Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
5-2
5.1 Rates of Return
5-3
Measuring Ex-Post (Past) Returns
One period investment: regardless of the length of the
period.
Holding period return (HPR):
HPR = where
P
S
= Sale price (or P
1
)
P
B
= Buy price ($ you put up) (or P
0
)
CF = Cash flow during holding period

Q:
Q:
[P
S
- P
B
+ CF] / P
B
Why use % returns at all?
What are we assuming about the cash flows in the
HPR calculation?
5-4
Annualizing HPRs
Q: Why would you want to annualize returns?
1. Annualizing HPRs for holding periods of greater
than one year:
Without compounding (Simple or APR):
HPR
ann
=

With compounding: EAR
HPR
ann
=

where n = number of years held

HPR/n
[(1+HPR)
1/n
]-1
5-5
Measuring Ex-Post (Past) Returns
An example: Suppose you buy one share of a stock today for
$45 and you hold it for two years and sell it for $52. You also
received $8 in dividends at the end of the two years.
(PB = , PS = , CF = ):
HPR =
HPR
ann
=

The annualized HPR assuming annual compounding is (n = ):
HPR
ann
=
$45 $52
$8
(52 - 45 + 8) / 45 = 33.33%
0.3333/2 = 16.66%
2
(1+0.3333)
1/2
- 1 = 15.47%
Annualized w/out compounding
5-6
Measuring Ex-Post (Past) Returns
Annualizing HPRs for holding periods of less than one
year:
Without compounding (Simple): HPR
ann
=

With compounding: HPR
ann
=

where n = number of compounding periods per year
HPR x n
[(1+HPR)
n
]-1
5-7
Measuring Ex-Post (Past) Returns
An example when the HP is < 1 year:
Suppose you have a 5% HPR on a 3 month
investment. What is the annual rate of return with and
without compounding?

Without:

With:

Q: Why is the compound return greater than the
simple return?
n = 12/3 = 4 so HPR
ann
= HPR*n = 0.05*4 = 20%
HPR
ann
= (1.05
4
) - 1 = 21.55%
5-8
Arithmetic Average
Finding the average HPR for a time series of returns:
i. Without compounding (AAR or Arithmetic Average
Return):


n = number of time periods

=
=
n
1 T
T
avg
n
HPR
HPR
5-9
Arithmetic Average





AAR =
An example: You have the following rates of return on a stock:
2000 -21.56%
2001 44.63%
2002 23.35%
2003 20.98%
2004 3.11%
2005 34.46%
2006 17.62%

=
=
n
1 T
T
avg
n
HPR
HPR

7
.1762) .3446 .0311 .2098 .2335 .4463 (-.2156
HPR
avg
=
+ + + + + +
=
17.51%
17.51%
5-10
Geometric Average



With compounding (geometric average or GAR:
Geometric Average Return):



GAR =
An example: You have the following rates of return on a stock:
2000 -21.56%
2001 44.63%
2002 23.35%
2003 20.98%
2004 3.11%
2005 34.46%
2006 17.62%
1 ) HPR (1 HPR
/ 1
n
1 T
T avg

(
(

+ =
[
=
n
1 1.1762) 1.3446 1.0311 1.2098 1.2335 1.4463 (0.7844 HPR
1/7
avg
= = 15.61%
15.61%
5-11
Measuring Ex-Post (Past) Returns
Finding the average HPR for a portfolio of assets for a
given time period:



where V
I
= amount invested in asset I,
J = Total # of securities
and TV = total amount invested;
thus V
I
/TV = percentage of total investment invested in
asset I

=
(

=
J
1 I
I avg
HPR HPR
TV
V
I
5-12
Measuring Ex-Post (Past) Returns
For example: Suppose you have $1000 invested in a stock
portfolio in September. You have $200 invested in Stock A,
$300 in Stock B and $500 in Stock C. The HPR for the month of
September for Stock A was 2%, for Stock B the HPR was 4%
and for Stock C the HPR was - 5%.

The average HPR for the month of September for this portfolio
is:

=
(

=
J
1 I
I avg
HPR HPR
TV
V
I
) (500/1000) (-.05 ) (300/1000) (.04 ) (200/1000) (.02 HPR
avg
= + + =
-0.9%
5-13
Measuring Ex-Post (Past) Returns
Measuring returns when there are investment
changes (buying or selling) or other cash flows
within the period.
An example: Today you buy one share of stock
costing ___. The stock pays a __ dividend one year
from now.
Also one year from now you purchase a second
share of stock for ____.
Two years from now you collect a ___ per share
dividend and sell both shares of stock for ___ a
share.

