Learning Module 2: Risk & Return Measurement: Portfolio Management

LEARNING MODULE 2:
RISK & RETURN

MEASUREMENT
Portfolio Management
Overview
◦ Interest rate determinants
◦ Rates of return for different holding periods
◦ Risk and risk premiums
◦ Estimations of return and risk
◦ Normal distribution
◦ Deviation from normality and risk estimation
◦ Historic returns on risky portfolios
RISK & RETURN
MEASUREMENT
Interest Rate Determinants
◦ Supply
◦ Households
◦ Demand
◦ Businesses
◦ Government’s net demand
◦ RBA / Fed actions
Real versus Nominal Interest Rates
rnom  Nominal Interest Rate
rreal  Real Interest Rate
i  Inflation Rate Note : rreal  rnom  i
rnom  i
rreal 
1 i
◦ As the inflation rate increases, investors will demand higher nominal rates of return
◦ If E(i) denotes current expectations of inflation, then we get the Fisher Equation:
rnom  rreal  E  i 
Rates of Return for Different
Holding Periods
◦ Zero Coupon Bond:
◦ Par = $100
◦ Maturity = T
◦ Price = P
◦ Total risk free return
100
rf (T )  1
P(T )
Effective Annual Rate (EAR) and
Annual Percentage Rate (APR) 1
◦ Effective Annual Rate (EAR) [1]: 1  EAR  1  rf  T   T
◦ Compare returns on investments with different horizons.
 1  EAR   1
T
APR 
◦ Annualized Percentage Rate (APR) [2]:
T
◦ For [1]: (1+EAR)^T = 1+rf(T) => (1+EAR)^T – 1 = rf(T) => APR = rf(T) / T => [2]
T-Bill Rates, Inflation Rates, and Real Rates, 1926-2015
Moderate i offsets most nominal gains on low-risk investments

$1 in T-bills from 1926–2015 grew to $20.25 but with a real
value of only $1.55, due to inflation
Negative correlation between rreal and i  rnom doesn’t fully
compensate investors for increases in i.
Risk and Risk Premiums
◦ Rates of return: Single period
E ( P1)  P 0  E ( D1)
HPR 
P0
◦ HPR = Holding period return
◦ P0 = Beginning price
◦ E(P1) = Expected Ending price
◦ E(D1) = Expected Dividend during period one
◦ (Could replace this with coupon payment if looking at bonds)
Example: Single Period Rates of Return
Expected Ending Price = $110
Beginning Price = $100
Expected Dividend = $4
E ( P1)  P 0  E ( D1) $110  $100  $4
HPR  
P0 $100
$110  $100 $4
 
$100 $100
 10%  4%  14% Holding Period Return
Capital Gains Yield Dividend Yield

Expected Return and Standard Deviation
◦ Expected returns
◦ p(s) = Probability of a state
E (r )   p( s)  r ( s)
◦ r(s) = Return if a state occurs s
◦ s = State
   p  s    r  s   E  r  
2 2
◦ Variance (VAR):
s
◦ Standard Deviation (STD): STD   2

Example: Returns and Standard Deviation
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%
 2  .25  (.31  0.0976) 2  .45  (.14  .0976) 2 σ  .038
.25  (0.0675  0.0976)2  .05  (.52  .0976) 2
 .1949
 .038
Returns Using Arithmetic and
Geometric Averaging
n n
1
E (r )   p( s)r ( s)   r ( s)
◦ Arithmetic Average
n s 1 s 1
◦ Geometric (Time-Weighted) Average

◦ Terminal value of the investment:
TVn  (1  r1 )(1  r2 )...(1  rn )
◦ Geometric Average:
g  TVn1/ n  1
Estimating
Variance and Standard Deviation
◦ Estimated Variance
◦ Expected value of squared deviations
n
1
ˆ    r  s   r 
2 2
n s 1
r is sample average, not the true population’s average: thus to reduce the bias, we have
◦ Unbiased estimated standard deviation n 2
1
ˆ   r s  r 
n  1 j 1
The Normal Distribution
◦ Investment management is easier with normal returns:
◦ Symmetric Returns  Standard deviation is a good measure of risk
◦ Symmetric Returns  Portfolio returns will be as well
◦ Only mean and standard deviation needed to estimate future scenarios
◦ Pairwise correlation coefficients summarize the dependence of returns
across securities
Normality and Risk Measures
◦ What if excess returns are not normally distributed?
◦ STD is no longer a complete measure of risk
◦ Skewness:  ( R  R )3 
Skew  Average  
 ˆ
3

 ( R  R )4 
Kurtosis  Average   3
 ˆ 4

◦ Kurtosis:
Skewness in picture
Kurtosis in picture
Normal and Skewed Distributions : application of
skewness
Mean = 6%
STD = 17%
Normal and Fat-Tailed Distributions: application of
kurtosis
Mean = 10%
STD = 20%
Historic Returns on Risky Portfolios
Historic Returns on Risky Portfolios
◦ The second half of the 20th century offered the highest average returns
◦ Firm capitalization is highly skewed to the right: Many small but a few gigantic firms
◦ Average realized returns have generally been higher for small stocks vs. large stocks
◦ Normal distribution is generally a good approximation of returns

◦ VaR indicates no greater tail risk than equivalent normal
◦ ES ≤ 0.41 of monthly SD  no evidence against normality
◦ However
◦ Negative skew is present in some portfolios some of the time
◦ Positive kurtosis is present in all portfolios all the time
Average “Excess” Returns Around the
World: 1900-2015

Learning Module 2: Risk & Return Measurement: Portfolio Management

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LEARNING MODULE 2:

RISK & RETURN

Moderate i offsets most nominal gains on low-risk investments

Capital Gains Yield Dividend Yield

◦ Standard Deviation (STD): STD   2

◦ Geometric (Time-Weighted) Average

◦ Normal distribution is generally a good approximation of returns

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