Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
CHAPTER 5
Risk and Return
Kind Reminders
Mid-term exam: Oct. 10
th
, 7:00pm am to 9:00pm.
The exam will cover lecture notes 1 to 5.
Those who can not attend the mid-term exam have to send
the TA an email to state your reason of missing the mid-
term exam.
The simulation trading game will start from this Monday.
HW#3 is uploaded to Moodle. It will be graded. Please put
some effort on solving those problems. You will benefit in the
mid-term exam.
5-2
Outline
Inflation, real rate of interest, nominal rates of interest
Rate of returns:
HPR (single-period return)
Multiple-period average return: Arithmetic average return vs. Geometric
average return
Conventions to annualize returns:
APR vs. EAR
Scenario analysis: expected return and standard deviation
Sharpe ratio
Asset allocation across risky and risk-free portfolios
Capital allocation line(CAL), Capital market line(CML)
5-3
5-4
Interest Rate Determinants
Supply
Supply of funds from savers, primarily households
Demand
The demand for funds from businesses to be used to finance
investments in plant, equipment, and inventories
Governments Net Supply and/or Demand
Central Banks (e.g. Federal Reserves) Actions
5-5
Real and Nominal Rates of Interest
Nominal interest rate: Growth rate of your money
Real interest rate: Growth rate of your purchasing power
The consumer price index(CPI) measures purchasing power by averaging
the prices of goods and services in the consumption basket.
Inflation rate is the percentage change in the CPI
Let R = nominal rate, r = real rate and I = inflation rate. Then:
i R r ~
i
i R
r
i
R
r
+

=
+
+
= +
1 1
1
1
Approximately:
5-6
Example 1
Over the past year you earned a nominal rate of interest of 8
percent on your money.
The inflation rate was 4 percent over the same period.
The exact actual growth rate of your purchasing power
was___?
A. 15.5%.
B. 10.0%.
C. 3.8%.
D. 4.8%.
E. 15.0%.
r = (1 + R)/(1 + i) 1
r = (1+8%)/(1+4%)-1 = 1.08%/1.04% 1 = 3.8%.
5-7
Example 2
A year ago, you invested $1,000 in a savings account
that pays an annual interest rate of 7%.
What is your approximate annual real rate of return if
the rate of inflation was 3% over the year?
A. 4%.
B. 10%.
C. 7%.
D. 3%.
E. 6%.
r = R-I = 7% 3% = 4%.
5-8
Equilibrium Real Rate of Interest
Determined by three basic factors:
Supply
Demand
Government actions
The nominal interest rate is determined by:
The real rate
Expected rate of inflation
5-9
Figure 5.1 Determination of the Equilibrium Real
Rate of Interest
5-10
Equilibrium Nominal Rate of Interest
The real rate of return is approximately equal to the
nominal rate minus the inflation rate.
Investors should be concerned with their real returns.
As the inflation rate increases, investors will demand
higher nominal rates of return on their investments.
If E(i) denotes current expectations of inflation, then we
get the Fisher Equation (1930):
Nominal rate = real rate + inflation forecast
( ) R r E i = +
5-11
Example: Fisher Equation
Suppose the real interest rate is 3% per
year and the expected inflation rate is 8%.
What is the nominal interest rate?
Suppose the expected inflation rate rises
to 10%, but the real rate is unchanged.
What happens to the nominal interest
rate?
Taxes and the Real Rate of Interest
5-12
Tax liabilities are based on nominal income
Given a tax rate (t) and nominal interest rate (R), i is the inflation
rate, the Real after-tax rate is:
The after-tax real rate of return falls as the
inflation rate rises.
(1 ) ( )(1 ) (1 ) R t i r i t i r t it = + =
5-13
Rates of Return for Different Holding Periods
100
( ) 1
( )
f
r T
P T
=
Consider an investor who seeks a safe investment,
for example, in U.S. Treasury securities.
Ex: Zero Coupon Treasury Bond, Par = $100,
T=maturity, P=price, r
f
(T) = total risk free return
Risk-free Return = the rate of return that can be
earned with certainty. E.g. return on a one-month
Treasury bill.
5-14
Example 5.2
5-15
Conventions to annualize the total return
How should we compare the returns on investments with
different horizons?
This requires that we express each total return as a rate
for a common period.
EAR VS. APR
5-16
EAR VS. APR
Effective Annual Rate(EAR): percentage increase in funds
invested over a 1-year horizon
Annual Percentage Return(APR): annualizing using
simple interest
( ) | |
( )
T
EAR
APR
T APR T r
T
T
f
EAR
1 1
) * 1 ( 1
] 1 [
+
= ==>
+ = = +
+
( ) | |
( ) | |
T
f
T
f
T r EAR
T r
EAR
1
1 1
1
] 1 [
+ = + ==>
= +
+
5-17
1. Quarterly return = 10%
which return is higher?
2. Monthly return = 3.3%

