lose more than 10%
• Deviation from Normality and Value at Risk
• Skew: Measure of asymmetry of probability distribution
•negative values of skew indicate that extreme bad outcomes are more
frequent than extreme positive ones,
•positive skew implies that extreme positive outcomes are more frequent.
• Kurtosis: Measure of fatness of tails of probability

distribution; indicates likelihood of extreme outcomes
• 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
Risk-averse investors consider risky portfolios only if they provide compensation

for risk via a risk premium
A>0
Risk-neutral investors find the level of risk irrelevant and consider only the
expected return of risk prospects
A=0
Risk lovers are willing to accept lower expected returns on prospects with higher
amounts of risk
A<0
Risk-averse investors:
∙ Conservative retirees who depend on their investment portfolio for income
∙ Pension funds with obligations to pay out fixed benefits
∙ Endowments that need to preserve capital over the long term
Risk-neutral investors:
∙ Highly diversified mutual funds or ETFs that don't have a particular risk tolerance
∙ Day traders focused only on short-term expected returns
∙ Quantitatively driven algorithmic funds
Risk-loving investors:
∙ Venture capital and private equity funds seeking high-risk/high-return
opportunities
∙ Young professionals with a long time horizon who can wait out downturns
∙ Investors engaging in derivatives or leverage to amplify potential upside
•Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios
5.4 The Historical Record
• Using Time Series of Return
• Scenario analysis derived from sample history of returns
• Variance and standard deviation estimates from time series of returns:
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
5.5 Asset Allocation across Portfolios
•Capital Allocation
• Choice between risky and risk-free assets
•Asset Allocation
• Portfolio choice among broad investment
classes
•Complete Portfolio
• Entire portfolio, including risky and risk-free
assets
The Risk-Free Asset
• Only the government can issue default-free bonds
• A security is risk-free with a guaranteed real return only if
• Its’ price is indexed
• Maturity is equal to the investor’s holding period
• T-bills viewed as “the” risk-free asset
• Broad range of money market instruments are considered effectively risk-free

assets
• It’s possible to create a complete portfolio by splitting investment funds
between safe and risky assets
Let
• y = Portion allocated to the risky portfolio, P
• (1 - y) = Portion to be invested in risk-free asset, F
5.3 Risk and Risk Premiums (Recap)
• 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
Risk-averse investors consider risky portfolios only if they provide

compensation for risk via a risk premium
A>0
Risk-neutral investors find the level of risk irrelevant and consider only the
expected return of risk prospects
A=0
Risk lovers are willing to accept lower expected returns on prospects with
higher amounts of risk
A<0
Risk and Risk Premiums
• A positive risk premium distinguishes speculation from gambling.
• Investors taking on risk to earn a risk premium are speculating.
• Speculation is undertaken despite the risk because of a favorable risk-return

trade-off.
• In contrast, gambling is the assumption of risk for no purpose beyond the
enjoyment of the risk itself. Gamblers take on risk even without a risk
premium.
• To determine an investor’s optimal portfolio strategy, we need to quantify his
degree of risk aversion.
• Risk-averse investors will not hold risky assets without the prospect of
earning some premium above the risk-free rate.
• Thus, a natural way to estimate risk aversion is to look at the risk-return
trade-off of portfolios in which individuals have been willing to invest. We infer
higher risk aversion if they have demanded higher risk premiums for any
given level of risk.
Portfolios: Risky Asset and Risk-Free
Asset
•It’s possible to create a complete portfolio
by splitting investment funds between safe
and risky assets
Let
• y = Portion allocated to the risky portfolio, P
• (1 - y) = Portion to be invested in risk-free asset,
F
Basic Asset Allocation Example
Assume that the total market value of an initial portfolio is $300,000, of which
$90,000 is invested in the Ready Asset money market fund, a risk-free asset for
practical purposes.
The remaining $210,000 is invested in risky securities—$113,400 in equities (E)

and $96,600 in long-term bonds (B).
What was the equities and bond holdings comprising “the” risky portfolio?
Complete Portfolio
Concept Check
What will be the dollar value of your position
in equities (E), and its proportion in your
overall portfolio, if you decide to hold 60% of
your investment budget in Ready Asset?
Rf= 60%
Risky= 40%
Total Amount =300,000
Risky investment= 120,000
Equites = 120000*.54= 64800 , so allocation of total investment =
64800/300000 = 21.6%
Bonds = 120000*.46= 55200 , so allocation of total

investment = 55200/300000 = 18.4%
Concept Check Solution
•Holding 50% of your invested capital in
Ready Assets means that your investment
proportion in the risky portfolio is reduced
from 70% to 50%.
•Your risky portfolio is constructed to invest
54% in E and 46% in B.
•proportion of E in your overall portfolio is .5
× 54% = 27%, and the dollar value of your
position in E is $300,000 × .27 = $81,000
5.5 Portfolio Asset Allocation: Expected Return and
Risk
One Risky Asset and a Risk-Free Asset: Example (1 of
2)
E(rP) = 15%
σp = 22%
rf = 7%
• Expected return on the complete
portfolio
6-39
One Risky Asset and a Risk-Free Asset: Example (2 of
2)
•The slope of the line is:
•Expected return-standard deviation tradeoff

for the complete portfolio is:
E(rC) = 7% + σC
Figure 5.7 Investment Opportunity Set
Y= 1.25 Portfolio B
E(r) = -.07*.25+ .15*1.25 =17% Er = 20
Std= 25
Std= 22*1.25 =27.5%
One Risky Asset and a Risk-Free Asset Portfolios
• Investment opportunity set offers feasible expected return and standard
deviation pairs of all portfolios resulting from different values of y
• Graph showing all feasible risk-return combinations of a risky and risk-free

asset is the capital allocation line (CAL)
• Reward-to-volatility ratio (aka Sharpe ratio)
• Ratio of excess return to portfolio standard deviation
Let's analyze the different portfolio allocation scenarios:
• All invested in risky asset (y = 1):

