Economics 122

F I N A NCI AL ECON OMI CS ( R I S K & R E T U RN)

M. DE BUQUE - GONZAL ES
1 ST S E MESTER, 2 0 1 4 -2015

SOURCE: BODIE ET AL. (2009)

Interest rate determinants
 Savers (primarily households)
Supply
 Firms, businesses (to finance investment)
Demand
 Government
Supply (central bank or monetary authority)
Demand (fiscal policy)
Determination of the Equilibrium Real
Rate of Interest
-Money Supply > Money
Demand -> Rates go down
-Money Demand > Money
Supply -> Rates go up
Equilibrium real rate of interest
 Determined by:
Households
Firms
Government actions (BSP and NG)
Expected rate of inflation
Equilibrium nominal rate of interest
 Recall the real interest rate formula:
𝑟= ≈𝑅−𝜋
 From which, 𝑅 ≈ 𝑟 + 𝜋.
 Recall macro, Irving Fisher (1930): argued that the nominal rate ought to
increase one-for-one with increases in the expected inflation rate.
 As the inflation rate increases, investors will demand higher nominal
rates of return.
 If 𝐸 𝜋 denotes current expectations of inflation, then we get the Fisher
Equation:
𝑅 = 𝑟 + 𝐸(𝜋)
Nominal rate = real rate + inflation forecast
Equilibrium nominal rate of interest
 Fisher Equation:
𝑅 = 𝑟 + 𝐸(𝑖)
Nominal rate = real rate + inflation forecast
 Note that if real rates are reasonably stable, then the increase in the
nominal rate ought to predict higher inflation rate.
 Nominal interest rates can be viewed as the sum of the required
real rate in nominally risk-free  assets  and  the  “noisy”  forecast  of  
inflation.
Risk of Inflation
 In deciding to invest, even if guaranteed a nominal interest rate, an
investor needs to infer the expected real rate by subtracting
inflation expectation.
 Because future inflation is risky, the real rate of return is risky even
when the nominal rate is risk-free.
Estimating risk and expected return
 There is no theory about the levels of risk we should find in the
marketplace (i.e., we cannot determine  a  “natural”  level  of  risk).
 Hence, we can at best estimate the level of risk likely to confront
investors by analyzing historical experience.
 Looking at risky assets, the following are important to learn:
 Scenario analysis of risky investments and the data inputs
necessary to conduct it.
 Statistical tools needed to make inferences from historical time
series of portfolio returns.
Holding period return
 Rate of return for a single period (holding period return):
(𝑃 − 𝑃 ) + 𝐷
𝐻𝑃𝑅 =
𝑃
where 𝐻𝑃𝑅 = holding period return
𝑃 = beginning price of share
𝑃 = ending price of share
𝐷 = cash dividend during period 1
ROR: single period example
Yearend price = 110
Beginning price = 100
Dividend = 4

( )
𝐻𝑃𝑅 = = 14% for 1-year investment horizon
Holding period return (HPR)
 In short, HPR for stocks is the capital gains yield plus the dividend
yield.
 Assumption: dividend is paid at the end of the holding period.
 To the extent that dividends are received earlier, HPR ignores
reinvestment income between receipt of payment and end of
holding period.
Expected return
 Expected returns: A probability-weighted average of the rates of
return in each possible scenario.
𝐸 𝑟 = 𝑝 𝑠 𝑟(𝑠)

where 𝑠 = state
𝑝(𝑠) = probability of a state
𝑟(𝑠) = return if a state occurs (the HPR)
Scenario returns: example
State Probability of State 𝑟 in State
Excellent .25 .31
Good .45 .14
Poor .25 –.0675
Crash .05 –.52
Expected return:
𝐸 𝑟 = .25 .31 + .45 .14 + .25 −.0675 + .05 −.52 =
.0976 or 9.76%
Variance and standard deviation
(measure of risk)
 Variance (𝜎 ): the expected value of the squared deviations from
the expected return.
𝜎 = 𝑝 𝑠 𝑟 𝑠 − 𝐸(𝑟)

 Standard deviation (𝜎): the square root of the variance.

