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Return Calculations
In this Chapter we cover asset return calculations with an emphasis on equity
returns. Section 1.1 covers basic time value of money calculations. Section
1.2 covers asset return calculations, including both simple and continuously
compounded returns. Section 1.3 illustrates asset return calculations using
R.
Updated: June 23, 2011
1.1 The Time Value of Money
This section reviews basic time value of money calculations. The concepts of
future value, present value and the compounding of interest are dened and
discussed.
1.1.1 Future value, present value and simple interest.
Consider an amount $V invested for n years at a simple interest rate of R
per annum (where R is expressed as a decimal). If compounding takes place
only at the end of the year the future value after n years is:
FV
n
= $V (1 +R) (1 +R) = $V (1 +R)
n
. (1.1)
Over the rst year, $V grows to $V (1+R) = $V +$V R which represents the
initial principle $V plus the payment of simple interest $V R for the year.
Over the second year, the newprinciple $V (1+R) grows to $V (1+R)(1+R) =
$V (1 +R)
2
, and so on.
1
2 CHAPTER 1 RETURN CALCULATIONS
Example 1 Future value with simple interest.
Consider putting $1000 in an interest checking account that pays a simple
annual percentage rate of 3%. The future value after n = 1, 5 and 10 years
is, respectively,
FV
1
= $1000 (1.03)
1
= $1030,
FV
5
= $1000 (1.03)
5
= $1159.27,
FV
10
= $1000 (1.03)
10
= $1343.92.
Over the rst year, $30 in interest is paid; over three years, $159.27 in interest
is accrued; over ve years, $343.92 in interest is accrued
The future value formula (1.1) denes a relationship between four vari-
ables: FV
n
, V, R and n. Given three variables, the fourth variable can be
determined. Given FV
n
, R and n and solving for V gives the present value
formula:
V =
FV
n
(1 +R)
n
. (1.2)
Given FV
n
, n and V, the annual interest rate on the investment is dened
as:
R =
FV
n
V
1/n
1. (1.3)
Finally, given FV
n
, V and R we can solve for n :
n =
ln(FV
n
/V )
ln(1 +R)
. (1.4)
The expression (1.4) can be used to determine the number years it takes
for an investment of $V to double. Setting FV
n
= 2V in (1.4) gives:
n =
ln(2)
ln(1 +R)
0.7
R
,
which uses the approximations ln(2) = 0.6931 0.7 and ln(1 + R) R for
R close to zero (see the Appendix). The approximation n 0.7/R is called
the rule of 70.
Example 2 Using the rule of 70.
1.1 THE TIME VALUE OF MONEY 3
The table below summarizes the number of years it takes for an initial in-
vestment to double at dierent simple interest rates.
R ln(2)/ ln(1 +R) 0.7/R
0.01 69.66 70.00
0.02 35.00 35.00
0.03 23.45 23.33
0.04 17.67 17.50
0.05 14.21 14.00
0.06 11.90 11.67
0.07 10.24 10.00
0.08 9.01 8.75
0.09 8.04 7.77
0.10 7.28 7.00
1 +
R
m
mn
.
R
m
is often referred to as the periodic interest rate. As m, the frequency of
compounding, increases the rate becomes continuously compounded and it
can be shown that future value becomes
FV
c
n
= lim
m
$V
1 +
R
m
mn
= $V e
Rn
,
where e
()
is the exponential function and e
1
= 2.71828.
Example 3 Future value with dierent compounding frequencies.
4 CHAPTER 1 RETURN CALCULATIONS
If the simple annual percentage rate is 10% then the value of $1000 at the
end of one year (n = 1) for dierent values of m is given in the table below.
Compounding Frequency Value of $1000 at end of 1 year (R = 10%)
Annually (m = 1) 1100
Quarterly (m = 4) 1103.8
Weekly (m = 52) 1105.1
Daily (m = 365) 1105.515
Continuously (m = ) 1105.517
FV
n
V
,
n =
1
R
ln
FV
n
V
.
1.1.3 Eective annual rate
We now consider the relationship between simple interest rates, periodic
rates, eective annual rates and continuously compounded rates. Suppose
an investment pays a periodic interest rate of 2% each quarter. This gives
rise to a simple annual rate of 8% (2% 4 quarters). At the end of the year,
$1000 invested accrues to
$1000
1 +
0.08
4
41
= $1082.40.
The eective annual rate, R
A
, on the investment is determined by the rela-
tionship
$1000 (1 +R
A
) = $1082.40.
