Chap 5

Chapter 5
Saturday, March 2, 2024 10:16 AM
Holding-Period of Return Scenario An

Rate of return over a given investment period. Scenario An
𝑃! − 𝑃" + 𝐷𝐼𝑉 and the HP
𝐻𝑃𝑅 = = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 Expected re
𝑃"
*Assumption DIV is paid at the end of the holding period
*need to account for reinvestment income if DIV is received earlier
Arithmetic Average 𝐸(𝑟) = I
/
The sum of returns in each period divided by the number of periods.
!
Geometric Average 𝑟̅ = % ∑ 𝑟
The single per-period return that gives the same cumulative performance as
the sequence of actual returns. 𝑉𝑎𝑟 (𝑟) =
(1 + 𝑟! )×(1 + 𝑟# )× ⋯ = (1 + 𝑟$ )%
𝑉𝑎𝑟 (𝑟) =
- Does not account for varying amounts of assets under management
Dollar Weighted Average Return 𝑆𝐷 (𝑟) =
The internal rate of return on an investment.
- Sets the NPV to 0 (PV of cash flows is equal to the initial cost of 𝑆𝐷(𝑟) =
establishing the portfolio)
#
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 Normal Dis
0 = −𝐶𝑜𝑠𝑡 + A + 𝐼𝑅𝑅E + A + 𝐼𝑅𝑅E + ⋯
1 1 - Symmetr
Annualized Rates of Return - Transform
APR = Per-period Return × Periods per year 𝑟!"#$ =
- Ignores compounding
%
𝐴𝑃𝑅
1 + 𝐸𝐴𝑅 = (1 + A E
𝑛
𝑟2 = 𝐸 (
Continuous Compounding
1 + 𝐸𝐴𝑅 = 𝑒 &'(
Value at Ri
nalysis and Probability Distribution Historical records
nalysis = A list of possible economic scenarios, the likelihood of each,
PR that will be realized in each case.
eturn = The mean value of the distribution of HPR.
/
s = scenario MEAN
I 𝑝(𝑠)𝑟(𝑠) r(s) = HPR
/0! p(s) = probability
/
s = scenario Variance
# )]#
= 𝜎 = I 𝑝(𝑠)[𝑟(𝑠) − 𝐸 (𝑟 r(s) = HPR
/0! p(s) = probability
1 E(r) = mean
= ∑ (𝑟 − 𝑟̅ )#
𝑛−1
𝜎 = P𝑉𝑎𝑟 (𝑟) P%# = % Standard
deviation
QR𝑉𝑎𝑟 (𝑟)S
stribution
ric plot, mean = median = mode
m normally distributed return r_i into a standard deviation score
%! &'(%! ) Standardized score
= - X minus mean over standard
*!
deviation
- N(0,1)
(𝑟2 ) + 𝑟2/34 ×𝜎
Asset Allocation A
isk (VaR)
Across risky and risk-free portfolios
𝑛
𝑟2 = 𝐸 (
Continuous Compounding
1 + 𝐸𝐴𝑅 = 𝑒 &'(
Inflation and the Real Rate of Interest Value at Ri

Nominal Interest Rate = The interest rate in terms of nominal (not adjusted Measure of
for purchasing power) dollars. Dollar value probability,
Real Interest Rate = The growth rate of purchasing power derived from an - You d
investment. - Set th
Inflation = The rate at which prices are rising, measured as the rate of
increase of the CPI. 𝑉𝑎𝑅
CPI = measures the purchasing power by averaging the prices of goods and Kurtosis =
services in the consumption basket of an average urban family of four fourth pow
Expectation : 𝑟)*+, ≈ 𝑟%-. − 𝑖 Skew = me
1 + 𝑟%-. the mean r
1 + 𝑟)*+, =
1+𝑖
Fisher's Equation
Risk Premiu
Investors demand higher nominal rates when the inflation rate increases
Risk Free R
- Fisher argued that the rates need to increase one for one with the
often meas
expected inflation rates to preserve
Risk Premiu
𝑟%-. = 𝑟)*+, + 𝐸(𝑖)
securities.
- Valid if the market participants can predict inflation over their
- Forec
investment horizon
Excess retu
- Only works better when the inflation is more predictable (stable
standard deviation) Risk aversio
- The in
order
these
Speculatio
Gambling
Price Risk (
The ratio of
𝐸R𝑟5
𝐴 =
𝜎
The Sharpe
Ratio of po
(𝑟2 ) + 𝑟2/34 ×𝜎
Asset Allocation A
isk (VaR) Asset Allocation =
f downside risk. The worst loss that will be suffered with a given Capital allocation
, often 1% or 5%. - Fraction of p
do worse in 5% of the times but better in 95% of the times - Speaks to th
he loss as a threshold Complete Portfoli
Risk free Asset
(5%) = 𝐸(𝑟) + (−1.65)𝜎
Treasury Bonds =
measures tail risk = average deviations from the mean raised to the - Affected by
wer Price-indexed gov
easures asymmetry of distribution = average value of deviations from Money market ins
raised to the third power risk but also prote
- Also offer hi
ums and Risk Aversion Portfolio Expected
Rate = The rate of return that can be earned with certainty,
sured by the rate on Treasury bills. 𝐸 (𝑟7 ) = 𝑦 × 𝐸 (𝑟
um = An expected return in excess of that on risk-free
casted by the average of historical excess returns