 Note:
◦ The standard deviation of the ROR does not distinguish between
downside risk and upside potential, treating both as deviations
from the mean.
Scenario variance and standard deviation
 Example 𝜎2 calculation:
𝜎2 = .25 .31 − 0.0976 2 + .45 .14 − .0976 2 +
. 25(−.0675 − 0.0976)2 + .05(−.52 − .0976)2
= .038
 Example 𝜎 calculation:
𝜎 = .038 = .1949
Excess returns and risk premiums
 Excess return: the difference in any particular period between the
actual HPR of a risky asset and the risk-free rate (i.e. on risk-free
assets such as T-bills, money market funds, or the bank).
 Risk premium: the difference between the expected HPR and the
risk-free rate.
Therefore, the risk premium is the expected value of the excess
return, and the standard deviation of the excess return is an
appropriate measure of its risk.
In theory, there must always be a positive risk premium to induce
risk-averse investors to hold risky assets instead of placing all on
risk-free assets (i.e., risk-averse investors will not invest in risky
assets like stocks if the risk premium is zero). Excess Return = E(r(HPR)) - E(r(Risk-Free)
Excess Return > 0
Application: Scenario analysis of a
specific risky portfolio
State of Probability Year-end Cash HPR Squared Excess Squared
the price dividends deviations returns deviations
economy from the from the
mean mean
Boom .3 129.5 4.5 .34 .04 .28 .04
Normal .5 110.0 4.0 .14 .00 .08 .00
Recession .2 80.5 3.5 -.16 .09 -.22 .09
Expected return (mean) = .14
Standard deviation of HPR = .1732
Risk premium = .08
Standard deviation of excess return = .1732
Purchase price = $100, T-bill rate = .06
Time series analysis of past returns
 Asset and portfolio return histories come in the form of time series
of past realized returns that do not explicitly provide investors’
original assessments of the probabilities of those observed returns,
as required in scenario analysis.
Can observe only dates and associated HPRs.
Must infer from this limited data the probability distributions from
which these returns might have been drawn or, at least, some of its
characteristics such as expected return and standard deviation.
Arithmetic average return (sample)
 Arithmetic average of the sample rates of return: estimates expected
return
1
𝐸 𝑟 = 𝑝 𝑠 𝑟 𝑠 = 𝑟 𝑠 = 𝑟̅
𝑛
Using historical data, treat each observation as an equally likely “scenario.”
With 𝑛 observations, there are equal probabilities of magnitude for each
𝑝 𝑠 .
If the time series of historical returns fairly represents the true underlying
probability distribution, then the arithmetic average return from a historical
period provides a good forecast of the investment’s HPR.
The arithmetic average provides an unbiased estimate of the expected ROR.
Geometric (time-weighted) average
return
 Geometric (time-weighted) average return: the fixed (annual) HPR that
would compound over the sample period to the same terminal value as
obtained from the sequence of actual returns in the time series. Denote
this rate by 𝑔 such that:
(1 + 𝑔) = 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
𝑔 = 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 / − 1
where 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 1 + 𝑟 ∗ 1 + 𝑟 ∗ ⋯ ∗ 1 + 𝑟 .
Geometric (time-weighted) average
return
𝑔 = 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 / − 1
𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 1 + 𝑟 ∗ 1 + 𝑟 ∗ ⋯ ∗ 1 + 𝑟
 Note:
To get 𝑔, each past return receives an equal weight in the process of
averaging.
The larger the swings in ROR, the greater the discrepancy between the
geometric average (the compound rate earned over the sample period) and
the arithmetic average (the average of annual returns).
If returns come from a normal distribution, then:
𝑔𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑎𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 − 𝜎 ,
expressing returns as decimals.
Variance and standard deviation (sample)
 Risk can be represented by the likelihood of deviations from
expected return, but one usually cannot directly observe this.
 Hence, we usually estimate the variance by averaging squared
deviations from the estimate of the expected return (i.e., the
arithmetic average 𝑟).
̅
 That is, for historical data, we often use the sample average in place
of the unobservable 𝐸 𝑟 .
Variance and standard deviation (sample)
 Using historical data with 𝑛 observations, variance can be estimated
by
1
𝜎 = [𝑟 𝑠 − 𝑟]̅
𝑛
 To correct for bias, i.e., since deviations taken from 𝑟̅ instead of true
expected value 𝐸 𝑟 , we multiply by to get
1
𝜎 = [𝑟 𝑠 − 𝑟]̅
𝑛−1
Excess not total!
 Investors price risky assets so that the risk premium will be
commensurate with the risk of the expected excess return, and
hence it is best to measure risk by the standard deviation of excess,
not total, returns.
The reward-to-volatility ratio
(Sharpe ratio)
 The importance of the trade-off between reward (the risk premium)
and risk (as measured by standard deviation or SD) suggests that we
measure the attraction of an investment portfolio by the ratio of its
risk premium to the SD of its excess returns:
𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 𝑓𝑜𝑟 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜𝑠 =
𝑆𝐷 𝑜𝑓 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛
 This reward-to-volatility measure, first proposed by William Sharpe,
is widely used to evaluate the performance of investment
managers.
 Example: From table above, Sharpe ratio is 8%/17.32% or 0.46
(which is within normal range of stock-index funds).
The normal distribution
 Investment management is easier when returns are normal.
Standard deviation is a good measure of risk when returns are
symmetric. (The probability of any positive deviation above the mean is
equal to that of a negative deviation of the same magnitude.)
If security returns are symmetric, portfolio returns will be, too. (Normal
distributions are “stable.”)
Future scenarios can be estimated using only the mean and the
standard deviation. (The normal distribution is completely characterized
by two parameters, the mean and SD.)
The normal (bell-shaped) distribution