1.1 THE TIME VALUE OF MONEY 5
Solving for R
A
gives
R
A
=
$1082.40
$1000
1 = 0.0824,
or R
A
= 8.24%. Here, the eective annual rate is the simple interest rate
with annual compounding that gives the same future value that occurs with
simple interest compounded four times per year. The eective annual rate
is greater than the simple annual rate due to the payment of interest on
interest.
The general relationship between the simple annual rate R with payments
m time per year and the eective annual rate, R
A
, is
(1 +R
A
) =
1 +
R
m
m
.
Given the simple rate R, we can solve for the eective annual rate using
R
A
=
1 +
R
m
m
1. (1.5)
Given the eective annual rate R
A
, we can solve for the simple rate using
R = m
(1 +R
A
)
1/m
1
.
The relationship between the eective annual rate and the simple rate
that is compounded continuously is
(1 +R
A
) = e
R
.
Hence,
R
A
= e
R
1,
R = ln(1 +R
A
).
.
Example 4 Determine eective annual rates.
6 CHAPTER 1 RETURN CALCULATIONS
The eective annual rates associated with the investments in Example 2 are
given in the table below:
Compounding Frequency Value of $1000 at end of 1 year (R = 10%) R
A
Annually (m = 1) 1100 10%
Quarterly (m = 4) 1103.8 10.38%
Weekly (m = 52) 1105.1 10.51%
Daily (m = 365) 1105.515 10.55%
Continuously (m = ) 1105.517 10.55%
Portfolio Returns
Consider an investment of $V in two assets, named asset A and asset B.
Let x
A
denote the fraction or share of wealth invested in asset A, and let
x
B
denote the remaining fraction invested in asset B. The dollar amounts
invested in assets A and B are $V x
A
and $V x
B
, respectively. We
assume that the investment shares add up to 1, so that x
A
+ x
B
= 1. The
collection of investment shares (x
A
, x
B
) denes a portfolio. For example, one
portfolio may be (x
A
= 0.5, x
B
= 0.5) and another may be (x
A
= 0, x
B
= 1).
Negative values for x
A
or x
B
represent short sales. Let R
A,t
and R
B,t
denote
the simple one-period returns on assets A and B. We wish to determine the
10 CHAPTER 1 RETURN CALCULATIONS
simple one-period return on the portfolio dened by (x
A
, x
B
) . To do this,
note that at the end of period t, the investments in assets A and B are worth
$V x
A
(1 +R
A,t
) and $V x
B
(1 +R
B,t
), respectively. Hence, at the end of
period t the portfolio is worth
$V [x
A
(1 +R
A,t
) +x
B
(1 +R
B,t
)] .
Hence, x
A
(1 +R
A,t
) +x
B
(1 +R
B,t
) denes the gross return on the portfolio.
The portfolio gross return is equal to a weighted average of the gross returns
on assets A and B, where the weights are the portfolio shares x
A
and x
B
.
To determine the portfolio rate of return , re-write the portfolio gross
return as
1 +R
p,t
= x
A
+x
B
+x
A
R
A,t
+x
B
R
B,t
= 1 +x
A
R
A,t
+x
B
R
B,t
,
since x
A
+x
B
= 1 by construction. Then the portfolio rate of return is
R
p,t
= x
A
R
A,t
+x
B
R
B,t
,
which is equal to a weighted average of the simple returns on assets A and
B, where the weights are the portfolio shares x
A
and x
B
.
Example 8 Compute portfolio return
Consider a portfolio of Microsoft and Starbucks stock in which you initially
purchase ten shares of each stock at the end of month t 1 at the prices
P
msft,t1
= $80 and P
sbux,t1
= $30, respectively. The initial value of the
portfolio is V
t1
= 10 $80 + 10 30 = $1, 100. The portfolio shares are
x
msft
= 800/1100 = 0.7272 and x
sbux
= 30/1100 = 0.2727. Suppose at the
end of month t, P
msft,t
= $90 and P
sbux,t
= $28. Assuming that Microsoft and
Starbucks do not pay a dividend between periods t 1 and t, the one-period
returns on the two stocks are
R
msft,t
=
$90 $85
$85
= 0.0588,
R
sbux,t
=
$28 $30
$30
= 0.067.