`
)
not comparable, convert to annual returns
Two methods to convert to annual returns:
Annual Percentage Rate (APR) = Per-period rate Periods per year
1
2
APR 10% 4 quarters
APR 3.3% 12 months 39.6%
40% = =

= =

Effective Annual Rate (EAR) = (1 + Per-period rate)

Periods per year
- 1
( )
( )
4
1
12
2
EAR 1 10% 1 46.41%
EAR 1 3.3 . 1 7 % % 4 64

= + =

= + =

If I tell you the quarterly return is quoted as APR = 40%, can you compute
EAR?
APR
EAR 1 1
n
n
| |
= +
|
\ .
4
40%
1 1 46.41%
4
| |
= + =
|
\ .
Exercise:
T-bill current price = $9,900
Maturity is one month
Face value = $10,000
What are APR and EAR?
18
Conventions to annualize total return
( )
( )
12
1
12
2
APR 1.01% 12.12%
12.12%
1 EAR 1 1 1.01% 1.1282
12
EAR 1.01% 12
12
1 1 .82%

= =

| |
+ = + = + = ==>

|
\ .
= =

APR
APR
1 EAR 1
n
n
e
n

| |
+ = +
|
\ .
Continuous compounding when n:
% 01 . 1
900 , 9 $
900 , 9 $ 000 , 10 $
=

= return
5-19
Table 5.2 Statistics for T-Bill Rates, Inflation
Rates and Real Rates, 1926-2009
5-20
Figure 5.3 Interest Rates and Inflation, 1926-2009
5-21
Bills and Inflation, 1926-2009
Moderate inflation can offset most of the nominal gains
on low-risk investments.
In both halves of the sample, the real return was roughly
one-fifth the nominal return.
A dollar invested in T-bills from19262009 grew to
$20.52, but with a real value of only $1.69.
Negative correlation between real rate and inflation rate
(-0.96, 1926~1967; -0.44, 1968~2009)
the nominal rate responds less than 1:1 to changes in
expected inflation. {R = r + E(i)}
5-22
Rate of Return
Single-period return:
Holding period return
Multi-period average return:
Arithmetic average
Geometric average
5-23
Rates of Return: Single Period
Holding-period Return (HPR) : Rate of return over a
given investment period.
Example:
Current stock price = $100
The holding time period is one year (or one month, it
doesnt matter, as long as its a single-period model)
Cash dividend at the year end is $4
Year-end stock price = $110
( )
$110- $100 $4
HPR 10% 4% 14%
$100
+
= = + =
Geometric Average = The single per-period return that
gives the same cumulative performance as the
sequence of actual returns.
Quarter 1 Quarter 2 Quarter 3 Quarter 4
HPR 10% 25% -20% 25%
10 25 20 25
10%
4
AA
r
+ +
= =
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
4
1/ 4
1 0.10 1 0.25 1 0.20 1 0.25 1
1 0.10 1 0.25 1 0.20 1 0.25 1 8.29%
GA
GA
r
r
+ + + = +
= + + + = (