urn = Rate of return in excess of the risk-free rate.
on = Reluctance to accept risk.
nvestors will require positive risk premium on risky assets in 𝜎7 = 𝑦𝜎'
r to induce risk-averse investors to hold the existing supply of
e assets
on Taking on risk to earn a risk premium
g Take on risk without taking a risk premium
(reward per unit of volatility)

f portfolio risk premium to variance.
5 S − 𝑟6
Expected return of portfolio Q minus the risk free
𝜎5# rate over variance of the portfolio
A = the degree of risk aversion
Variance used to quantify the return dispersion
Indexing - selectin
500
e Ratio The capital marke
strategy using a br
ortfolio risk premium to standard deviation.
Across risky and risk-free portfolios
= Portfolio choice among broad investment classes. (bills, bonds, stock securities)
to risky assets = The choice between risky and risk-free assets.
portfolio placed in risky assets
he investors risk aversion
io = The entire portfolio including risky and risk-free assets.
= risk controlled by gov printing money and the power to tax

inflation
vernment bonds = TIPS = the risk free asset in real terms
struments = immune to interest rate risk bc of short maturities and minimal defeault
ected by FDIC
igher yields than the treasury bonds
d Return and Risk
𝑟' ) + (1 − 𝑦)× 𝑟6 y = the proportion of investment to be allocated to risky

investment
(1-y) = the proportion of investment to be allocated to risk
free assets
r_P = rate of return on risky asset
r_f = rate of return on risk free asset
Proportion of risky assets times the st dev of portfolio
Intercept = r_f
Slope = Sharpe ratio
Capital allocation line (CAL) = Plot of risk-return
combinations available by varying portfolio allocation
between a risk-free asset and a risky portfolio.
ng a diversified portfolio mirroring the broad economy or a market index like the S&P
et line (CML) represents the investment opportunity set generated by a passive

road stock market index as the risky portfolio.
The Sharpe
Ratio of po
- The h
more
- Risk f
𝑆 =
𝑆𝑇. 𝐷
Mean-varia
returns and
A = the degree of risk aversion
Variance used to quantify the return dispersion
Indexing - selectin
500
e Ratio The capital marke
strategy using a br
ortfolio risk premium to standard deviation.
higher the Sharpe ratio the better the reward per unit of SD,
e efficient portfolio
free asset has st dev of 0
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐸(𝑟' ) − 𝑟6
=
𝐷𝑒𝑣 𝑜𝑓 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝜎'
ance analysis = Evaluating portfolios according to their expected
d standard deviations (or variances).
ng a diversified portfolio mirroring the broad economy or a market index like the S&P
et line (CML) represents the investment opportunity set generated by a passive

road stock market index as the risky portfolio.

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Chapter 5

Saturday, March 2, 2024 10:16 AM

Holding-Period of Return Scenario An

Inflation and the Real Rate of Interest Value at Ri

casted by the average of historical excess returns

(reward per unit of volatility)

= risk controlled by gov printing money and the power to tax

𝑟' ) + (1 − 𝑦)× 𝑟6 y = the proportion of investment to be allocated to risky

et line (CML) represents the investment opportunity set generated by a passive

et line (CML) represents the investment opportunity set generated by a passive

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