The one-month rate of return on the portfolio is then
R
p,t
= (0.7272)(0.0588) + (0.2727)(0.067) = 0.0245,
1.2 ASSET RETURN CALCULATIONS 11
and the portfolio value at the end of month t is
V
t
= V
t1
(1 +R
p,t
) = $1, 100 (1.0245) = $1, 126.95.
t
=
CPI
t
CPI
t1
CPI
t1
= %CPI
t
, (1.16)
then 1 +
t
=
CPI
t
CPI
t1
and (1.14) may be re-expressed as
R
Real
t
=
1 +R
t
1 +
t
1. (1.17)
Example 10 Compute real return
Consider, again, a one-month investment in Microsoft stock. Suppose the
CPI in months t 1 and t is 1 and 1.01, respectively, representing a 1%
monthly growth rate in the overall price level. The real prices of Microsoft
stock are
P
Real
t1
=
$85
1
= $85, P
Real
t
=
$90
1.01
= $89.1089,
and the real monthly return is
R
Real
t
=
$89.10891 $85
$85
= 0.0483.
The nominal return and ination over the month are
R
t
=
$90 $85
$85
= 0.0588,
t
=
1.01 1
1
= 0.01.
Then the real return computed using (1.17) is
R
Real
t
=
1.0588
1.01
1 = 0.0483.
Notice that simple real return is almost, but not quite, equal to the simple
nominal return minus the ination rate:
R
Real
t
R
t
t
= 0.0588 0.01 = 0.0488.
P
t
P
t1
, (1.18)
where ln() is the natural log function
2
. To see why r
t
is called the contin-
uously compounded return, take the exponential of both sides of (1.18) to
give:
e
rt
= 1 +R
t
=
P
t
P
t1
.
Rearranging we get
P
t
= P
t1
e
rt
,
so that r
t
is the continuously compounded growth rate in prices between
months t 1 and t. This is to be contrasted with R
t
, which is the simple
growth rate in prices between months t 1 and t without any compounding.
Furthermore, since ln
x
y
P
t
P
t1
= ln(P
t
) ln(P
t1
)
= p
t
p
t1
,
where p
t
= ln(P
t
). Hence, the continuously compounded monthly return, r
t
,
can be computed simply by taking the rst dierence of the natural loga-
rithms of monthly prices.
Example 14 Compute continuously compounded returns
Using the price and return data from Example 1, the continuously com-
pounded monthly return on Microsoft stock can be computed in two ways:
r
t
= ln(1.0588) = 0.0571,
r
t
= ln(90) ln(85) = 4.4998 4.4427 = 0.0571.
2
The continuously compounded return is always dened since asset prices, P
t
, are
always non-negative. Properties of logarithms and exponentials are discussed in the ap-
pendix to this chapter.
1.2 ASSET RETURN CALCULATIONS 17
Notice that r
t
is slightly smaller than R
t
. Why?
Given a monthly continuously compounded return r
t
, is straightforward
to solve back for the corresponding simple net return R
t
:
R
t
= e
r
t
1. (1.19)
Hence, nothing is lost by considering continuously compounded returns in-
stead of simple returns. Continuously compounded returns are very similar
to simple returns as long as the return is relatively small, which it generally
will be for monthly or daily returns. Since R
t
is bounded from below by 1,
the smallest value for r
t
is . This, however, does not mean that you could
lose an innite amount of money on an investment. The actual amount of
money lost is determined by the simple return (1.19).
For modeling and statistical purposes it is often much more convenient
to use continuously compounded returns due to the additivity property of
multiperiod continuously compounded returns discussed in the next sub-
section.
Example 15 Determine simple return from continuously compounded re-
turn
In the previous example, the continuously compounded monthly return on
Microsoft stock is r
t
= 5.71%. The simple net return is then
R
t
= e
.0571
1 = 0.0588.
Multi-Period Returns
The relationship between multi-period continuously compounded returns and
one-period continuously compounded returns is more simple than the rela-
tionship between multi-period simple returns and one-period simple returns.
To illustrate, consider the two-month continuously compounded return de-
ned as:
r
t
(2) = ln(1 +R
t
(2)) = ln
P
t
P
t2
= p
t
p
t2
.
Taking exponentials of both sides shows that
P
t
= P
t2
e
rt(2)
18 CHAPTER 1 RETURN CALCULATIONS
so that r
t
(2) is the continuously compounded growth rate of prices between
months t 2 and t. Using
P
t
P
t2
=
P
t
P
t1
P
t1
P
t2
and the fact that ln(x y) =
ln(x) + ln(y) it follows that
r
t
(2) = ln
P
t
P
t1
P
t1
P
t2
= ln
P
t
P
t1
+ ln
P
t1
P
t2
= r
t
+r
t1
.