Multi-period average return
Arithmetic Average = The sum of returns in each
period divided by the number of periods.
5-25
Scenario Analysis
Devise a list of possible economic scenarios
Specify the likelihood (probability) of each scenario
Specify the HPR that will be realized in each scenario
Future Scenario Probability HPR(%)
1. Severe recession 0.05 -37
2. Mild recession 0.25 -11
3. Normal growth 0.40 14
4. Boom 0.30 30
5-26
Expected Return and Standard Deviation
Expected returns
p(s) = probability of a state
r(s) = return if a state occurs
s = state
( ) ( ) ( )
s
E r p s r s =

5-27
Scenario Returns: Example
State Prob. of State r in State
Excellent .25 0.3100
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200
E(r) = (.25)(.31) + (.45)(.14) + (.25)(-.0675)
+ (0.05)(-0.52)
E(r) = .0976 or 9.76%
5-28
Variance (VAR):
Variance and Standard Deviation
| |
2
2
( ) ( ) ( )
s
p s r s E r o =

2
o = STD
Standard Deviation (STD):
5-29
Scenario VAR and STD: Example
Example VAR calculation:

2
= .25(.31 - 0.0976)
2
+.45(.14 - .0976)
2
+ .25(-
0.0675 - 0.0976)
2
+ .05(-.52 - .0976)
2
= .038
Example STD calculation:
1949 .
038 .
=
= o
5-30
Risk Premium and Risk Aversion
Risk-free Rate = the rate of return that can be earned with certainty.
E.g. return on a one-month Treasury bill.
Risk Premium = Excess Return = an expected return in excess of
that on risk-free securities. E.g., if risk-free rate is 4% per year, the
expected index fund return is 10%, then the risk premium is
Risk Aversion = reluctance to accept risk, , need compensation.
Investors will not be willing to invest any money in stocks if the risk
premium is zero.
If we quantify the degree of risk aversion with the parameter A, it makes
sense that the risk premium is proportional to both the degree of risk
aversion (A) and the risk of the portfolio ( ):
( )
10 4 6%
p f
E r r = =
( )
2
p f p
E r r Ao
(


2
p
o
Example:
One-year forecast of S&P500 return = 10%
One-year T-bill rate = 5%
Standard deviation of recent S&P500 returns = 18%
What is the Sharpe ratio?
31
Sharpe Ratio (Reward-to-Volatility Ratio)
( )
Portfolio risk premium
Std.Dev. of portfolio excess return
p f
p
E r r
S
o

= =
( )
10 5
0.28
18
p f
p
E r r
S
o


= = =
32
Asset Allocation across risky and risk-free portfolios
Assume that the investor constructs a complete portfolio (denoted as C) by
allocating assets into two major security classes: a portfolio of risky assets denoted
as P, and a risk-free asset denoted as F. Within the risky portfolio, there are two
different risky assets 1 and 2.
Risk-free asset ( )
Complete portfolio ( ) Risky asset 1
Risky portfolio ( )
Risky asset 2
F
C
P

1
2
1 30%
100% 40%
=70%
60%
y
w
y
w
=

For now, we assume the portfolio weights, y, w

1
, w
2
, have already been chosen
optimally (focus of Chapter 6).
Assume the investor has an initial investment of $100 million dollars. He allocates
the money as follows:
( )
1 1
$30 Money market fund =2%, 0
$28 Vanguard's S&P 500 Index Fund =5%, 8% $100
$70
f f
r
E r
o
o

