Investment Analysis and Portfolio

Management
Instructor: Attila Odabasi

Introduction to Risk, Return, and

the Historical Record on T-bills
and US equity
Ref Ch 5, BKM

Learning Objectives
Time Value of Money Review
How to calculate the return on an investment using
different methods.
The historical returns on various important types of
investments.
The historical risks of various important types of
investments.
The relationship between risk and return.
1-2

The Time Value of Money

Future Value:
$V invested for n years at simple interest rate r
per year
Compounding of interest occurs at the end of
year
FVt = $V * (1+r)t
where FVt is future value after t years
5-3

The Time Value of Money

Example: Consider putting $1000 in an
interest checking account that pays a simple
annual percentage rate of 3%. The future
value after t = 1, 5, 10 years is, respectively,
FV1 = $1000 * (1.03)1 = $1030,

FV5 = $1000 * (1.03)5 = $1159.27,

FV10 = $1000 * (1.03)10 = $1343.92

5-4

TVM
FV function is a relationship between four
variables: FVn, V, r, t. Given three variables, you
can solve for the fourth:
FVt
Present Value
V
(1 r ) t

Compound annual return

Investment horizon

FVt
r

V
t

1/ t

ln( FVt / V )
ln(1 r )

5-5

Compounding occurs m times per year

FVt

r mt
$V (1 ) ,
m

r
periodic return
m

Continuous compounding:
r mt
FVt lim $V (1 ) $Ve r t
m
m
where e1 2.71828

5-6

Example
If the simple annual percentage rate is 10% then
the value of $1000 at the end of one year (t =1)
for different values of m is given in the table
below.
Compounding

Value of $1000 at end of

Frequency

1 year (r = 10%)

Annually (m = 1)

1100.00

Quarterly (m = 4)

1103.81

Weekly (m = 52)

1105.06

Daily (m = 365)

1105.16

Continuously (m = )

1105.17
5-7

Quoting Rates of Return

Annual Percentage Return (or Simple Annual Return)
can be translated to an effective annual rate (EAR) by:
APR

$V (1 EAR) $V 1

APR
1 EAR 1

APR

EAR 1

Note that APR or a given EAR:

APR

1 EAR
m

APR

1/ m
1

(1 EAR)
m

APR m[(1 EAR)1 / m 1]

5-8

Continuous Compounding
EAR of APR with continuous compounding:
(1 EAR ) e APR
EAR e APR 1
or equivalently
APR ln(1 EAR)

Example: The effective annual rate associated with

continuously compounded (m=) APR= 10% is
determined by:
EAR e 0.10 1 1.10517 1
EAR 0.10517
EAR 10.517%
5-9

Measuring Past Returns

One period investment:
Holding Period Percentage Return (HPR):
HPR= r1 = P1 P0 + D1
P0

P0 = Beginning price (or, PV)

P1 = Ending price (or, FV)

D1 = Dividend (cash flow) during period

Q: Why use % returns at all?
Q: What are we assuming about the cash flows in the
HPR calculation?
10

Measuring Past Returns

HPR defined as:
r1 = P1 P0 + D1 = (P1+D1) - 1

P0

P0

Then we can define gross return:

(1 + r1) = (P1+D1) / P0

11

Annualizing HPRs (n > 1 year)

Q: Why would you want to annualize returns?
1. Annualizing HPRs for holding periods of greater
than one year:

Without compounding (Simple or APR):

HPRann = HPR / n

With compounding: EAR

HPRann = [(1+HPR)1/n]-1
where n = number of years held

Ex:Annualizing Ex-Post (Past) Returns

Example: Suppose that the price of Microsoft stock 24
months ago is Pt-24 = $50 and the price today is Pt = $90.

The two year gross return is:

1+rt(2) = 90/50 = 1.80

The two-year net return is: rt(2) = 0.80 = 80%.