∙ Expected return on complete portfolio, E(rC) = 15%
∙ Standard deviation of portfolio, σC = 22%
• All invested in risk-free asset (y = 0):
Expected return on complete portfolio, E(rC) = 7% (risk-free rate)
∙
∙ Standard deviation of portfolio, σC = 0% (no risk)

• Equal allocation to risky and risk-free assets (y = 0.5):
∙ Expected return on complete portfolio, E(rC) = 0.5 × 7% + 0.5 × 15% = 11%
∙ Risk premium on complete portfolio = 11% - 7% = 4%
∙ Standard deviation of portfolio, σC = 11%
Generalizing the relationship:

∙ 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.
∙ For example, with y = 0.5, the risk premium is 0.5 × (15% - 7%) = 4%.
∙ When the fraction invested in the risky asset (y) is reduced by half, both the
risk premium and the standard deviation are also reduced by half.
• As the fraction invested in the risky asset (y) increases, the expected return and
risk premium of the complete portfolio rise proportionally.
• Similarly, the standard deviation of the complete portfolio increases linearly with
the fraction invested in the risky asset.
This relationship allows us to infer the investor's degree of risk aversion from their
portfolio choices:
1. Risk-averse investors will demand a higher risk premium per unit of risk (σ) in their
complete portfolio.
2. By observing the risk-return tradeoff of the investor's complete portfolio, we can
estimate their level of risk aversion.
3. Investors with higher risk aversion will have a steeper risk premium-to-risk ratio in
their portfolios, meaning that steeper CAL
The Opportunity Set with Different Borrowing and Lending Rates
•Nongovernment
investors cannot borrow
at a risk-free rate.
•The risk of a borrower’s
default leads lenders to
demand higher interest
rates on loans.
•Suppose borrowing rate
is = 9%.
Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. 6-46 46
•Risk Aversion and Capital Allocation
• y: Preferred capital allocation
Ex
An investor is allocating between a market
portfolio and a risk-free asset. The market
portfolio has a risk premium of 8% and a
standard deviation of 15%. If an investor
allocates 70% to market portfolio, what is
the investor’s risk aversion?
Problem
You manage a risky portfolio with an expected rate of return of 18% and a standard
deviation of 28%. The T-bill rate is 8%.
Your client chooses to invest 70% of a portfolio in your fund and 30% in an essentially
risk-free money market fund.
What are the expected values and standard deviations of the rate of return on his portfolio?
Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 25%
Stock B 32%
Stock C 43%
A. What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?
B. What is the reward-to-volatility (Sharpe) ratio (S) of your risky portfolio? Your clients?
C. Draw the CAL of your portfolio on an expected return–standard deviation diagram.
D. What is the slope of the CAL? Show the position of your client on your fund’s CAL
Investment proportions: 30.0% in T-bills
A. 0.7 × 25% =
0.7 × 32% =
17.5% in Stock A
22.4% in Stock B
0.7 × 43% = 30.1% in Stock C
B. Expected return = (0.7 × 18%) + (0.3 × 8%) = 15%
Standard deviation = 0.7 × 28% = 19.6%
Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. 5-50 50
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
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

•What is the HPR for a share of stock that was purchased

• How would we characterize fund performance over the entire period,

• ignores timing of cash flows.

• Gives same cumulative performance as sequence of actual returns

• Dollar-weighted average return

• reflects investor experience.

• Geometric average: Single period return that gives the

• AA each of these scenarios is 0% per annum (over-weighting the effect of

• the dollar-weighted return (IRR) is 3.38%.

• EAR = Effective Annual Rate

•Scenario Analysis and Probability Distributions

Standard Deviation (STD):

What expected holding period returns and STD?

Risk free rate is 7%

a) What would be expected returns and Std deviation?

b) Which alternative is performing better?

How do evaluate whether our assumptions are reasonable?

Historical Returns could be reference points

r = 10% and σ = 20%

Value at risk (VaR):

• Kurtosis: Measure of fatness of tails of probability

• 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

Risk-averse investors consider risky portfolios only if they provide compensation

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

• A security is risk-free with a guaranteed real return only if

• Its’ price is indexed

• Maturity is equal to the investor’s holding period

• T-bills viewed as “the” risk-free asset

• Broad range of money market instruments are considered effectively risk-free

• (1 - y) = Portion to be invested in risk-free asset, F

• 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

Risk-averse investors consider risky portfolios only if they provide

• Investors taking on risk to earn a risk premium are speculating.

• Speculation is undertaken despite the risk because of a favorable risk-return

The remaining $210,000 is invested in risky securities—$113,400 in equities (E)

Bonds = 120000*.46= 55200 , so allocation of total

•The slope of the line is:

•Expected return-standard deviation tradeoff

• Graph showing all feasible risk-return combinations of a risky and risk-free

• Reward-to-volatility ratio (aka Sharpe ratio)

• Ratio of excess return to portfolio standard deviation

• All invested in risky asset (y = 1):

∙ Standard deviation of portfolio, σC = 0% (no risk)

Generalizing the relationship:

•Capital Market Line (CML)

•Cost and Benefits of Passive Investing

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