=
( )
2 2 1,2

$42 Fidelity's Investment Grade Bond Fund =10%, 12%, 10%% E r o o

= =

( )
1
2
1 =30%
100% 70% 0.4 28%
70%
70% 0.6 42%
y
yw
y
yw

= =

=

= =

Assume that we know the expected returns and standard deviations of each
security:
How do we compute the expected returns and standard deviations of the risky
portfolio and the complete portfolio: ?
( ) ( )
1 2 1 2 1,2
, , , , , ,
f f
E r E r r o o o o
( ) ( )
, , ,
P c P c
E r E r o o
Risk-free asset ( )
Complete portfolio ( ) Risky asset 1
Risky portfolio ( )
Risky asset 2
C
P
F

(1) For risky portfolio, P,

34
Portfolio Expected Return and Risk
( ) ( ) ( ) ( )
( ) ( )
1 1 2 2 1 1 2 2
1 1 2 2
2
1 1 2 2
0.4 5 0.6 1 8% 0
p
p
p p
E wr w r w E r w E r
r wr w r
Var r V wr
r
r
E
ar w o

= + = + = + =

= +

= = +

( ) ( ) ( )
( )
2 2
1 1 2 2 1 2 1 2
2 2 2 2
1 1 2 2 1 2 1,2
2 2 2
2
2 ,
2
.4 8 .6 12 2 .
7.
4 .6 10 57.28%%
57 5 28% 7% . %
p p
w Var r w Var r w w Cov r r
w w w w o o o
o o
= + +
= + +
= + + =
= = =
( )
( )
( )
1 1 1
2 2 2 1,2
1 30%( )
40% =5%, 8% we know: 100%( )
=70%
60% =10%, 12%, 10%%
y F
w E r C
y P
w E r
o
o o
=

= =

= = =

We can compute as follows:

( )
,
P P
E r o
(2) For complete portfolio, C,
35
Portfolio Expected Return and Risk
( )
( ) ( ) ( ) ( )
( ) ( )
2
1 1 0.7 8 0.3 2 6
1
2%
1
.
p f p f
c p f
c c p
c
f
E yr y r yE r y r
r yr y r
Var r Var yr
E r
y r o

( = + = + = + =

= +

( = = +

( ) ( ) ( ) ( ) ( )
( ) ( )
( ) ( )
2
2
2
2 2 2
,
2
2 2
2 2
2 2
1 2 1 ,
1 2 1
1 0 2 1 0
.7 7. 5. 7 3% 5
p f p f
p f
c
p f
p
p
p p
y Var r y Var r y y Cov r r
y y y y
y y y y
y
y y
o o o
o
o
o o o
= + +
= + +
= + +
=
= = = =
We can compute as follows:
( )
,
c c
E r o
( ) ( )
1 30%( ) =2%, 0
we know: 100%( )
=70 8%, 7 57% % .
f f
p p
E
y F r
C
y r P
o
o
=
=

Capital allocation line (CAL): Plot of risk-return combinations by

varying y.
Capital Allocation Line
0 2 4 6 8 1 0
0
2
4
6
8
1 0
7 . 5 7 - 0 = 7 . 5 7 %
5 . 3 - 0 = 5 . 3 %
6 . 2 - 2 = 4 . 2 %
r
f
= 2 %
o
f
= 0
E ( r
c
) = 6 . 2 %
o
c
= 5 . 3 %
o
E ( r )
E ( r
p
) = 8 %
o
P
= 7 . 5 7 %
8 - 2 = 6 %
0.7 y =
1 y =
0 y =
Note:
4.2%
0.7
6%
=
5.3%
Note: 0.7
7.57%
=
( ) ( ) ( ) ( ) ( )
1
c p f c f p f
E r yE r y r E r r y E r r
(
= + =

6.2% 2% 4.2%
0.7
8% 2% 6%

= = =

( )
( )
c f
p f
E r r
y
E r r

5.3%
0.7
7.57%
c p
y o o = = =
c
p
y
o
o
=
If you have a target return, E(r
c
)=6.2%, how much money should you
allocate to the risky portfolio?
If you have a target risk,
c
=5.3%, how much money should you allocate to
the risky portfolio?
The slope of the CAL is Sharpe ratio:
( )
p f
p
E r r
S
o