Q: What was your average (annual) return?
A: It depends. There are different ways to measure
this.
$50
$2
$53
$2
$54
5-14
Dollar-Weighted Return
i. Dollar-weighted return procedure (DWR):
Find the internal rate of return for the cash
flows (i.e. find the discount rate that makes the
NPV of the net cash flows equal zero.)

5-15
Tips on Calculating Dollar
Weighted Returns
This measure of return considers both changes in investment
and security performance








Initial Investment is an _______

Ending value is considered as an ______

Additional investment is an _______

Security sales are an ______
outflow
inflow
outflow
inflow
5-16
Measuring Ex-Post (Past) Returns
i. Dollar-weighted return procedure (DWR):
Find the internal rate of return for the cash
flows (i.e. find the discount rate that makes
the NPV of the net cash flows equal zero.)

NPV =
Solve for IRR:
IRR =
Total Cash Flows Each Year
Year
0 1 2
-$50 $ 2 $ 4
-$53 $108
Net -$50 -$51 $112

$0 = -$50/(1+IRR)
0
- $51/(1+IRR)
1
+ $112/(1+IRR)
2

7.117% average annual dollar weighted return
The DWR gives you an average return based on the stocks
performance and

the dollar amount invested (number of
shares bought and sold) each period.
5-17
Measuring Ex-Post (Past) Returns





Q: You are paying somebody to advise you which assets to
buy, but you are deciding when to buy and sell shares.

If you want to evaluate the quality of the investment advice
you are getting, should you use dollar weighted returns to
evaluate the quality of the investment advice?
Total Cash Flows Each Year
Year
0 1 2
-$50 $ 2 $ 4
-$53 $108
Net -$50 -$51 $112

5-18
Time-Weighted Returns
ii. Time-weighted returns (TWR):
TWRs assume you buy ___ share of
the stock at the beginning of each
interim period and sell ___ share at
the end of each interim period. TWRs are thus
___________ of the amount invested in a given period.

To calculate TWRs:


Calculate the return for each time period, typically a year.
Then calculate either an arithmetic (AAR) or a geometric
average (GAR) of the returns.
one
one
independent
5-19
Time-Weighted Returns


Same example as before, initially buy one share at $50,
in one year collect a $2 dividend, and you buy another
share at $53. In two years you sell the stock for $54,
after collecting another $2 dividend per share.

+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
TWR Cash Flows
TWRs assume you buy one share of the stock
at the beginning of each period and sell it at the
end of each period after collecting any cash
flow.
5-20
Measuring Ex-Post (Past) Returns


Same example as before, initially buy one share at $50,
in one year collect a $2 dividend, and you buy another
share at $53. In two years you sell the stock for $54,
after collecting another $2 dividend per share.

Year 0-1 Year 1-2
0 1 1 2
-$50 $ 2 -$53 $ 2
+$53 +$54
Year 0-1 Year 1-2
0 1 1 2
-$50 $ 2 -$53 $ 2
+$53 $54
$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
TWR Cash Flows

Year 0-1
Year 1-2
0 1 1 2
-$50 $ 2 -$53 $ 2
+$53 +$54
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
TWR Cash Flows
5-21
Measuring Ex-Post (Past) Returns


HPR for year 1:

HPR for year 2:

a) Calculating the arithmetic average TW return:
Arithmetic Average Return (AAR): Calculate the
arithmetic average
[$54 - $53 +$2] / $53 = 5.66%
[$53 + $2 - $50] / $50 = 10%
AAR = [0.10 + 0.0566] / 2 = 7.83%
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
TWR Cash Flows
5-22
Measuring Ex-Post (Past) Returns



b) Calculating the geometric average TW return (GAR):



GAR =

1 1.0566) (1.10 HPR
1/2
avg
= =
HPR1 = 10%
HPR2 = 5.66%
7.81%
7.81%
1 ) HPR (1 HPR
/ 1
n
1 T
T avg

(
(

+ =
[
=
n
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
+$54 +$53
$ 2 -$53 $ 2 -$50
2 1 1 0
Year 1-2 Year 0-1
TWR Cash Flows
5-23
Measuring Ex-Post (Past) Returns
Q: When should you use the GAR and when should you use
the AAR?
A1: When you are evaluating PAST RESULTS (ex-post):







