RISK vs.

RETURNS
LEARNING ABOUT RISK & RETURNS FROM THE HISTORICAL RECORD

Interest Rates: Determinants

Recap: Supply, Demand & Government Policy Originates from the Money Supply diagram in Macroeconomics

Money supply curve Liquidity Preference

Transactionary, precautionary, speculative demands

Daily market operation by Central Banks

Open Market Operation, Lending to Financial Institutions, Increasing/Decreasing the Reserve Requirement

Real vs. Nominal Interest Rates

Nominal Rate, R

% growth rate of your money % growth rate of your purchasing power Take into account inflation rate: r R i

Real rate, r

1+ R 1+ r = 1+ i

Effect of Taxes on ROI

Real after tax rate: r(1 t) it

Inverse relationship between real rate and inflation rate 30% tax bracket; 12% investment yield; 8% inflation rate

Example:

Inflation 8% ROI 12%

Initial ROI

8%*(1-30%) = 5.6% 4%*(1-30%) = 2.8%

ROI After Tax, After Inflation

Real ROI b4 tax: 4%

ROI b4 tax, after inflation

EAR vs. APR

A bank offers you two alternative interest schedules for a savings account of RM100,000 locked in for 3 years. You are asked to choose either

A monthly rate of 1%; OR An annually , continuously compounded rate of 12%. EAR = 12.68% EAR = 12.75%

And your option is

*EAR = Effective Annual Rate; APR = Annual Percentage Rate

(1 + EAR ) APR =
T

Some formula on Rates

Risk Free Rate for an investment horizon of T years

100 rf (T ) = 1 P(T )
with P(T) = the price of a Treasury bond with par value 100, maturity of T years.

1 + rf (T ) = (1 + EAR )

Following the formula in the previous slide, we get

1 + rf (T ) = (1 + EAR ) = 1 + APR * T
T

Some formula on Returns

Realized return (what we actually obtain, after liquidate position)

P P0 + D1 1 HPR = P0

(sometimes use HPR = r)

Expected Return & Standard Deviation

E(r) Probability-weighted average of the returns in each scenario measure of risk (uncertainty of returns)

E (r ) = p (s )r (s )
s 2 s

= p (s )[r (s ) E (r )]

Risk & Rewards

Risk free rate, rf

The rate we can earn if we leave our money in riskless assets Riskless asset: T-bills, cash deposit account, money market fund

Expected return, E(r), actual return, r Excess return: r rf

Difference between actual return and risk free rate Expected reward for the risk tolerated in investing money Expected excess return

Risk premium: E(r) rf

Time Series Analysis of Past Returns

Arithmetic Average, E(r)

Treat past data as an equally likely scenario (equal probability, 1/n)

1 n E (r ) = r (s ) n s =1

Geometric Average, (1 + g)

Time weighted

(1 + g )

= (1 + r1 )(1 + r2 )(1 + r3 )(1 + rn )

Risk Estimate

Risk: How disperse will the future return be from the expected return Since we cant observe the whole population of expectations, we estimate the average, denoted as r Hence, the estimated variance is given as

1 n 2 s = r (s ) r n 1 s =1

Portfolio Sharpe Ratio

Trade off between reward (risk premium) and risk (standard deviation) How much reward can we earn for each unit of risk borne

Risk premium Sharpe ratio = SD of excess return

Useful to evaluate portfolio managers performance

Normal Distribution of Return

Tractable investment management if returns are normally distributed

Least likely to obtain extreme outcomes, mid range outcome more likely Stable distribution: Sum of assets with Normal returns = Normal distribution of portfolio returns (apply iid assumptions) Simplified scenario analysis as there are only 2 parameters that need to be estimated

If returns are not normally distributed, then SD is useless as an indicator

Measures of Normality

In a normally distributed returns, we consider

r > 3 as outlier negligible probability of occurrence

|Skewness| > 0: Skewed distribution Kurtosis > 3: Fat tail distribution Jarque-Bera test statistics

Measure of departure from normality based on sample kurtosis & skewness, good for n > 2000.

n 2 K2 2 S + ~ 2, JB = 6 4

Measuring Risk: Non-Normal Distributions

Value at Risk (VaR)

Quantile of a distribution Interpretation

A portfolio of stocks has a one-day 5% VaR of RM K million,

There is 5% chance/probability that the value of the portfolio will fall by more than RM K million over a one day period, assuming markets are normal and there is no trading In other words, this portfolio is expected to lose RM K million or more on 1 day in 20.

VaR gives a useful information on the loss magnitude if distribution is non-normal

Value-at-Risk in Normal: Drawbacks

Historical VaR and simulation approaches are often not comparable Normal VaR interpretation is uninformative about the extreme tail losses beyond VaR

It cannot answer the question of the potential loss exceeding VaR So, well need complex global optimization techniques to find the optimal weight of each portfolios component, as opposed to the mean-variance risk-measures

Normal VaR presents a non-convex multi-extreme function

Measuring Risk: Non-Normal Distributions

Conditional Tail Expectation (CTE)

Assuming the terminal value of the portfolio in the bottom 5% of possible outcomes, what is its Expected Value? Accounts for the entire tail of the distribution (or worst case scenario) A measure of risk for non-normal distribution Computes the standard deviation only from the values below the expected return the downside risk

Lower Partial Standard Deviation (LPSD)

THE END OF CHAP 5

Exercises

Chapter 5, Bodie, Kane , Marcus

Question 15 (page 152) No.17 (page 153)

CFA problems:

BRAINTEASER

You have 100kg of grapes. 99% of the weight of grapes is water. Time passes and some amount of water evaporates, so our grapes are now 98% of water. What is the weight of grapes now? (No calculator allowed. Do this one in your head)