Background Concepts & Tools

 2013 – Equity Investments & Markets

 Learning Objectives

 Provide definitions of returns for stocks and portfolios

 Discuss measures of average returns
 Discuss the construction of indexes
 Present the dividends
 Discuss realized and expected returns
 Discuss nominal and real returns
 Explain leverage, short selling, and arbitrage
 Define risk

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 One-Period Returns
 When you make a financial investment, you expect to get a
return (how well an investment performs). How should we
measure return?
 Consider a stock that you buy today. Suppose you buy one share
for $Pt. You sell it one period later for $Pt+1 (at this stage we are
not making assumptions on the time interval. A “period” can be
any length of time from a second or less to a millennium or
more)
 The payoff is the sales proceeds Pt+1. It has units of dollars
 We want to measure a return that does not depend on how much
you invest initially. That is, we want to measure the rate of
return or return per dollars invested:
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 Contd.
(1 + Rt+1) = Pt+1/Pt, gross simple return
or,
Rt+1 = (Pt+1/Pt) – 1 = (Pt+1 – Pt)/Pt, net simple return
 This is also the way we measure the return or interest on a bank
deposit
 If the bank offers 4% simple interest per year, $1 invested today
becomes $1.04 in a year. The simple gross return is 1.04 and the
net simple return is 0.04 = 4%. Since this return is (almost) free
of risk, we often write it as Rf:
(1+Rf) = 1.04, Rf = 0.04
 Note that returns, unlike payoffs, are natural numbers. They do
not have units of dollars

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 Limited Liability
 A limited liability asset is one whose price is never
negative
 If you hold a limited liability asset, the worst thing
that can happen is that the price goes to zero, in which
case, the simple gross return is zero and the simple net
return is –1 = –100%

 Almost all financial assets have limited liability

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 Measuring Returns over many Periods
 What if you hold an asset for more than one period, say for two periods?
 The gross cumulative return is:
Pt+2/Pt = (Pt+2/Pt+1)(Pt+1/Pt)
 The two period gross cumulative return is the product of two successive
one-period returns. Returns multiply over time. This is called
compounding
 If we consider a bank deposit paying interest R f, each dollar invested is
worth (1+Rf)2 after two years and (1+Rf)T after T years. This is called
compound interest
 Over k periods (from t-k to t), the return compounds:
1+Rt(k) = (1+Rt) (1+Rt-1) … (1+Rt-k+1)
= (Pt/Pt-1)(Pt-1/Pt-2) … (Pt-k+1/Pt-k) = (Pt/Pt-k)
To annualize, take the k’th root (raise to the power 1/k)
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 Measuring Average Returns
 The obvious measure of average return is the sample mean of the
simple return, often called the arithmetic average return
 If we have historical observations for periods 1…T, the arithmetic
average return A is given by:
1+A = (1/T)(1+Rt), or A = (1/T)Rt
 An alternative measure of average return is the cumulative return over
the period from 1 to T, annualized by taking the T’th root (raising to
the power 1/T. This is called the geometric average return:
1+G = [(1+Rt)]1/T
 We can understand the relation between these two averages if we take
their logs. Using lowercase letters to denote logs of the corresponding
uppercase letters, we have:

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 Contd.
A>G

The difference depends on the volatility of the return series

 A good rule of thumb is that

A = G + (1/2)(Return variance),
or G = A – (1/2)(Return variance)

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 Example

 These numbers are geometric averages

(1+0.072)55 = (1+R1871)…(1+R1925)
where R1925 is the nominal stock return in 1925

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 Contd.

 The difference between the arithmetic mean and

geometric mean goes up with return variability

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 Which Average is Better?
It depends on your purpose
 G is a good summary of past performance, since it depends only
on the cumulative return earned over the sample period used to
compute the average
 Under reasonable assumption that log returns are symmetric, G
gives the median of the return distribution. Half the time you
will do better, half the time worse than G
 A is the expected return if you hold the asset for a single random
selected period
 Relative to A, G penalizes returns for risk. This may be
appropriate for an investor who dislikes risk

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 Portfolios
 Instead of just buying one share, you might split your money
among several shares
 For example, you might buy 2 shares of stock 1, each costing P 1t
and 3 shares of stock 2, each costing P2t. The total cost of this
portfolio is 2P1t+3P2t
 Next period, you portfolio is worth (2P 1,t+1+3P2,t+1)
 Your gross simple return is:
(1+Rp,t+1) = (2P1,t+1+3P2,t+1)/(2P1t+3P2t)
= 2P1,t+1/(2P1t+3P2t) + 3P2,t+1/(2P1t+3P2t)
= [2P1t/(2P1t+3P2t)](P1,t+1/P1t) + [3P2t/(2P1t+3P2t)] (P2,t+1/P2t)

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 Contd.