The annual return for this investment:
HPRann = 0.80/2 = 0.40 or 40% Annualized w/out comp
The annual HPR assuming annual compounding is (n=2):
HPRann = (1+0.80)1/2 - 1 = 1.3416 1= 0.3416 or 34.16%
5-13

Annualizing Past Returns (n<1y)

Annualizing HPRs for holding periods of less than one year:

Simple annual return: HPRann = HPR x n

Compounded annual return: HPRann = [(1+HPR)n]-1

where n = number of compounding periods per year

Ex: Annualizing past returns (n < 1y)

You buy 200 shares of Lowes Companies, Inc. at $48
per share. Three months later, you sell these shares
for $51 per share. You received no dividends. What is
your return? What is your annualized return?
Return: (Pt+1 Pt) / Pt = ($51 - $48) / $48 = 0.0625 or
6.25% for 3 months
Without: n=12/3= 4 so HPann=HPRxn= 0.0625x4=0.25
With: HPRann = (1.06254) - 1 = 0.2744

Q: Why is the compound return greater than the simple

return?

1-15

Multi-period vs One-period Returns

Simple two - month return (ignoring dividends)
Pt Pt 2
Pt
rt (2)

1
Pt 2
Pt 2
Relationship to one - month returns
P P
rt (2) t t 1 1 (1 rt )(1 rt 1 ) 1
Pt 1 Pt 2
1 rt (2) (1 rt )(1 rt 1 ) 1 rt rt 1 rt rt 1
rt (2) rt rt 1 rt rt 1
two - month gross return the product of two one - month gross returns
Single - period simple returns are not additive

5-16

Ex: Multi-period vs One-period Returns

Suppose the price of Msoft stock in month t-2 is $80,
$85 in t-1, and $90 at t. No dividends paid between t-2
and t. The two - month net return :
90 80 90
rt ( 2)

1 1.125 1 0.125
80
80
The two one - month returns are :
85 80
rt 1
1.0625 1 0.0625
80
90 85
rt
1.0588 1 0.058823
85
The two - month gross return is equal to :
1 rt (2) (1 rt )(1 rt 1 ) 1.0625 1.058823 1.1250
The two - month siple return is not equal to :
rt ( 2) (rt rt 1 ) 0.1250 0.0588 5-17
0.0625

Averages of Multi-period Returns

You invested on Msoft stock at $80 two months ago, and the terminal value in t
is $90.
What is the arithmetic average of monthly returns over two months?
r (rt 1 rt ) (0.058823 0.0625) / 2 0.0606615
What is the geometric (actual) average return over two months?
The single per - period return that would give the same cumulative performance
over the investment horizon :
rg (1 rt 1 )(1 rt ) (1 rg ) n
rg n (1 rt 1 )(1 rt ) 1 (1 rt (2))1 / n 1 (1.125)1 / 2 1 0.0606601

18

Arithmetic vs Geometric Average Returns

Arithmetic and geometric average returns will give
different values for the returns over some evaluation
period.
Arithmetic average return: the amount invested is
assumed to be maintained at the initial market value
The geometric average return: it is a return on an
investment that varies in size because of the assumption
that all proceeds are reinvested.

19

Measuring Ex-Post (Past) Returns

Q: When should you use the GAR and when should you

use the AAR?

A1: When you are evaluating PAST RESULTS (ex-post):
Use the AAR (average without compounding) if you ARE NOT
reinvesting any cash flows received before the end of the period.
Use the GAR (average with compounding) if you
are reinvesting any cash flows received before the end of the
period.

A2: When you are trying to estimate an expected return

(ex-ante return):