A2: When you are trying to estimate an expected return (ex-
ante return):

Use the AAR (average without compounding) if you ARE
NOT reinvesting any cash flows received before the end of
the period.
Use the GAR (average with compounding) if you
ARE reinvesting any cash flows received before the end of
the period.
Use the AAR
5-24
5.2 Risk and Risk
Premiums
5-25
Subjective expected returns
E(r) = Expected Return
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states
Measuring Mean:
Scenario or Subjective Returns
a. Subjective or Scenario


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

5-26
o = [o
2
]
1/2
E(r) = Expected Return
p(s) = probability of a state
r
s
= return in state s
Measuring Variance or
Dispersion of Returns
a. Subjective or Scenario
Variance

=
s
2
s
2
E(r)] [r p(s)
5-27
Numerical Example: Subjective or
Scenario Distributions
State Prob. of State Return
1 .2 - .05
2 .5 .05
3 .3 .15

E(r) =

(.2)(-0.05) + (.5)(0.05) + (.3)(0.15) = 6%
o
2
= [(.2)(-0.05-0.06)
2
+ (.5)(0.05- 0.06)
2
+ (.3)(0.15-0.06)
2
]
o
2
= 0.0049%
2
o = [ 0.0049]
1/2
= .07 or 7%

=
s
2
s
2
E(r)] [r p(s)
5-28
Expost Expected Return & o





Annualizing the statistics:

=
n
i
i
r r
n
1
2
) (
1
1
: Variance Expost
2
o
periods #
period annual
o = o
periods # r r
period annual
=
2
: Deviation Standard Expost =

=
=
n
1 T
T
n
HPR
r
HPR average r =
ns observatio # n =
5-29
Average 0.011624 0.219762458
Variance 0.003725
Stdev 0.061031 n 60
n-1 59
Annualized
Average 0.139486
Variance 0.044697
Stdev 0.211418
E (r - r
avg
)
2
=
Annualizing the statistics: Annualizing the statistics:

