Chapter Five

Risk, Return, and the

Historical Record

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 Chapter Overview
• Interest rate determinants
• Rates of return for different holding periods
• Risk and risk premiums
• Estimations of return and risk
• Normal distribution
• Deviation from normality and risk estimation
• Historic returns on risky portfolios

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 Interest Rate Determinants
• Supply
• Households
• Demand
• Businesses
• Government’s net demand
• Federal Reserve actions

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Interest Rate Determinants
Gli effetti dinamici di una
espansione monetaria su Y e su i
Un aumento di M inizialmente sposta
la LM verso il basso, riducendo il
tasso di interesse e aumentando la
produzione. Nel corso del tempo, il
livello dei prezzi aumenta, riportando
la LM verso l’alto fino a quando la
produzione non è tornata al suo
livello naturale.

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 Interest Rate Determinants
Nel breve periodo un’espansione monetaria provoca un
aumento della produzione, una riduzione del tasso di
interesse e un aumento del livello dei prezzi.
Nel medio periodo, l’aumento dello stock nominale di
moneta si riflette in un aumento del livello dei prezzi; esso
non ha invece alcun effetto sulla produzione e sul tasso di
interesse.

La neutralità della moneta nel medio periodo non significa

che la politica monetaria non possa o non debba essere
usata per influenzare la produzione nel breve periodo, ma
che non può sostenere un livello di produzione più elevato
per sempre.
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Interest Rate Determinants

Gli effetti dinamici di

una riduzione del
disavanzo di bilancio.
Una riduzione del
disavanzo di bilancio
provoca inizialmente un
calo della produzione.
Nel corso del tempo, la
produzione torna al suo
livello naturale.

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Interest Rate Determinants
Gli effetti dinamici di una
riduzione del disavanzo di
bilancio sulla produzione e sul
tasso di interesse.
Nel breve periodo, la riduzione del
disavanzo riduce la produzione e i.
Si noti che l’equilibrio da B verso A’
è spiegato dalla riduzione di P.
Nel medio periodo, Y torna al suo
livello naturale, mentre il tasso di
interesse diminuisce ulteriormente.

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Determination of the Equilibrium
Real Rate of Interest
Although there are many different interest rates
economywide (as many as there are types of debt
securities), these rates tend to move together, so
economists frequently talk as if there were a single
representative rate.

We can use this abstraction to gain some insights

into the real rate of interest if we consider the
supply and demand curves for funds.

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 Real versus Nominal Interest Rates
https://it.wikipedia.org/wiki/Tasso_d%27interesse_reale

• Nominal interest rate:

• Real interest rate:
rnom  Nominal Interest Rate
rreal  Real Interest Rate
i  Inflation Rate
rnom  i
rreal 
1 i
Note : rreal  rnom  i
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 Equilibrium Nominal Rate of
Interest
• As the inflation rate increases, investors will
demand higher nominal rates of return
• If E(i) denotes current expectations of
inflation, then we get the Fisher Equation:

rnom  rreal  E i 

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 Taxes and the Real Interest Rate
• Tax liabilities are based on nominal income

rnom  Nominal Interest Rate

rreal  Real Interest Rate
i  Inflation Rate
t  Tax Rate
rnom  1  t   i   rreal  i   1  t   i  rreal 1  t   i  t

• The after-tax real rate falls as the inflation rises

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 Taxes and the Real Interest Rate
Example
rnom  7%
i  3.5%
t  40%
rnom  1  t   i  i  t
rreal 
1 t
.07  1  .4   .035  .035  .4

1  .4
 .035 or 3.5%
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 Rates of Return for Different
Holding Periods
• Zero Coupon Bond:
• Par = $100
• Maturity = T
• Price = P
• Total risk free return

100
rf (T )  1
P(T )

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Annualized Rates of Return

100
rf (T )  1
P(T )

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 Effective Annual Rate (EAR) and
Annual Percentage Rate (APR)
• Effective Annual Rate (EAR):

1
1  EAR  1  rf T  T

• Annualized Percentage Rate (APR):

1  EAR 
T
1
APR 
T
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APR versus EAR

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T-Bill Rates, Inflation Rates,
and Real Rates, 1926-2015

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 Bills and Inflation, 1926-2015
• Moderate i offsets most nominal gains on low-risk
investments

• $1 in T-bills from 1926–2015 grew to $20.25 but with

a real value of only $1.55

• Negative correlation between rreal and i  rnom

doesn’t fully compensate investors for increases in i.

