Ch.

5 Risk, Return, and the Historical

Record
Investments
Chienlin Lu
How to pick financing tools
and reduce risk

How to evaluate
financing tools

Harry Markowitz
William Sharpe

Nobel Prize winner Nobel Prize winner

1990 1990
2
 5.1 Rates of Return

Realized rate of return

• Holding-Period Return (HPR)

• Rate of return over given investment period

PEnding  PBeginning  DivCash PS  PB  Div

HPR  HPR 
PBeginning PB
where
PS  Sale Price
PB  Buy Price
Div  Cash Dividend
3
 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?

PS  PB  Div $27  25  1.25

HPR    13%
PB 25

Capital Gains Yield? Dividend Yield?

$27  25 $1.25
 8%  5%
25 25
4
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

5
Arithmetic average 算術平均
法
n

 HPR
t 1
t
算術平均報酬率 
n

Geometric average 幾何平均

法
n
幾何平均報酬率  n  (1  HPR
t 1
t) -1

6
Table 5.1 Annual Cash Flows & Rates of Return of a
Mutual Fund

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of 1 1.2 2 0.8
quarter ($ million)
Holding-period return (%) 10 25 −20 20
( 基金該期本身報酬率 )

Total assets before net inflows 1.1 1.5 1.6 0.96

( 期初規模 ×(1+ 報酬 ))
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of 1.2 2 0.8 1.56
quarter ($ million)

7
 Table 5.1 Annual Cash Flows & Rates of Return of a
Mutual Fund

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of quarter 1 1.2 2 0.8
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of quarter 1.2 2 0.8 1.56

Arithmetic Average Geometric Average

10%  25%  (20%)  20% 1
 8.75% [(1.1)  (1.25)  (.8)  (1.2)]  1  7.19%
4
4

8
 Below are three year period performance for Frim
ABC. Calculate the Geometric average and
Arithmetic average returns

期別 (t) 期初每股價格 期末每股價格 每股現金股利

Initial Price End year price Cash dividend (end
each year)
1 40 48 2.5
2 48 67 2.0
3 67 58 1.5

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 Allenholds 1,000 shares of Firm XYZ stock. Below
are three year period performance for Frim ABC.
Calculate the Geometric average and Arithmetic
average returns
T 期間 Initial Price End year price Stock dividend (End period)
期初價格 期末價格 期末發放的股票股利
1 50 元 75 元 250 shares
2 75 元 100 元 300 shares
3 100 元 50 元 100 shares

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11
 Dollar-weighted average return (IRR)
IRR: 等於投資報酬率
• Assuming you bought a TSMC share in Jan.
2016 by 71 Dolloar ， and sold it in the end of
2018 for 105 dollar ， how much is the dollar
weighted average returns in these three
years ？
105
71 
(1  r )3

• R=IRR, internal rate of return

105
 NPV  71   0  r  13.93%
(1  r ) 3

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 Dollar-weighted average return (IRR)
IRR: 等於投資報酬率
• If TSMC distributed 3$ dividend every year
between 2016 to year 2018, computing the
IRR ？
3 3 3 105
71    
(1  r )1 (1  r ) 2 (1  r )3 (1  r )3
3 3 3 105
 NPV  71     0
(1  r ) (1  r )
1 2
(1  r ) (1  r )
3 3

 r  17.67%

• IRR is also similar to yield to maturity in bond

valuation (YTM).
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 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

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 5.1 Rates of Return: EAR vs.
APR

n-Periods of Compounding: Continuous Compounding:

 APR 
n
EAR  e APR  1
EAR  1   1
 n 

APR  [( EAR  1)1/ n  1]  n APR  ln( EAR  1)

where
n  compounding per period

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5.1 Rates of Return : EAR vs.
APR

16
 Example
• Buy treasury bill with 10,000 face value
maturing in six months for 9,900
0  100
HPR   1.01%
9,900

• APR=1.01%×2=2.02%
• 1+EAR=(1+1.01%)2=1.0203
=>EAR=(1+1.01%)2−1=2.03%

17
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%
18
5.2 Inflation and The Real Rate of Interest
• Equilibrium Nominal Rate of Interest
• Fisher Equation (5.9)

rNom  rReal  E (i )

19
 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

20
Figure 5.1 Inflation and Interest rates (1927-2018)

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 5.3 Risk and Risk Premiums
What is risk?
• 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
24
Spreadsheet 5.1 Scenario Analysis for a Stock Index
Fund

Risk: Deviation from your expectation.

25
 Investment Risk 投資活動的風險來源

Market Risk/Systematic Risk

不可分散風險
Market
Market
市場風險
市場風險
Interest
Interest FX
FXrate
rate
利率風險
利率風險 匯率風險
匯率風險
Inflation
Inflation
通貨膨脹風
通貨膨脹風
險險
Firm
Firm
Firm
FirmCredit
Credit Operation
Operation
信用風險
信用風險 營運風險
營運風險
Firm
FirmLiquidity
Liquidity
流動性風險
流動性風險
Unique Risk/
diversifiable Risk 可分散風險
 Market Risk 市場風險
• Market Risk/ systematic risk / non-diversifiable Risk
• 市場風險來自於足以影響金融市場中所有資產或金融工具報酬的非預期
事件，其衝擊是屬於全面性的，主要包括經濟成長、利率、匯率與物價
的波動或政治因素的干擾等，又稱不可分散風險或系統風險

Financial
Financial
International Oil
Oil Crisis
Crisis 911
911
Crisis
Crisis
國際性
系統風險