=
n
i
i
r r
n
1
2
) (
1
1
: Variance Expost
2
o

=
=
n
1 T
T
n
HPR
r HPR average r =
12 =
monthly annual
o o
12 r r
monthly annual
=
2
: Deviation Standard Expost =
ns observatio # n =
31 0.027334 0.000246811 3/1/2005
32 -0.088065 0.009937839 4/1/2005
33 0.037904 0.000690654 5/2/2005
34 -0.089915 0.010310121 6/1/2005
35 0.0179 3.93874E-05 7/1/2005
36 -0.017814 0.000866572 8/1/2005
37 -0.043956 0.003089121 9/1/2005
38 0.010042 2.50266E-06 10/3/2005
39 0.022495 0.00011818 11/1/2005
40 -0.029474 0.001689005 12/1/2005
41 0.05303 0.001714497 1/3/2006
42 0.09589 0.007100858 2/1/2006
43 -0.003618 0.000232311 3/1/2006
44 0.002526 8.27674E-05 4/3/2006
45 0.083361 0.005146208 5/1/2006
46 -0.016818 0.000808939 6/1/2006
47 -0.010537 0.000491104 7/3/2006
48 -0.001361 0.000168618 8/1/2006
49 0.04081 0.000851813 9/1/2006
50 0.01764 3.61885E-05 10/2/2006
51 0.047939 0.001318787 11/1/2006
52 0.044354 0.001071242 12/1/2006
53 0.02559 0.000195054 1/3/2007
54 -0.026861 0.001481106 2/1/2007
55 0.005228 4.09065E-05 3/1/2007
56 0.015723 1.68055E-05 4/2/2007
57 0.01298 1.83836E-06 5/1/2007
58 -0.038079 0.002470321 6/1/2007
59 -0.034545 0.002131602 7/2/2007
60 0.017857 0.000038854 8/1/2007
Monthly Source Yahoo finance
HPRs
Obs DIS (r - r
avg
)
2
1 -0.035417 0.002212808 9/3/2002
2 0.093199 0.006654508 10/1/2002
3 0.15756 0.021297275 11/1/2002
4 -0.200637 0.045054632 12/2/2002
5 0.068249 0.00320644 1/2/2003
6 -0.026188 0.001429702 2/3/2003
7 -0.00183 0.000181016 3/3/2003
8 0.087924 0.005821766 4/1/2003
9 0.050211 0.001489002 5/1/2003
10 0.004734 4.74648E-05 6/2/2003
11 0.099052 0.00764371 7/1/2003
12 -0.068896 0.006483384 8/1/2003
13 -0.016478 0.000789704 9/2/2003
14 0.109174 0.009516098 10/1/2003
15 0.019343 5.95893E-05 11/3/2003
16 0.019409 6.06076E-05 12/1/2003
17 0.02829 0.000277753 1/2/2004
18 0.095035 0.00695741 2/2/2004
19 -0.061342 0.005324028 3/1/2004
20 -0.085344 0.00940277 4/1/2004
21 0.018851 5.22376E-05 5/3/2004
22 0.079128 0.004556811 6/1/2004
23 -0.103832 0.013330149 7/1/2004
24 -0.028414 0.001603051 8/2/2004
25 0.004562 4.98687E-05 9/1/2004
26 0.105671 0.008844901 10/1/2004
27 0.061998 0.002537528 11/1/2004
28 0.041453 0.000889761 12/1/2004
29 0.028856 0.000296963 1/3/2005
30 -0.024453 0.001301505 2/1/2005
Monthly Source Yahoo finance
HPRs
Obs DIS (r - r
avg
)
2
1 -0.035417 0.002212808 9/3/2002
2 0.093199 0.006654508 10/1/2002
3 0.15756 0.021297275 11/1/2002
4 -0.200637 0.045054632 12/2/2002
5 0.068249 0.00320644 1/2/2003
6 -0.026188 0.001429702 2/3/2003
7 -0.00183 0.000181016 3/3/2003
8 0.087924 0.005821766 4/1/2003
9 0.050211 0.001489002 5/1/2003
10 0.004734 4.74648E-05 6/2/2003
11 0.099052 0.00764371 7/1/2003
12 -0.068896 0.006483384 8/1/2003
13 -0.016478 0.000789704 9/2/2003
14 0.109174 0.009516098 10/1/2003
15 0.019343 5.95893E-05 11/3/2003
16 0.019409 6.06076E-05 12/1/2003
17 0.02829 0.000277753 1/2/2004
18 0.095035 0.00695741 2/2/2004
19 -0.061342 0.005324028 3/1/2004
20 -0.085344 0.00940277 4/1/2004
21 0.018851 5.22376E-05 5/3/2004
22 0.079128 0.004556811 6/1/2004
23 -0.103832 0.013330149 7/1/2004
24 -0.028414 0.001603051 8/2/2004
25 0.004562 4.98687E-05 9/1/2004
26 0.105671 0.008844901 10/1/2004
27 0.061998 0.002537528 11/1/2004
28 0.041453 0.000889761 12/1/2004
29 0.028856 0.000296963 1/3/2005
30 -0.024453 0.001301505 2/1/2005

5-30
Using Ex-Post Returns to estimate
Expected HPR
Estimating Expected HPR (E[r]) from ex-post data.





Use the arithmetic average of past returns as a
forecast of expected future returns as we did and,

Perhaps apply some (usually ad-hoc) adjustment to
past returns

Problems?
Which historical time period?
Have to adjust for current economic
situation
Unstable averages
Stable risk
5-31
Characteristics of Probability
Distributions
1. Mean: __________________________________ _
2. Median: _________________
3. Variance or standard deviation:

4. Skewness:_______________________________
5. Leptokurtosis: ______________________________
If a distribution is approximately normal, the distribution
is fully described by _____________________
Arithmetic average & usually most likely
Dispersion of returns about the mean
Long tailed distribution, either side
Too many observations in the tails
Characteristics 1 and 3
Middle observation
5-32
Normal Distribution
E[r] = 10%
o = 20%
Average = Median
Risk is the
possibility of getting
returns different
from expected.
o measures deviations
above the mean as well as
below the mean.
Returns > E[r] may not be
considered as risk, but with
symmetric distribution, it is
ok to use o to measure risk.
I.E., ranking securities by o
will give same results as
ranking by asymmetric
measures such as lower
partial standard deviation.
5-33
r
Negative Positive
Skewed Distribution:
Large Negative Returns
Possible (Left Skewed)
Median
r = average
Implication?
o is an incomplete
risk measure
5-34
Negative Positive
Skewed Distribution:
Large Positive Returns
Possible (Right Skewed)
Median
r = average
r
5-35
Leptokurtosis

