RISK, RETURN &

THE HISTORICAL Chapter 6

RECORD
 DETERMINANTS OF
THE LEVEL 6.1
OF INTEREST RATES
DETERMINANTS OF THE LEVEL
OF INTEREST RATES
Factors that determine the level of interest rates:
1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance
investments in plant, equipment, and inventories (real assets or
capital formation).
3. The government’s net demand for funds as modified by actions of
the Federal Reserve Bank.
4. The expected rate of inflation.
REAL AND NOMINAL RATES OF
INTEREST
An interest rate is a promised rate of return denominated in some unit of account
(dollars, yen, euros, or even purchasing power units) over some time period (a
month, a year, 20 years, or longer)
Nominal interest rate: Growth rate of your money
Real interest rate: Growth rate of your purchasing power
Let = nominal rate, = real rate and i = inflation rate. Then:

1+𝑟 𝑛𝑜𝑚 𝑟 𝑛𝑜𝑚 −𝑖

1+𝑟 𝑟𝑒𝑎𝑙 = 𝑟 𝑟𝑒𝑎𝑙 =
≈−𝑖
1+𝑖 1+ 𝑖
REAL AND NOMINAL RATES OF
INTEREST
If the nominal interest rate on a 1-year CD is 8%, and you expect inflation to
be 5% over the coming year, then using the approximation formula, you
expect the real rate of interest to be real = 8% − 5% = 3%.
Using the exact formula, the real rate is

or 2.86%. Therefore, the approximation rule overstates the expected real rate
by 0.14% (14 basis points)
DETERMINATION OF THE EQUILIBRIUM
REAL RATE OF INTEREST
Three basic factors—supply, demand, and government actions—determine the real
interest rate

The supply curve slopes up from left to right because the higher the real interest
rate, the greater the supply of household savings.
The demand curve slopes down from left to right because the lower the real interest
rate, the more businesses will want to invest in physical capital.
DETERMINATION OF THE EQUILIBRIUM
REAL RATE OF INTEREST
The government and the central
bank can shift these supply and
demand curves either to the right or
to the left through fiscal and
monetary policies.
For example, consider an increase
in the government’s budget deficit
EQUILIBRIUM NOMINAL RATE OF
INTEREST
As the inflation rate increases, investors will demand higher nominal rates of
return
Irving Fisher argued that the nominal rate ought to increase one-for-one with
expected inflation, E(i). The so-called Fisher hypothesis is:

The Fisher hypothesis implies that when real rates are stable, changes in
nominal rates ought to predict changes in inflation rates
TAXES AND THE REAL RATE OF
INTEREST
Tax liabilities are based on nominal income
Given a tax rate (t) and a nominal interest rate, , the after-tax interest rate is
(1 − t).
The real after-tax rate is approximately the after-tax nominal rate minus the
inflation rate:
=

The after-tax real rate of return falls as the inflation rate rises.
TAXES AND THE REAL RATE OF
INTEREST
For example, you are in a 30% tax bracket and your investments provide a
nominal return of 12% while inflation runs at 8%
Your before-tax real rate is approximately 4%
After-tax real return of 4%(1 − 0.3) = 2.8%.
But the tax code does not recognize that the first 8% of your return is only
compensation for inflation—not real income. Your after-tax nominal return is
12%(1 − 0.3) = 8.4%, so your after-tax real interest rate is only 8.4% − 8% =
0.4%.
your after-tax real return has fallen by it = 8% × 0.3 = 2.4%.
 COMPARING RATES OF
RETURN FOR DIFFERENT 6.2
HOLDING PERIODS
COMPARING RATES OF RETURN FOR
DIFFERENT HOLDING PERIODS
Consider an investor who seeks a safe investment in U.S. Treasury securities.
Zero-coupon bonds, are sold at a discount from par value and provide their
entire return from the difference between the purchase price and the ultimate
repayment of par value
Par = $100, T=maturity, P=price, rf(T)=total risk free return

