Professional Documents
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Department of Economics
Topic: Risk and Return I
dollar return
beginning market val ue
Returns: Example
Suppose you bought 100 shares of XYC Inc. one year ago today at $25. Over the last
year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of
the year, the stock sells for $30. How did you do?
Quite well. You invested $25 100 = $2,500. At the end of the year, you have shares
worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000
$2,500).
$520
$2,500
The holding period return is the return that an investor would get when holding an
investment over a period of n years, when the return during year i is given as ri:
Year Return
1
10%
2
-5%
3
20%
4
15%
Year Return
1
10%
2
-5%
3
20%
4
15%
So, our investor made 9.58% on his money for four years, realizing a holding period
return of 44.21%
1.4421 (1.095844) 4
Arithmetic average return
r1 r2 r3 r4
4
The geometric average is not the same thing as the arithmetic average.
Return Statistics
average return
( R1 RT )
T
( R1 R ) 2 ( R2 R ) 2 ( RT R ) 2
SD VAR
T 1
The Risk Premium is the additional return (over and above the risk-free rate) resulting
from bearing risk.
One of the most significant observations of stock and bond market data is this long-run
excess of security return over the risk-free return.
The average excess return from Canadian common shares for the period 1957
through 2013 was:
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The average excess return from Canadian long-term bonds for the period 1957
through 2013 was:
2.41% = 8.38% 5.97%
Risk Premia
Suppose that the current rate for one-year Treasury bills is 2%.
Recall that the average excess return from Canadian common stocks for the period
1957 through 2013 was 4.46%.
Given a risk-free rate of 2%, we have an expected return on the market of Canadian
common shares of: 6.46% = 4.46% + 2%
Risk Statistics
The measures of risk that we discuss are variance and standard deviation.
The variance, and its square root, standard deviation measure variability.
The probability that a yearly return will fall within 16.64-percent of the mean of 10.43percent will be approximately 2/3.
The probability that a yearly return will fall within 34.10-percent (217.05) of the mean
of 10.43-percent will be 0.9544.
The probability that a yearly return will fall within 51.15-percent (317.05) of the mean
of 10.43-percent will be 0.9974.
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Geometric average average compound return per period over multiple periods
Forecasting Return
To address the time relation in forecasting returns, use Blumes formula:
T 1
N T
R(T )
Geometric Average
Arithmetic Average
N 1
N 1
where, T is the forecast horizon and N is the number of years of historical data we are
working with. T must be less than N.
Many of the worlds major markets declined more than those in the US and Canada.
Losses on a diversified portfolio of stocks and bonds would have been much
smaller.
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Chapter 11: Risk and Return: The Capital Asset Pricing Model
Expected Return, Variance, and Covariance
Consider the following two risky asset worlds. There is a 1/3 chance of each state of
the economy and the only assets are a stock fund and a bond fund.
Scenario Probability
Recession
33.3%
Normal
33.3%
Boom
33.3%
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation
Rate of Return
Stock fund Bond fund
-7%
17%
12%
7%
28%
-3%
Stock fund
Rate of
Squared
Return Deviation
-7%
3.24%
12%
0.01%
28%
2.89%
11.00%
0.0205
14.3%
Bond Fund
Rate of
Squared
Return Deviation
17%
1.00%
7%
0.00%
-3%
1.00%
7.00%
0.0067
8.2%
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0.0205
Note that stocks have a higher expected return than bonds and higher risk. Let us turn
now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
Scenario
Recession
Normal
Boom
Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%
Expected return
Variance
Standard Deviation
11.00%
0.0205
14.31%
7.00%
0.0067
8.16%
squared deviation
0.160%
0.003%
0.123%
9.0%
0.0010
3.08%
The rate of return on the portfolio is a weighted average of the returns on the stocks
and bonds in the portfolio:
14.3% 0.0205
Note that stocks have a higher expected return than bonds and higher risk. Let us turn
now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
The rate of return on the portfolio is a weighted average of the returns on the stocks
and bonds in the portfolio:
rP wB rB wS rS
The expected rate of return on the portfolio is a weighted average of the expected
returns on the securities in the portfolio.
The variance of the rate of return on the two risky assets portfolio is
P2 (w B B ) 2 (w S S ) 2 2(w B B )(w S S ) BS
where BS is the correlation coefficient between the returns on the stock and bond
funds.
% in stocks
Risk
Return
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%
7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%
P ortfolio Return
5.0%
10.0%
15.0%
20.0%
We can consider other portfolio weights besides 50% in stocks and 50% in bonds
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Portfolio Return
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Consider a world with many risky assets; we can still identify the opportunity set of riskreturn combinations of various portfolios.
Given the opportunity set we can identify the minimum variance portfolio
The section of the opportunity set above the minimum variance portfolio is the
efficient frontier.
Diversification
This reduction in risk arises because worse than expected returns from one asset are
offset by better than expected returns from another.
However, there is a minimum level of risk that cannot be diversified away, and that is
the systematic portion.
The variance (risk) of a single securitys return can be broken down into:
In addition to stocks and bonds, consider a world that also has risk-free securities like Tbills.
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Homogenous expectations results from the simplifying assumption that all investors
have access to similar sources of information.
If this is so, then everyone would have the same efficient set of risky assets.
However, in reality, investors have different risk-free rates due to their investment
horizons.
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Researchers have shown that the best measure of the risk of a security in a large
portfolio is the beta (b)of the security.
Cov( Ri , RM )
2 ( RM )
R i RF i ( R M RF )
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R i RF i ( R M RF )
Ri R M
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