Implication?
o is an incomplete
risk measure
5-36
Value at Risk (VaR)
Value at Risk attempts to answer the following question:
How many dollars can I expect to lose on my portfolio in
a given time period at a given level of probability?
The typical probability used is 5%.
We need to know what HPR corresponds to a 5%
probability.
If returns are normally distributed then we can use a
standard normal table or Excel to determine how many
standard deviations below the mean represents a 5%
probability:
From Excel: =Norminv (0.05,0,1) = -1.64485 standard
deviations
5-37
Value at Risk (VaR)
From the standard deviation we can find the corresponding
level of the portfolio return:
VaR = E[r] + -1.64485o

For Example:
A $500,000 stock portfolio has an annual expected return of
12% and a standard deviation of 35%. What is the portfolio
VaR at a 5% probability level?
VaR = 0.12 + (-1.64485 * 0.35)
VaR = -45.57% (rounded slightly)
VaR$ = $500,000 x -.4557 = -$227,850

What does this number mean?
5-38
Value at Risk (VaR)
VaR versus standard deviation:
For normally distributed returns VaR is equivalent to
standard deviation (although VaR is typically
reported in dollars rather than in % returns)

VaR adds value as a risk measure when return
distributions are not normally distributed.
Actual 5% probability level will differ from 1.68445
standard deviations from the mean due to
kurtosis and skewness.
5-39
Risk Premium & Risk Aversion
The risk free rate is the rate of return that can be
earned with certainty.
The risk premium is the difference between the
expected return of a risky asset and the risk-free rate.
Excess Return or Risk Premium
asset
=

Risk aversion is an investors reluctance to accept
risk.

How is the aversion to accept risk overcome?
By offering investors a higher risk premium.

E[r
asset
] rf
5-40
5.3 The Historical Record
5-41
Frequency distributions of annual HPRs,
1926-2008
5-42
Rates of return on stocks, bonds and
bills, 1926-2008
5-43
Annual Holding Period Returns Statistics 1926-2008
From Table 5.3
Geometric mean:
Best measure of
compound historical
return

Arithmetic Mean:
Expected return
Deviations from
normality?
Geom. Arith. Excess
Series Mean% Mean% Return% Kurt. Skew.
World Stk 9.20 11.00 7.25 1.03 -0.16
US Lg. Stk 9.34 11.43 7.68 -0.10 -0.26
Sm. Stk 11.43 17.26 13.51 1.60 0.81
World Bnd 5.56 5.92 2.17 1.10 0.77
LT Bond 5.31 5.60 1.85 0.80 0.51
5-44
Deviations from Normality: Another Measure
Portfolio
World Stock US Small Stock US Large Stock
Arithmetic Average .1100 .1726 .1143
Geometric Average .0920 .1143 .0934
Difference .0180 .0483 .0209
Historical Variance .0186 .0694 .0214
If returns are normally distributed then the following
relationship among geometric and arithmetic averages
holds:
Arithmetic Average Geometric Average = o
2
The comparisons above indicate that US Small Stocks may
have deviations from normality and therefore VaR may be
an important risk measure for this class.
5-45
Actual vs. Theoretical VaR 1926-2008
Actual
VaR%
VaR% if Normal
Series
World Stk -21.89 -21.07
US Lg. Stk -29.79 -22.92
US Sm. Stk -46.25 -44.93
World Bnd -6.54 -8.69
US LT Bond -7.61 -7.25
These comparisons indicate that the U.S. Large
Stock portfolio, the US small stock portfolio and the
World Bond portfolio may exhibit differences from
normality.
5-46
Annual Holding Period Excess Returns
1926-2008 From Table 5.3 of Text
Arith. Required
Series Avg% Return%
World Stk 7.25
US Lg Stk 7.68
US Sm Stk 13.51
World Bonds 2.17
US LT Bonds 1.85

If the risk free rate is currently 3%, then what return
should an investor require for each asset class?
Problems with this approach?
10.25
10.68
16.51
5.17
4.85
Historical data
Assumes all securities in the
category are equally risky
5-47
5.4 Inflation and Real Rates
of Return
5-48
Inflation, Taxes and Returns
The average inflation rate from 1966 to 2005 was _____.
This relatively small inflation rate reduces the terminal
value of $1 invested in T-bills in 1966 from a nominal
value of ______ in 2005 to a real value of _____.