Use the AAR

Continuously Compounded (cc) Returns

Let rt = simple monthly (or daily) return on an
investment
Corresponding continuously compounded
monthly return (rcc) :
e

r cc

cc

1 rt
Pt
ln(1 rt ) ln(
)
Pt 1
r cc

also given e we can calculate rt :

e

r cc

1 rt
5-21

Example: Compute cc return

Let Pt-1 = 85, Pt = 90 then simple return is
0.0588.
The cc monthly return can be computed as:
rcc = ln(1.0588) = 0.0571
rcc = ln(90) ln(85) = 4.4998 4.4427 = 0.0571
Notice that cc return is slightly smaller than
simple return.
Notice also: rt = ercc 1 = e0.0571 1 = 0.0588
5-22

r t=

Multi-period cc Returns
Pt
r (2) ln(1 rt (2)) ln
Pt 2

cc

r cc (2) ln( Pt ) ln( Pt 2 )

r cc (2) cc growth rate in prices between months t - 2 and t
cc returns are additive :
Pt Pt 1

rt (2) ln

Pt 1 Pt 2
cc

Pt
P
ln t 1
Pt 1
Pt 2
rtcc (2) rtcc rtcc1
rtcc (2) ln

This is the main difference between simple and cc returns.

5-23

Ex: Multi and one-period cc returns

Suppose Pt-2= 80, Pt-1= 85, Pt= 90. The cc twomonth return can be computed in two equivalent
ways:
1) Take difference in log prices:
r2cc (2) ln(90) ln(80) 4.4998 4.3820 0.1178

2) Sum the two cc one-month returns:

rtcc ln(90) ln(85) 0.0571
rtcc1 ln(85) ln(80) 0.0607
rtcc (2) 0.0571 0.0607 0.1178

5-24

Adjusting for Inflation

The computation of real returns on an asset:

Deflate the nominal price Pt of the asset by an index of

the general price level CPIt
Compute returns in the usual way using the deflated
prices For ex : P Re al Pt
t

rt

Re al

CPI t

al
Pt Re al Pt Re
1

al
Pt Re
1

Pt
P
t 1
CPI t CPI t 1
P CPI t 1

t
1
Pt 1
Pt 1 CPI t
CPI t 1

Alternatively, define inflation as

CPI t CPI t 1
t
CPI t 1
rt Re al

1 rt
1
1 t

5-25

Ex: Adjusting for Inflation

Consider a one-month investment in Msoft
stock. Suppose the CPI in months t-1 and t is 1
and 1.01, respectively. The real prices of the
stock are:

85
90
Re al
P

85, Pt

89.1089
1
1.01
and the real monthly return is
89.1089 85
Re al
rt

0.0483
85
Re al
t 1

5-26

Ex: Adjusting for Inflation

The nominal return and inflation over the month

90 85
1.01 1
rt
0.0588, t
0.01
85
1
Then the real return is
1.0588
Re al
rt

1 0.0483
1.01
Notice that simple real return is almost, but not quite
equal to the simple nominal return minus the inflation rate
rt Re al rt t 0.0588 0.01 0.0488

5-27

Ex: Adjusting for Inflation

Suppose you buy a 0-coupon T-Bond maturing in
20 years, priced to yield 12%
Price = $1000/(1.12)20 = $103.67
If the CPI is 1.00 today and 2.65 in 20 years,
what is your Real rate of return?
r

Re al

Pt k CPI t
1000
1
20

1 20 3.639997 1 0.0667
Pt CPI t k
103.67 2.65

28

Ex-Ante Return Estimation

Some asset classes are called risky. They offer a
risk premium over risk-free assets.
These assets involve some degree of uncertainty
about future holding-period returns.
We have to estimate these future holding period
returns and related uncertainty.
How?
29

Expected Return & Std; Scenario

Analysis
Purchase
Price

100

T-bill Rate

0.04

State of the
market
Excellent
Good
Poor
Crash

Expected
Value
Variance of
HPR
Std of HPR
Risk
Premium

Cash
Dividen
Prob Y-E Price d
0.25 126.50
4.50
0.45 110.00
4.00
0.25
89.75
3.50
0.05
46.00
2.00

Squared
Sqrd
Deviations Deviation
Deviation
from the
s from
Excess s from
HPR mean
Mean
Returns Mean
0.3100
0.2124
0.0451 0.2700
0.0729
0.1400
0.0424
0.0018 0.1000
0.0100
-0.0675
-0.1651
0.0273 -0.1075
0.0116
-0.5200
-0.6176
0.3815 -0.5600
0.3136
<-{=SUMPRODUCT(B5:B8,E5:E8)
0.0976 }
<-{=SUMPRODUCT(B5:B8,G5:G8
0.0380 )}
0.1949<-- =SQRT(E11)
<-{=SUMPRODUCT(B5:B8,H5:H8
5-30
0.0576 )}