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Normality and Risk Measures
 What if excess returns are not normally distributed?
The standard deviation is no longer a complete measure of risk.
The Sharpe ratio is not a complete measure of portfolio
performance.
We need to consider skew and kurtosis!
“Skewness”  of  a  distribution
 Asymmetry or skewness (of a distribution): This is measured by the ratio
of the average cubed deviations from the mean, called the third
moment, to the cubed standard deviation.
𝐸[𝑟 𝑠 − 𝐸 𝑟 ]
𝑆𝑘𝑒𝑤 =
𝜎

If distribution skewed to the right  (“positively  skewed”),  extreme positive

values when cubed will dominate the third moment resulting in a positive
measure of the skew.
In this case, the SD overestimates risk, because extreme positive deviations
from expectation (not a concern for investors!) nonetheless increases the
estimate of volatility.
Normal and Skewed Distributions

5-30
“Skewness”  of  a  distribution
If distribution skewed to the left  (“negatively  skewed),  extreme
negative values when cubed will dominate the third moment resulting
in a negative measure of the skew.
In this case, the standard deviation underestimates risk. (Why?)
 (Kurtosis)

“Fat”  tails  of  the  distribution

 This refers to the likelihood of extreme values on either side of the
mean (at the expense of a smaller fraction of moderate deviations).
Graphically, there is more probability mass in the tails of the
distribution than predicted by the normal distribution, at the
expense of slender shoulders (i.e., less probability mass near the
center).
Although symmetry is preserved, the SD will underestimate the
likelihood of extreme events (large losses as well as large gains).
(Why?)
Normal and Fat-Tailed Distributions
(mean = .1, SD =.2)

5-33
“Fat”  tails  of  the  distribution
 Kurtosis: a measure of the degree of fat tails.
𝐸[𝑟 𝑠 − 𝐸(𝑟)]
𝑘𝑢𝑟𝑡𝑜𝑠𝑖𝑠 = −3
𝜎

The ratio for a normal distribution would be 3, hence in

subtracting 3, kurtosis of a normal distribution would be zero.
Any kurtosis above zero is a sign of fatter tails than would be
observed in a normal distribution.
Skew and Kurtosis (sample)
SKEW KURTOSIS

𝑠𝑘𝑒𝑤 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑘𝑢𝑟𝑡𝑜𝑠𝑖𝑠 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 −3

Lower partial standard deviation (LPSD)
and the Sortino ratio
 Issue:
Need differentiate harmful volatility from general volatility.
Need to consider negative deviations separately.
 The LPSD is similar to the usual SD, but uses only negative
deviations from 𝑟 . *the mean

 The Sortino ratio replaces the Sharpe ratio.

 The  denominator  is  now  the  “downside deviation”  (i.e.,  the  SD  of  
negative asset returns).
Value at risk (VaR)
 A measure of loss most frequently associated with extreme
negative returns.
 VaR is the quantile of a distribution below which lies 𝑞% of the
possible values of that distribution.
 The 5% VaR , commonly estimated in practice, is the return at the
5th percentile when returns are sorted from high to low.
Expected shortfall (ES)
 Also called the conditional tail expectation (CTE).
 It is a more conservative measure of downside risk than VaR.
ES takes an average return of the worst cases. (VaR takes the
highest return from the worst cases.)