= w1t(P1,t+1/P1t) + w2t(P2,t+1/P2t)
= w1t(1+R1,t+1) + w2t(1+R2,t+1)
where = w1t is the share of your wealth invested in stock 1 at
time t and w2t= 1 – w1t is the share of your wealth invested in
stock 2 at time t

 The portfolio return is a weighted average of the returns on the

individual stocks, where the weights are the shares of wealth
invested in each stock

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 Contd.
 The principle holds more generally with any number of stocks
in the portfolio
(1+Rp,t+1) = w1t(1+R1,t+1) + … + wnt(1+Rn,t+1)
(1+Rp,t+1) =  wit(1+Ri,t+1)
where  wit=1, or with net returns:
Rp,t+1 =  witRi,t+1

 Sometimes, it is convenient to include a bank account with a

return Rf as the first possible investment. Then the portfolio
return would be:
Rp,t+1 = w1tRf +  witRi,t+1
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 Stock Indexes
 Indexes are just portfolios that are thought to be representative of the
general stock market

 Measures the performance of a particular market or group of securities

 Each index is described by:
 the number of shares included
 the identities of the included shares
 the weights placed on each included share
 Often use an index as a benchmark to:
(1) outperform if you are a professional money manager
(2) evaluate historical performance if you are an investor

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 Weighting Schemes
 Equal-weighted
wi=1/n
This requires trading every period to rebalance the portfolio back to equal
weights.
Example: Value Line Index

 Price-weighted
wi=Pi/(P1+…+Pn)
Example: The Dow Jones Industrial Average (DJIA)

 Value-weighted
wi=Vi/(V1+…+Vn)
where Vi is the total market value (market capitalization) of company i, V i =
PiMi where Mi is the number of shares outstanding.
Example: Standard and Poor’s 500 (S&P 500) and TSX
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Discussion on the DJIA and its Divisor

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©©2012
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Instruments 18
NASDAQ

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 Dividends/Returns
 To handle dividends, we modify the definition of the return on a
share to:
(1 + Rt+1) = (Pt+1+ Dt+1)/Pt
Subtracting one to get the net return:
Rt+1 = (Pt+1+ Dt+1– Pt)/Pt = (Pt+1 – Pt)/Pt + (Dt+1/Pt)
 The return is now the sum of two components, the capital gain or
price return (Pt+1 – Pt)/Pt , and the dividend price ratio or dividend
yield Dt+1/Pt
 Even with dividends, returns still compound the same way as
before if dividends are reinvested in the stock (when you buy a
mutual fund, you can arrange to reinvest all dividends
automatically in the fund)
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 Expected and Realized Returns
 At the start of the period, some of the variables are not
known, so we can only calculate the expected return:

E(Rt+1) = [E(Pt+1)+E(Dt+1)]/Pt – 1

 At the end of period, we know what happened and can

calculate realized return:
Rt+1 = (Pt+1+Dt+1)/Pt – 1

 The two numbers may be very different

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Historical Breakdown

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 Nominal and Real Returns
 So far we have measured all prices in dollars. Thus we have
defined returns in nominal dollars terms
 But if the purchasing power of the dollar change over time, it is
more meaningful to correct the returns for changes in the value
of the dollar
 For this purpose, we use a price index, say the consumer price
index or CPI. If the index is 100 in one year and 103 the next,
this means that 103 dollars are needed in the second year to buy
the same basket of goods that cost only 100 dollars in the first
year
 We say that the inflation rate is
t = (103–100)/100 = 0.03 = 3%

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 Contd.
 To calculate the purchasing power of an asset in any year , we
divide the dollar value by the CPI of that year
 The gross real return on a stock that pays no dividends is now:
(Pt+1/CPIt+1)/(Pt/CPIt) = (Pt+1/Pt)/(CPIt+1/CPIt)
= (1+Rt+1)/(1+t+1) = 1 + (Rt+1–t+1)/(1+t+1)
 1 + Rt+1–t+1

 The net real return is approximately Rt+1–t+1, the nominal

return less inflation
 This approximation is quiet accurate except in conditions of
extremely high inflation
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Historical Overview

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Return Averages

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 Leverage
 If you can borrow money from the bank as well as deposit money
there, you can invest more aggressively in a stock
 Suppose you start with $100. You borrow $50 from the bank at an
interest rate of Rf, and buy $150 worth of stock with return Rt+1
 After one period, you portfolio is worth:
–50(1+Rf) + 150(1+Rt+1)
 The negative first term is the amount you owe the bank, and the
positive second term is the value of your stock
 The return on the portfolio is:
(1+Rp,t+1) = [–50(1+Rf) + 150(1+Rt+1)]/100
(1+Rp,t+1) = –0.5(1+Rf) + 1.5(1+Rt+1)

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 Contd.
 This is just the usual formula for portfolio return in terms of
portfolio weights, except that the portfolio weight on the riskless
asset is negative because you have borrowed money instead of
depositing it
 The negative portfolio weight on the riskless asset enables the
portfolio weight on the stock to be greater than one