For T = 1, Equation provides the risk-free rate for an investment horizon of 1

year
COMPARING RATES OF RETURN FOR
DIFFERENT HOLDING PERIODS
EFFECTIVE ANNUAL RATE
VERSUS TOTAL RETURN
To compare returns on investments with differing horizons. We express each
total return as a rate of return for a common period.
We typically express all investment returns as an effective annual rate (EAR),
defined as the percentage increase in funds invested over a 1-year horizon.
For a 1-year investment, the EAR equals the total return, rf (1), and the gross
return, (1 + EAR), is the terminal value of a $1 investment
In general, we can relate EAR to the total return, rf (T), over a holding period
of length T by using the following equation:
1
1+𝐸𝐴𝑅= [ 1+𝑟 𝑓 ( 𝑇 ) ] 𝑇
EFFECTIVE ANNUAL RATE VERSUS
TOTAL RETURN
For the 6-month Treasury, T = ½, and 1/T = 2. Therefore
1 + EAR = = 1.0549 ⇒ EAR = 5.49%

For the 25-year Treasury, T = 25. Therefore

1 + EAR = = 1.060 ⇒ EAR = 6.0%
ANNUAL PERCENTAGE RATES
Annualized rates on short-term investments (by convention, T < 1 year) often are
reported using simple rather than compound interest. These are called annual
percentage rates, or APRs.
If there are n compounding periods in a year, and the per-period rate is rf (T), then
APR = n × rf (T). The APR of the 6-month bond rate of 2.71% is 2 × 2.71 = 5.42%
Conversely, you can find the per-period rate from the APR as rf (T) = APR/n, or
equivalently, as T × APR

𝑇
( 1+ 𝐸𝐴𝑅 ) −1
𝐴𝑃𝑅=
𝑇
RISK AND RISK 6.3
PREMIUMS
HOLDING PERIOD RETURN
Rates of Return: Single Period
Rate of return on your investment will depend on
(a) the price per share at year’s end and
(b) the cash dividends you will collect over the year
HPR = Holding Period Return
P0 = Beginning price 𝑃 1 − 𝑃 0 + 𝐷1
P1 = Ending price 𝐻𝑅𝑃=
𝑃0
D1 = Dividend during period one
HOLDING PERIOD RETURN
Suppose the price per share at year’s end is $110 and cash dividends over the
year amount to $4
Ending Price = 110
Beginning Price = 100
Dividend = 4

HPR = (110 - 100 + 4 )/ 100) = 14%

EXPECTED RETURN AND STANDARD
DEVIATION
The expected rate of return is a probability-weighted average of the rates of
return in each scenario. Calling p(s) the probability of each scenario and r(s)
the HPR in each scenario, where scenarios are labeled or “indexed” by s
p(s) = probability of a state
r(s) = return if a state occurs
s = state

𝐸(𝑟)=∑ 𝑝(𝑠)𝑟(𝑠)
𝑠
EXPECTED RETURN AND
STANDARD DEVIATION
State Prob. of State r in State
Excellent 0.25 0.3100
Good 0.45 0.1400
Poor 0.25 -0.0675
Crash 0.05 -0.5200

E(r) = (0.25)(0.31) + (0.45)(0.14) + (0.25)(-0.0675) + (0.05)(-0.52)

E(r) = 0.0976 or 9.76%
VARIANCE AND STANDARD
DEVIATION
Variance (VAR):

𝜎 =∑ 𝑝 ( 𝑠 ) [𝑟 ( 𝑠 ) −𝐸 ( 𝑟 ) ]
2 𝜎 =∑ 𝑝 (𝑠) [ 𝑟 (𝑠)− 𝐸 (𝑟 )]
2 2
2
𝑠

𝑠
Standard Deviation (STD):

𝜎 =√𝜎 2
EXCESS RETURNS AND RISK
PREMIUMS
We measure the reward as the difference between the expected HPR on the index stock
fund and the risk-free rate, that is, the rate you would earn in risk-free assets such as T-
bills, money market funds, or the bank. We call this difference the risk premium on
common stocks.
For example: the risk-free rate in our example is 4% per year, and the expected index
fund return is 9.76%, so the risk premium on stocks is 5.76% per year
The difference in any particular period between the actual rate of return on a risky asset
and the actual risk-free rate is called the excess return
The risk premium is the expected value of the excess return, and the standard deviation
of the excess return is a measure of its risk
The degree to which investors are willing to commit funds to stocks depends on their
risk aversion
VARIANCE AND STANDARD
DEVIATION
𝜎 =∑ 𝑝 (𝑠) [ 𝑟 (𝑠)− 𝐸 (𝑟 ) ]
2 2