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Interest Rates and Inflation,
1926-2015

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 Risk and Risk Premiums

• Rates of return: Single period

E ( P1)  P 0  E ( D1)
HPR 
P0
• HPR = Holding period return
• P0 = Beginning price
• E(P1) = Expected Ending price
• E(D1) = Expected Dividend during period one
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 Rates of Return: Single Period
Example
Expected Ending Price = $110
Beginning Price = $100
Expected Dividend = $4
E ( P1)  P 0  E ( D1) $110  $100  $4
HPR  
P0 $100
$110  $100 $4
 
$100 $100
 10%  4%  14% Holding Period Return

Capital Gains Yield Dividend Yield

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 Expected Return and
Standard Deviation (1 of 2)
• Expected returns

E (r )   p( s )  r ( s )
s

• p(s) = Probability of a state

• r(s) = Return if a state occurs
• s = State

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 Scenario Returns: Example
State Prob. of State r in State
Excellent .25 0.3100
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200

E (r )  .25   .31  .45   .14   (.25)  ( .0675)  0.05     0.52 

E (r )  .0976 or 9.76%

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 Expected Return and
Standard Deviation (2 of 2)
• Variance (VAR):

   p  s    r  s   E  r 
2 2

s
• Standard Deviation (STD):

STD   2

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 Scenario VAR and STD: Example
• Example VAR calculation:
 2  .25  (.31  0.0976)2  .45  (.14  .0976)2
.25  (0.0675  0.0976) 2  .05  (.52  .0976) 2
 .038
• Example STD calculation:

σ  .038
 .1949

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 Time Series Analysis
of Past Rates of Return
• True means and variances are unobservable
• Possible scenarios like the one in the examples are
unknown

• Means and variances must be estimated

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 Returns Using Arithmetic and
Geometric Averaging
• Arithmetic Average
n
1 n
E (r )   p( s)r ( s)   r ( s)
s 1 n s 1
• Geometric (Time-Weighted) Average
• Terminal value of the investment:
TVn  (1  r1 )(1  r2 )...(1  rn )
• Geometric Average:
g  TVn1/ n  1

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 Estimating
Variance and Standard Deviation
• Estimated Variance
• Expected value of squared deviations

n
1
ˆ   r s   r 
2 2

n s 1
• Unbiased estimated standard deviation
n 2
1
ˆ   r s   r 
n  1 j 1
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 The Reward-to-Volatility (Sharpe)
Ratio
• Excess Return

• Risk Premium

• Sharpe Ratio (rp-rm)/rp

Risk premium
SD of excess returns

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The Normal Distribution
(1 of 2)

Mean = 10%, SD = 20%

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 The Normal Distribution
(2 of 2)

• Investment management is easier with normal returns:

• Symmetric Returns  Standard deviation is a good
measure of risk

• Symmetric Returns  Portfolio returns will be as well

• Only mean and standard deviation needed to estimate

future scenarios

• Pairwise correlation coefficients summarize the

dependence of returns across securities
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 Normality and Risk Measures
(1 of 3)

• What if excess returns are not normally

distributed?
• STD is no longer a complete measure of risk
• Skewness:
 ( R  R )3 
Skew  Average  
 ˆ
3

• Kurtosis:
 ( R  R )4 
Kurtosis  Average   3
 ˆ 4

• Sharpe ratio is not a complete measure of
portfolio performance

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 Normal and Skewed Distributions

Mean = 6%

STD = 17%

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 Normal and Fat-Tailed Distributions

Mean = 10%

STD = 20%

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 Normality and Risk Measures
(2 of 3)

• Value at Risk (VaR)

(https://it.wikipedia.org/wiki/Valore_a_rischio)

• Expected Shortfall (ES)

Differenza tra VaR e ES??

https://www.youtube.com/watch?v=eHGJFOjyzr4

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 Normality and Risk Measures
(3 of 3)

• Lower Partial Standard Deviation (LPSD)

• Similar to usual standard deviation
• Uses only negative deviations from the risk-free
return
• Addresses the asymmetry in returns issue
• Sortino Ratio
• The ratio of average excess returns to LPSD
• (recall Sharpe Ratio..)

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Historic Returns on Risky Portfolios
(1 of 2)

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Historic Returns on Risky Portfolios:
Treasury Bills and Bonds

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Historic Returns on Risky Portfolios:
Equity Markets (1 of 2)
• The second half of the 20th century offered
the highest average returns

• Firm capitalization is highly skewed to the

right: Many small but a few gigantic firms

• Average realized returns have generally been

higher for small stocks vs. large stocks

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Historic Returns on Risky Portfolios:
Equity Markets (2 of 2)

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 Historic Returns on Risky Portfolios
(2 of 2)

• Normal distribution is generally a good approximation of

returns
• VaR indicates no greater tail risk than equivalent normal
• ES ≤ 0.41 of monthly SD  no evidence against normality

• However
• Negative skew is present in some portfolios some of the
time
• Positive kurtosis is present in all portfolios all the time

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 Average Excess Returns
Around the World: 1900-2015

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