Local
本土性 Taiwan-China
Taiwan-China Local
Local Election
Election 921
921 Earthquake
Earthquake
系統風險
 Standard Deviation / Volatility 標準差
Total risk
• Expected STDV
• STDV represents volatility, total risk (We don’t know where it comes
from).
• 標準差愈大，代表報酬率的波動程度愈大，其實際報酬率愈不容易等於
預期報酬率，亦即風險愈大，是總風險（＝非系統風險＋系統風險）的
衡量指標
n
  s
R -
s 1
E(R) 2
 Prob s

• Sample STDC
Why historical return?
• 樣本標準差
n
Because we predict future badly.


i 1
(R i - R ) 2
So we use the trend to predict
future.

n -1
• If Firm CDE has below information,
calculate the standard deviation based on
the Arithmetic average returns.
Business Cycle Prob. Possible returns
發生機率 可能報酬率
Growth 成長 0.6 50%

Stable 持平 0.2 10%

Recession 衰退 0.2 -30%

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 • Below is the month returns for Firm EG in
the past 1 year, please compute average
monthly standard deviation of EG share.
Month 1月 2月 3月 4月 5月 6月 7月 8月 9月 10 月 11 月 12 月
Return 5.06% 2.67% -6.42% -3.53% 13.85% -10.81% -5.30% -2.00% 14.29% -8.75% -0.20% 12.55
%

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32
 (Beta)  係數 : Systematic risk
• Beta  represents the linear correlation between the underlying
assets and the market, it is also representing the systemic risk of
the asset.
•  係數是系統風險的衡量指標，衡量當市場報酬率變化 1% 時，個
別資產預期報酬率的變化幅度，幅度愈大代表個別資產對市場報酬率
(Rm) 變化的敏感度愈大

Cov(R i , R m ) i
i    i ,m 
 m2 m
• 樣本係數 Sample
n

Côv(R i , R m )  (R i,t - R i )  (R m, t - R m )
ˆi   t 1

ˆ m
2 n

 m,t m
(R
t 1
- R ) 2

33
 • Below is the month returns for Firm EG and
the market index in the past 1 year, please
compute the Beta  of the EG share.
• 請問晶電股票在這段期間的係數是多少？
Month 1月 2月 3月 4月 5月 6月 7月 8月 9月 10 月 11 月 12 月

EG 5.06% 2.67% -6.42% -3.53% 13.85% -10.81% -5.30% -2.00% 14.29% -8.75% -0.20% 12.55%

Index
1.94% 0.61% 0.26% 2.21% 1.99% -2.33% 0.57% -1.06% 1.89% 3.38% -1.04% 2.98%

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• If the Delta share has expected return=10%,
share STDV=6%, Covariance=0.9%, market
index STDV=15%, compute the total risk and
the systematic risk of the Delta share.

35
Figure 5.3 Normal Distribution r = 10% and σ
= 20%

36
 5.3 Risk and Risk Premiums
• The Normal Distribution

• Transform normally distributed return into

standard deviation score:

Z-score
• Original return, given standard normal return:

Where are you when compared

with E(r)

37
 5.3 Risk and Risk Premiums

• 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 a crucial role

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 5.3 Risk and Risk Premiums: Value
at Risk
We don’t care much about upside risk
• Value at risk (VaR): > Make big money is a good thing!
• Measure of downside risk
• Worst loss with given probability, usually 1% or
5%

e.g., -1.65

39
Coefficient of variation (CV) 變異係數

• How do we compare risk and returns

between different assets ？

變異係數(CV)  100%
E(R)
 Coefficient of variation (CV) 變異係數
 If there are two shares VB and VP, VB has STDV=10%
and E(R)=20%, VP has STDV=15%. How much return
VP should have for the investors willing to invest?

41
 5.3 Risk and Risk Premiums
• 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

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 5.3 Risk and Risk Premiums
• Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios

Portfolio Risk Premium E (rp )  rf

SP 
Standard Deviation of Excess Returns P
where
E (rp )  Expected Return of the portfolio
rf  Risk Free rate of return
 P  Standard Deviation of portfolio excess return

43
 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

44
Table 5.3: Historical Return and Risk

Risk-free rate

5.83-3.38

45
Figure 5.4: Treasury Bills

46
Figure 5.4: 30-year Treasury Bonds

47
Figure 5.4: Common Stocks

48
 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

49
 5.5 Asset Allocation across Portfolios

• 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

50
5.5 Portfolio Asset Allocation: Expected Return
and Risk

Expected Return of the Complete Portfolio

E (rC )  y  E (rp )  (1  y)  r f risky and risk-free assets
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

 C  y  p All come from risky assets
where  C  Standard deviation of the complete portfolio
 P  Standard deviation of the risky portfolio
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Figure 5.7 Investment Opportunity Set

Our portfolio contains only one risky and risk-free assets

Case 3:
Put all money in risky assets

Case 4:
Suppose you can borrow at Rf
Case 2:
Put equal money in two assets

Case 1:
Put all money in risk-free asset

52
 5.5 Asset Allocation across Portfolios
• Capital Allocation Line (CAL)
• Plot of risk-return combinations available by
varying allocation between risky and risk-free
assets

53
 5.5 Asset Allocation across Portfolios
• 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 ] /  P2 [ E (rP )  rf ] When you require higher
  compensation for taking
A A P2 risk, you need a higher
Sharpe ratio to encourage
𝐸 ( 𝑟 𝑄 ) −𝑟 𝑓 P.123
you invest in a risky asset.
𝐴= 2 Your own requirement
𝜎 𝑄

54
5.6 Passive Strategies and the Capital Market
Line

• Passive Strategy
• Investment policy that avoids security analysis

• Capital Market Line (CML)

• Capital allocation line provided by one-month T-
bills and a broad index of common stocks.

55
Table 5.5: Excess Returns Statistics for the Market Index

56
57
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

58