=
8% 2%
0.79
7.57%

= =
( )
?
c f
c
E r r
S
o

=
37
Individual investors with different levels of risk aversion will pick different
points along the CAL:
Risk-averse investor: pick a portfolio close to F, , more risk-free
asset.
Risk-tolerant investor: pick a portfolio close to P, , more risky
asset.
Risk lover: pick a portfolio to the right of point P along the CAL, .
The investor is taking a leverage position. After investing all money into
risky portfolio, he borrows additional money at from bank and
invests that money in risky portfolios.
0 y
1 y
1 y >
f
r
Example: Leverage

5-39
( ) ( )
c f P f
E r r y E r r
(
= +

2 2 2
C P
y o o =
Capital Market Line
The CAL is derived with the risk-free and the risky portfolio.
Determination of the assets to include in risky portfolio may
result from a passive and an active strategy.
A passive strategy describes a portfolio decision that avoids
any direct or indirect securities analysis.
A natural candidate for a passively held risky asset would be
a well-diversified portfolio of common stocks such as the
S&P 500.
5-40
Capital Market Line
The capital market line (CML) = the capital allocation line
formed from 1-month T-bills and a broad index of common
stocks (e.g. the S&P 500).
CML = The Capital Allocation Line (CAL) using the market
index portfolio as the risky asset.
From 1926 to 2009, the passive risky portfolio offered an
average risk premium of 7.9% with a standard deviation of
20.8%, resulting in a reward-to-volatility ratio of .38.
5-41
Exercise 1
5-42
You purchase a share of Boeing stock for $90. One year
later, after receiving a dividend of $3, you sell the stock
for $92. What was your holding-period return?
A. 4.44%
B. 2.22%
C. 3.33%
D. 5.56%
E. 5.91%
HPR = (92 90 + 3)/90 = 5.56%
Exercise 2
5-43
If a portfolio had a return of 12%, the risk free asset return
was 4%, and the standard deviation of the portfolio's excess
returns was 25%, the risk premium would be _____.
A. 8%
B. 16%
C. 37%
D. 21%
E. 29%
12 4 = 8%.
Exercise 3
5-44
If a portfolio had a return of 15%, the risk free asset return
was 5%, and the standard deviation of the portfolio's excess
returns was 30%, the Sharpe measure would be _____.
A. 0.20
B. 0.35
C. 0.45
D. 0.33
E. 0.25
(15 5)/30 = 0.33
Exercise 4
5-45
An investment provides a 2% return semi-annually, its
effective annual rate (EAR) is
A. 2%.
B. 4%.
C. 4.02%.
D. 4.04%.
E. 4.53%.
EAR = (1+2%)
2
1= (1.02)
2
1 = 4.04%
Exercise 5
5-46
You have been given this probability distribution for the
holding-period return for a stock:
What is the expected holding-period return for the stock?
HPR = .40 (22%) + .35 (11%) + .25 (9%) = 10.4%
Exercise 5
5-47
You have been given this probability distribution for the
holding-period return for a stock:
What is the expected variance for the stock?
Variance = [.40 *(22 10.4)
2
+ .35* (11 10.4)
2
+ .25* (9 10.4)
2
] =
148.04%
What is the expected standard deviation for the stock?
SD = [Variance]
1/2
= [148.04%]
1/2
= 12.167%
Exercise 6
5-48
An investor invests 30 percent of his wealth in a risky asset
with an expected rate of return of 0.15 and a variance of 0.04
and 70 percent in a T-bill that pays 6 percent.
His portfolio's expected return and standard deviation are
__________ and __________, respectively.
A. 0.114; 0.12
B. 0.087; 0.06
C. 0.295; 0.12
D. 0.087; 0.12
E(r
P
) = 6%+0.3*(15%-6%)=0.3(15%) + 0.7(6%) = 8.7%;
sd
P
= 0.3(0.04)
1/2
= 6%.