CHAPTER4

RETURNANDRISK:ANALYZINGTHEHISTORICALRECORD
1.

Yourholdingperiodreturnforthenextyearonthemoneymarketfunddependsonwhat
30dayinterestrateswillbeeachmonthwhenitistimetorollovermaturingsecurities.
Theoneyearsavingsdepositwilloffera7.5%holdingperiodreturnfortheyear.Ifyou
forecasttherateonmoneymarketinstrumentstorisesignificantlyabovethecurrentyield
of6%,thenthemoneymarketfundmightresultinahigherHPRfortheyear.Whilethe
20yearGovernmentofCanadabondsisofferingayieldtomaturityof9%peryear,
whichis150basispointshigherthantherateontheoneyearsavingsdepositatthebank,
youcouldwindupwithaoneyearHPRofmuchlessthan7.5%onthebondiflongterm
interestratesriseduringtheyear.IftheGovernmentofCanadabondsyieldsriseabove
9%duringtheyear,thenthepriceofthebondwillfall,andthecapitallosswillwipeout
someorallofthe9%returnyouwouldhavereceivedifbondyieldshadremained
unchangedoverthecourseoftheyear.

2.a.

Ifbusinessesincreasetheircapitalspendingtheyarelikelytoincreasetheirdemandfor
funds.ThiswillshiftthedemandcurveinFigure5.1totherightandincreasethe
equilibriumrealrateofinterest.

b.

Increasedhouseholdsavingwillshiftthesupplyoffundscurvetotherightandcausereal
interestratestofall.

c.

AnopenmarketsaleofTreasurysecuritiesbytheBankofCanadaisequivalenttoa
reductioninthesupplyoffunds(ashiftofthesupplycurvetotheleft).Theequilibrium
realrateofinterestwillrise.

3.a.

TheInflationPlusGICissaferbecauseitguaranteesthepurchasingpowerofthe
investment.Usingtheapproximationthattherealrateequalsthenominalrateminusthe
inflationrate,theGICprovidesarealrateof3.5%regardlessoftheinflationrate.

b.

Theexpectedreturndependsontheexpectedrateofinflationoverthenextyear.Ifthe
rateofinflationislessthan3.5%thentheconventionalGICwillofferahigherrealreturn
thantheInflationPlusGIC;ifinflationismorethan3.5%,theoppositewillbetrue.

c.

Ifyouexpecttherateofinflationtobe4%overthenextyear,thentheconventionalGIC
offersyouanexpectedrealrateofreturnof3%,whichis0.5%lowerthantherealrateon
theinflationprotectedGIC.Butunlessyouknowthatinflationwillbe3%with
41

certainty,theconventionalGICisalsoriskier.Thequestionofwhichisthebetter
investmentthendependsonyourattitudetowardsriskversusreturn.Youmightchoose
todiversifyandinvestpartofyourfundsineach.
d.

No.Wecannotassumethattheentiredifferencebetweenthenominalriskfreerate(on
conventionalGICs)of7%andtherealriskfreerate(oninflationprotectedGICs)of
3.5%istheexpectedrateofinflation.Partofthedifferenceisprobablyariskpremium
associatedwiththeuncertaintysurroundingtherealrateofreturnontheconventional
GICs.Thisimpliesthattheexpectedrateofinflationislessthan3.5%peryear.

4.

E(r)=.3544%+.3014%+.35(16%)=14%.
Variance=.35(4414)2 +.30(1414)2 +.35(1614)2 =630

Standarddeviation=25.10%
Themeanisunchanged,butthestandarddeviationhasincreased,astheprobabilitiesof
thehighandlowreturnshaveincreased.

5.

Probabilitydistributionofpriceand1yearholdingperiodreturnon30yearCanada
bonds(whichwillhave29yearstomaturityatyearsend):
Economy
Boom
NormalGrowth
Recession

Probability

YTM

Price

.20
.50
.30

11.0%
8.0
7.0

$74.05
100.00
112.28

Capitalgain Coupon
$25.95
0.00
12.28

$8.00
8.00
8.00

HPR
17.95%
8.00%
20.28%

6.

TheaverageriskpremiumonS&P/TSXcompositestocksfortheperiod19572006was
4.72%peryear.Addingthistoariskfreerateof6%givesanexpectedreturnof10.72%
peryearfortheS&P/TSXIndexportfolio.

7.

Theaveragerateofreturnandstandarddeviationarequitedifferentinthesubperiods:
Mean
19572009
19571984
19852009

STOCKS
Std.Dev.

10.72%
10.82
10.61

17.12%
17.72
16.79
42

Mean

BONDS
Std.Dev.

8.69%
6.82
10.78

9.78%
10.39
8.99

8.a

Iwouldprefertousetheriskpremiumsandstandarddeviationsestimatedovertheperiod
19571984,becausethecurrentinflationaryexpectationsareclosertothoseof19571984
thantothemoreinflationarylaterperiod.
Realholdingperiodreturn = 1 =
= = .0588=5.88%

b.

TheapproximationgivesarealHPRof80%70%=10%,whichisclearlytoohigh.

9.

E(q)=0x.25+1x.25+2x.5=1.25;E(q2)=1x.25+22x.50=2.25Var(q)=2.251.252=0.6875

10.

a.(correspondstoplusorminustwostandarddeviations)

11.

20%,10%

12.

24%,13%

13.

19%

14.

$13,000Expecteddollarreturnonequityinvestmentis$18,000versus$5,000returnon
Tbills]

15.

10%

16.

11.4

17.

Theprobabilitythattheeconomywillbeneutralis0.50,or50%.Givenaneutral
economy,thestockwillexperiencepoorperformance30%ofthetime.Theprobability
ofbothpoorstockperformanceandaneutraleconomyistherefore:
0.30x0.50=0.15=15%

18.a. ProbabilityDistributionofHPRontheStockMarketandPut
Stateofthe
Economy
Boom
NormalGrowth
Recession

Probability
.25
.50
.25

STOCK

Endingprice
+$4dividend HPR
$144
114
84

44%
14%
16%
43

PUT

Ending
Value
HPR
0
0
$30

100%
100%
150%

Rememberthatthecostofthestockis$100pershare,andthatoftheputis$12.
b.

Thecostofoneshareofstockplusaputis$112.TheprobabilitydistributionofHPRon
thestockmarketplusputis:
Stateofthe
Economy
Boom
NormalGrowth
Recession

Probability
.25
.50
.25

Stock+Put+$4dividend
EndingValue HPR
$144
28.6%
114
1.8
114
1.8

(144112)/112
(114112)/112

c.

BuyingtheputoptionguaranteesyouaminimumHPRof1.8%regardlessofwhat
happenstothestock'sprice.Thus,itoffersinsuranceagainstapricedecline.

19.

TheprobabilitydistributionofthedollarreturnonCDpluscalloptionis:
Economy
CombinedValue
Boom
NormalGrowth
Recession

Probability EndingValueCDEndingValueCall
.25$
.50
.25

114(107.55x1.06)
114
114

44

$30
0
0

$144
114
114