𝑠
TIME SERIES ANALYSIS
OF PAST RATES OF 6.4
RETURN
TIME SERIES ANALYSIS OF PAST
RATES OF RETURN
When we use historical data, we treat each observation as an equally likely
“scenario.” So if there are n observations, we substitute equal probabilities of
1/n for each p(s)
The Arithmetic Average of rate of return:

𝑛 𝑛
1
𝐸 (𝑟 )=∑ 𝑝 ( 𝑠)𝑟 ( 𝑠)= ∑ 𝑟 (𝑠)
𝑠=1 𝑛 𝑠=1
 GEOMETRIC AVERAGE RETURN
The arithmetic average provides an unbiased estimate of the expected future
return

𝑇 𝑉 𝑛 =(1+ 𝑟 1)( 1+ 𝑟 2 )...(1+ 𝑟 𝑛 )

g: geometric average rate of return
1 /𝑛
=𝑇𝑉 −1
GEOMETRIC AVERAGE RETURN
VARIANCE AND STANDARD
DEVIATION
Variance (VAR):

𝜎 =∑ 𝑝 ( 𝑠 ) [𝑟 ( 𝑠 ) −𝐸 ( 𝑟 ) ]
2 𝜎 =∑ 𝑝 (𝑠) [ 𝑟 (𝑠)− 𝐸 (𝑟 )]
2 2
2
𝑠

𝑠
Using historical data with n observations, we could estimate variance as

𝑛
[ ]
¿ ¿ 2
1
𝜎 = ∑ 𝑟 ( 𝑠 ) −𝑟
2
𝑛 𝑠=1
THE REWARD-TO-VOLATILITY
(SHARPE) RATIO
Investors price risky assets so that the risk premium will be commensurate
with the risk of that expected excess return, and hence it’s best to measure
risk by the standard deviation of excess, not total, returns.
Sharpe Ratio for Portfolios:

Risk Premium
𝑆h𝑎𝑟𝑝𝑒𝑟𝑎𝑡𝑖𝑜=
SD of Excess Returns
THE REWARD-TO-VOLATILITY
(SHARPE) RATIO
Measure sharpe ratio
 THE NORMAL 6.5
DISTRIBUTION
THE NORMAL DISTRIBUTION
Investment management is easier when returns are normal.
 Standard deviation is a good measure of risk when returns are symmetric.
 If security returns are symmetric, portfolio returns will be, too.
 Future scenarios can be estimated using only the mean and the standard deviation.
THE NORMAL DISTRIBUTION
NORMALITY AND RISK MEASURES
What if excess returns are not normally distributed?
 Standard deviation is no longer a complete measure of risk
 Sharpe ratio is not a complete measure of portfolio performance
 Need to consider skew and kurtosis
 DEVIATIONS FROM
NORMALITY AND RISK 6.6
MEASURES
SKEW AND KURTOSIS
A measure of asymmetry called skew is the ratio of the average cubed
deviations from the sample average
Another potentially important deviation from normality, kurtosis, concerns
the likelihood of extreme values on either side of the mean at the expense of a
smaller likelihood of moderate deviations
NORMAL AND SKEWED
DISTRIBUTIONS
NORMAL AND FAT-TAILED DISTRIBUTIONS
(MEAN = .1, SD =.2)
VALUE AT RISK (VAR)
The value at risk (denoted VaR to distinguish it from Var, the abbreviation for
variance) measure the amount of potential loss that could happen in an
investment over a given time period. It is another name for the quantile of a
distribution.
Practitioners commonly estimate the 1% VaR ( or 5% VaR) , meaning that
99% of returns will exceed the VaR, and 1% of returns will be worse
EXPECTED SHORTFALL (ES)
Also called conditional tail expectation (CTE)
More conservative measure of downside risk than VaR
 VaR takes the highest return from the worst cases
 ES takes an average return of the worst cases
For example: Using a sample of historical returns, we would estimate the 1%
expected shortfall by identifying the worst 1% of all observations and taking their
average.
LOWER PARTIAL STANDARD DEVIATION (LPSD)
AND THE SORTINO RATIO
The use of standard deviation as a measure of risk when the return
distribution is nonnormal presents two problems:
Need to consider negative deviations separately
Need to consider deviations of returns from the risk-free rate.

•LPSD: similar to usual standard deviation, but uses only negative deviations
from risk free rate
•Sortino Ratio replaces Sharpe Ratio