 In this example, we say that leverage is “1.5 to 1”

If the bank lends you $100 and you start with $100, then you
can buy $200 of stock with $100 of wealth and we say that
leverage is “2 to 1”

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 Implications
 Leverage is dangerous because it can lead to bankruptcy (a gross return less
than zero, so your wealth is exhausted) even if the stock you hold has limited
liability
 In theory we could imagine that a bank might lend you money even if you
have no money of your own to invest. Suppose the bank lends you $50 and
you invest this in the stock. Your portfolio is initially worth zero, and after one
period is worth
–50(1+Rf) + 50(1+Rt+1) = 50(Rt+1–Rf)
 The portfolio value is the initial investment in the stock times the excess return
on the stock (the difference between the return and risk free interest rate)
 This type of portfolio, with no money down (a zero initial value) is known as
an arbitrage portfolio. The return on an arbitrage portfolio is undefined
because you have to divide by the initial value of zero. However, we can talk
about the dollar return per dollar invested in the stock; this is just the excess
return on the stock over the riskless interest rate

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 Shorting Stocks
 It is also possible to borrow stocks rather than money from the bank
(broker). Suppose you arrange to borrow a stock and promise to return
it next period
 Assuming the stock pays no dividend during the period, there should
be very little cost to this arrangement because the stock’s owner still
earn the return on the stock when he gets back next period
 If there is a dividend, you must pass it on to the owner of the stock
 Suppose you start with $100. You borrow $50 of stock 1, sell it for
$50, and buy $150 of stock 2. After one period, you portfolio is worth
–50(1+R1,t+1) + 150(1+R2,t+1)
 The negative first term is the cost of buying back the same number of
shares of stock 1 to return to the person who lent them to you, and the
positive second term is the value of you position in stock 2

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 Contd.
 The return on the portfolio is:
(1+Rp,t+1) = [–50(1+R1,t+1) + 150(1+R2,t+1)]/100
= –0.5(1+R1,t+1) + 1.5(1+R2,t+1)

 This is just the usual formula for portfolio return in terms of

portfolio weights, except that the portfolio weight on stock 1 is
negative because you borrowed it and sold it instead of buying it

 We say that you shorted, you took a short position in stock 1.

Shorting stock 1 enables the portfolio weight on stock 2 to be
greater than 1

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 Remarks
 What is the purpose of shorting? Shorting stock is profitable if the
price of that stock falls; then you should short stocks that you think
are overvalued
 What is the effect of shorting? Shorting, like selling puts downward
pressure on stock prices. This makes shorting unpopular with
corporate executives and politicians
 There are several practical difficulties with shorting stock:
 The owner of the stock has the right to ask for its return at any
time, not just at the end of a fixed period of time
 All investors make their stocks available for lending, and some
stocks may be in limited supply for this purpose in which case
shorting becomes expensive
 In general, the regulations governing shorting are cumbersome,
perhaps because shorting is unpopular politically
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 Arbitrage
 A riskless profit opportunity that any individual who prefers more
wealth to less will exploit. It is such that:
 the opportunity never looses money today and tomorrow
 the opportunity makes money today or it may make money
tomorrow
 Note that the money you make is random, but always positive.

 Arbitrage (type 1): Portfolio strategy that: – requires no initial

cash outlay – never result in negative payoff, – sometimes results
in a positive payoff

 Arbitrage (type 2): Portfolio strategy that: – gives an initial strictly

positive cash inflow, – and never results in a negative payoff

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 Examples
 A package of 12 pencils sells for $1 today, 1 pencil sells for 10
cents today, there are no costs of packaging or unpackaging
pencils. Buy 12 pencils today, unpackage them, sell them again
today. Profit today is $0.20, and nothing happens tomorrow

 A package of 12 pencils sells for $1 today, and money can be

borrowed at 5% interest. Tomorrow 12 pencils will sell for $1.05
or $1.20. Borrow $1 today, use the money to buy 12 pencils. Sell
the pencils tomorrow, pay off the loan with $1.05, keep $0.00 or
$0.15

$ Finance theory assumes that there are no arbitrage

opportunities, because any opportunities that arise are eliminated
so quickly that we never observe them. This assumption allows
us to relate the prices of some assets to the prices of other assets

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 Risk
 Risk is uncertainty about the future
 While stocks do better on average, investors know that in
any one year stocks may do much worse than bonds (i.e.
they are more risky)
 One common way of summarizing risk is through standard
deviation, , a measure of dispersion
 If R1, R2, R3, …, RT are yearly returns, first compute the
sample variance of the returns
Var = 2 = [1/(T–1)](Rt – avgR)2
using the sample mean (avg) of returns = (1/T)Rt

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 Contd.
 The sample standard deviation is just the square root of the
sample variance
 = [2]0.5

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