Time Series Analysis of Past Returns

Period
2000
2001
2002
2003
2004
2005

Implicitly
Assumed
Prob = 1/5
0.2
0.2
0.2
0.2
0.2

100.000
88.110
68.638
88.330
97.940
102.749

HPR
(decimal)
-0.1189
-0.2210
0.2869
0.1088
0.0491

Squared
Deviation
0.0196
0.0586
0.0707
0.0077
0.0008

Gross
HPR=
1 + HPR
0.8811
0.7790
1.2869
1.1088
1.0491

Wealth
Index
100.000
88.110
68.638
88.330
97.940
102.749

Arithmetic
Average

<-0.0210 =AVERAGE(D4:D8)

Expected Value
Standard
Deviation
Standard
Deviation

0.0210<-- =SUMPRODUCT(B4:B8,D4:D8)
<-0.1774 =SUMPRODUCT(B4:B8,E4:E8)^0.5

Geometric Average Return

Geometric Average Return

0.1774<-- =STDEV.P(D4:D8)
<-0.0054 =GEOMEAN(F4:F8)-1
0.0054<-- =((G8/G3)^0.2)-1
5-31

Using Ex-Post Returns to estimate

Expected HPR

Estimating Expected HPR (E[r]) from ex-post data.

Use the arithmetic average of past returns as a forecast
of expected future returns as we did and,
Perhaps apply some (usually ad-hoc) adjustment to past
returns
Problems?

Which historical time period?

Have to adjust for current economic
situation

The Normal Distribution

We assume that (past) returns are distributed
normally!
Normal distribution: A symmetric, bell-shaped
frequency distribution that can be described with only
an average and a standard deviation.
Mean: Average return
Variance is a common measure of return dispersion.
Standard deviation is the square root of the variance.
Standard Deviation is handy because it is in the same
"units" as the average.
Standard Deviation is a good measure of risk
when returns are symmetric around the mean.
If security returns are symmetric, portfolio returns will
be, too.
1-33

Figure 5.4 The Normal Distribution

5-34

Characteristics of Probability
Distributions
1. Mean: __________________________________
_
Arithmetic average & usually most likely
2. Median: _________________
Middle observation
3. Variance or standard deviation:
Dispersion of returns about the mean

4. Skewness:_______________________________
Long tailed distribution, either side
5. Leptokurtosis: ______________________________
Too many observations in the tails

If a distribution is approximately normal, the distribution

Characteristics 1 and 3
is fully described by _____________________

Given Historical Returns

Expected Return:
n

Historical Average Return

yearly return
i1

1-36

Return Variability: The Statistical

Tools

The formula for return variance is ("n" is the number of returns):

N

VAR(r) 2

i
i 1

N 1

Sometimes, it is useful to use the standard deviation, which is

related to variance like this:
SD(r) VAR(r)

1-37

Skew and Kurtosis

Skew

Kurtosis

Equation 5.19

Equation 5.20

r r

skew average
^

r r
kurtosis average ^

5-38

Skewed Distribution: Large Negative

Returns (Left Skewed)
Implication?

r = average

is an incomplete
risk measure

Median

Negative

Positive

Skewed Distribution: Large Positive

Returns (Right Skewed)
r = average

Median

Negative

Positive

Implication?

Leptokurtosis

is an incomplete risk
measure

Value at Risk (VaR)

Value at Risk attempts to answer the following question:
How many dollars can I expect to lose on my portfolio in
a given time period at a given level of probability?
The typical probability used is 5%.
We need to know what HPR corresponds to a 5%
probability.
If returns are normally distributed then we can use a
standard normal table or Excel to determine how many
standard deviations below the mean represents a 5%
probability:
From Excel: =Norminv (0.05,0,1) = -1.64485 standard
deviations

Value at Risk (VaR)

From the standard deviation we can find the corresponding
level of the portfolio return:
VaR = E[r] + -1.64485
For Example:
A $500,000 stock portfolio has an annual expected return
of 12% and a standard deviation of 35%.
What is the portfolio VaR at a 5% probability level?
VaR = 0.12 + (-1.64485 * 0.35)
VaR = -45.57% (rounded slightly)
VaR$ = $500,000 x -.4557 = -$227,850
What does this number mean?