Hence the continuously compounded two-month return is just the sum of
the two continuously compounded one-month returns. Recall, with simple
returns the two-month return is a multiplicative (geometric) sum of two one-
month returns.
Example 16 Compute two-month continuously compounded returns.
Using the data from Example 2, the continuously compounded two-month
return on Microsoft stock can be computed in two equivalent ways. The rst
way uses the dierence in the logs of P
t
and P
t2
:
r
t
(2) = ln(90) ln(80) = 4.4998 4.3820 = 0.1178.
The second way uses the sumof the two continuously compounded one-month
returns. Here r
t
= ln(90) ln(85) = 0.0571 and r
t1
= ln(85) ln(80) =
0.0607 so that
r
t
(2) = 0.0571 + 0.0607 = 0.1178.
Notice that r
t
(2) = 0.1178 < R
t
(2) = 0.1250
The continuously compounded kmonth return is dened by
r
t
(k) = ln(1 +R
t
(k)) = ln
P
t
P
tk
= p
t
p
tk
.
Using similar manipulations to the ones used for the continuously com-
pounded two-month return, we can express the continuously compounded
kmonth return as the sum of k continuously compounded monthly returns:
r
t
(k) =
k1
X
j=0
r
tj
. (1.20)
The additivity of continuously compounded returns to form multiperiod re-
turns is an important property for statistical modeling purposes.
1.2 ASSET RETURN CALCULATIONS 19
Portfolio Returns
The continuously compounded portfolio return is dened by (1.18), where
R
t
is computed using the portfolio return (1.11). However, notice that
r
p,t
= ln(1 +R
p,t
) = ln(1 +
n
X
i=1
x
i
R
i,t
) 6=
n
X
i=1
x
i
r
i,t
, (1.21)
where r
i,t
denotes the continuously compounded one-period return on asset
i. If the portfolio return R
p,t
=
P
n
i=1
x
i
R
i,t
is not too large then r
p,t
R
p,t
otherwise, R
p,t
> r
p,t
.
Example 17 Compute continuously compounded portfolio returns
Consider a portfolio of Microsoft and Starbucks stock with x
msft
= 0.25,
x
sbux
= 0.75, R
msft,t
= 0.0588, R
sbux,t
= 0.0503 and R
p,t
= 0.0356. Using
(1.21), the continuous compounded portfolio return is
r
p,t
= ln(1 0.0356) = ln(0.9645) = 0.0359.
Using r
msft,t
= ln(1+0.0588) = 0.0572 and r
sbux,t
= ln(10.0503) = 0.0690,
notice that
x
msft
r
msft
+x
sbux
r
sbux
= 0.0375 6= r
p,t
3
Show formula from Campbell, Lo and MacKinlay.
20 CHAPTER 1 RETURN CALCULATIONS
Adjusting for Ination
Adjusting continuously compounded nominal returns for ination is particu-
larly simple. The continuously compounded one-period real return is dened
as:
r
Real
t
= ln(1 +R
Real
t
). (1.22)
Using (1.15), it follows that
r
Real
t
= ln
P
t
P
t1
CPI
t1
CPI
t
(1.23)
= ln
P
t
P
t1
+ ln
CPI
t1
CPI
t
= ln(P
t
) ln(P
t1
) + ln(CPI
t1
) ln(CPI
t
)
= ln(P
t
) ln(P
t1
) (ln(CPI
t
) ln(CPI
t1
))
= r
t
c
t
,
where r
t
= ln(P
t
) ln(P
t1
) = ln(1 + R
t
) is the nominal continuously com-
pounded one-period return and
c
t
= ln(CPI
t
) ln(CPI
t1
) = ln(1 +
t
)
is the one-period continuously compounded growth rate in the general price
level (continuously compounded one-period ination rate). Hence, the real
continuously compounded return is simply the nominal continuously com-
pounded return minus the the continuously compounded ination rate.
Example 19 Compute continuously compounded real return
From example 10, the nominal simple return is R
t
= 0.0588, the monthly
ination rate is
t
= 0.01, and the real simple return is R
Real
t
= 0.0483.
Using (1.22), the real continuously compounded return is
r
Real
t
= ln(1 +R
Real
t
) = ln(1.0483) = 0.047.
Equivalently, using (1.23) the real return may also be computed as
r
Real
t
= r
t
c
t
= ln(1.0588) ln(1.01) = 0.047.