Value at Risk (VaR)

VaR versus standard deviation:
For normally distributed returns VaR is equivalent to
standard deviation (although VaR is typically reported in
dollars rather than in % returns)
VaR adds value as a risk measure when return
distributions are not normally distributed.
Actual 5% probability level will differ from 1.68445
standard deviations from the mean due to kurtosis
and skewness.

Value at Risk (VaR)

Simple approach:
Assume we have 100 HPR observations not
necessrily normally distributed.
To obtain an estimate of VaR of this sample of
100 observations, rank the returns from highest
to lowest.
Find the 5th percentile:
........... -25% / -26% -30% -33% -35% -40%
45

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
(26% + 30% + 33% +35% +40%)/5=
32.8%
46

Risk Premium & Risk Aversion

The risk free rate is the rate of return that can be earned
with certainty.
The risk premium is the difference between the expected
return of a risky asset and the risk-free rate.
Excess Return or Risk Premiumasset = E[r ] rf
asset

Risk aversion is an investors reluctance to accept risk.

How is the aversion to accept risk overcome?
By offering investors a higher risk premium.

Frequency distributions of annual HPRs,

1926-2008, Historical Records

Rates of return on stocks, bonds and

bills, 1926-2008

Annual Holding Period Returns Statistics

1926-2008
Geom.
Series
World Stk
US Lg. Stk
Sm. Stk
World Bnd

Arith.

Excess

Mean% Mean% Return%

9.20
11.00
7.25
9.34

11.43

7.68

11.43

17.26

13.51

5.56

5.92

2.17

5.60

1.85

LT Bond
Geometric 5.31
mean:

Best measure of compound

T-Bill historical return over
3.75
the period
Arithmetic Mean:
Expected return, best estimate
for next years single-period
return

Sharpe
SD Kurt. Skew.
Ratio
18. 1.03 -0.16
0.396
28
20. -0.10 -0.26
0.371
67
0.81
37. 1.60
0.362
26
0.77
9.0 1.10
0.239
5
0.80
0.51
8.0
Deviations
from 0.231
1normality?
3.0
8

Deviations from Normality: Another Measure

Portfolio
World
Stock

US Small Stock US Large

Stock

Arithmetic Average

.1100

.1726

.1143

Geometric Average

.0920

.1143

.0934

Difference

.0180

.0483

.0209

Historical
Variance

.0186

.0694

.0214

If returns are normally distributed then the following

relationship among geometric and arithmetic averages holds:
Arithmetic Average Geometric Average = 2
The comparisons above indicate that US Small Stocks may
have deviations from normality and therefore VaR may be
an important risk measure for this class.

Sharpe Ratio (Reward-to-volatility)

Risk aversion implies that investors will accept a
higher return in exchange of a higher risk as
measured by the std of returns.
A statistic commonly used to rank assets in
terms of risk-return trade-off is the Sharpe
Measure:
Sharpe Ratio
SR

Risk Premium
SD of excess return

E[ri ] r f

ri r f

The higher the Sharpe ratio the better.

5-52

Historic Returns on Risky Portfolios

Observations:
Returns appear normally distributed
E(Geomean)=E(arith Mean) var
Except small stocks, equation is nearly satisfied.
Overall, no serious deviations from normality
observed.

Lesson: Risk and Return

The First Lesson: There is a reward, on average, for
bearing risk.
That is if we are willing to bear risk, then we can expect
to earn a risk premium, at least on average.
Second Lesson: Further, the more risk we are willing
to bear, the greater the expected risk premium.

1-54