Taxes are paid on _______ investment income. This
reduces _____ investment income even further.

You earn a ____ nominal, pre-tax rate of return and you
are in a ____ tax bracket and face a _____ inflation rate.
What is your real after tax rate of return?
r
real
~ [6% x (1 - 0.15)] 4.29% ~ 0.81%; taxed on nominal
4.29%
$10.08 $1.63
nominal
real
6%
15%
4.29%
5-49
Real vs. Nominal Rates
Fisher effect: Approximation
real rate ~ nominal rate - inflation rate
r
real
~ r
nom
- i
Example r
nom
= 9%, i = 6%
r
real
~ 3%
Fisher effect: Exact
r
real
= or
r
real
=
r
real
=
The exact real rate is less than the approximate
real rate.
[(1 + r
nom
) / (1 + i)] 1
(r
nom
- i) / (1 + i)
(9% - 6%) / (1.06) = 2.83%
r
real
= real interest rate
r
nom
= nominal interest rate
i = expected inflation rate
5-50
Exact Fisher Effect Explained
1) I want to be able to buy more Quantity or
Q
new
= Q
old
x (1 + r
real
) BUT

2) The Price, P, is also rising
P
new
= P
old
x (1 + i) i = inflation

Total $ spent = P
new
x Q
new

P
new
x Q
new
= P
old
x Q
old
x [(1 + r
real
) x (1 + i)]

or (1 + r
nom
)= (1 + r
real
) x (1 + i)

5-51
Nominal and Real interest
rates and Inflation
5-52
Historical Real Returns & Sharpe
Ratios
Real Returns% Sharpe Ratio Series
World Stk 6.00 0.37
US Lg. Stk 6.13 0.37
Sm. Stk 8.17 0.36
World Bnd 2.46 0.24
LT Bond 2.22 0.24
Real returns have been much higher for stocks than for bonds
Sharpe ratios measure the excess return to standard deviation.
The higher the Sharpe ratio the better.
Stocks have had much higher Sharpe ratios than bonds.
5-53
5.5 Asset Allocation Across
Risky and Risk Free
Portfolios
5-54
Allocating Capital Between Risky &
Risk-Free Assets
Possible to split investment funds between safe and
risky assets
Risk free asset rf : proxy; ________________________
Risky asset or portfolio r
p
: _______________________

Example. Your total wealth is $10,000. You put $2,500
in risk free T-Bills and $7,500 in a stock portfolio
invested as follows:
Stock A you put ______
Stock B you put ______
Stock C you put ______
$2,500
$3,000
$2,000
T-bills or money market fund
risky portfolio
$7,500
5-55
Weights in rp
W
A
=
W
B
=
W
C
=

The complete portfolio includes the riskless
investment and r
p
.

$2,500 / $7,500 = 33.33%
$3,000 / $7,500 = 40.00%
$2,000 / $7,500 = 26.67%
100.00%
Your total wealth is $10,000. You put $2,500 in risk free
T-Bills and $7,500 in a stock portfolio invested as follows
W
rf
= ; W
rp
=
In the complete portfolio
W
A
= 0.75 x 33.33% = 25%;

W
B
= 0.75 x 40.00% = 30%
W
C
= 0.75 x 26.67% = 20%;
25%
75%
Stock A $2,500 Stock A $2,500
Stock B $3,000 Stock B $3,000
Stock C $2,000 Stock C $2,000
W
rf
= 25%
Allocating Capital Between Risky &
Risk-Free Assets
5-56
Issues in setting weights
Examine ___________________

Demonstrate how different degrees of risk
aversion will affect __________ between risky and
risk free assets
risk & return tradeoff
allocations
Allocating Capital Between Risky &
Risk-Free Assets
5-57
r
f
= 5%
o
rf
= 0%
E(r
p
) = 14%
o
rp
= 22%
y = % in r
p
(1-y) = % in rf
Example
5-58
E(r
C
) =



Expected Returns for Combinations
E(r
C
) =
For example, let y = ____
E(r
C
) =
E(r
C
) = .1175 or 11.75%
o
C
= yo
rp
+ (1-y)o
rf
o
C
= (0.75 x 0.22) + (0.25 x 0) = 0.165 or 16.5%
o
c
=

r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
yE(r
p
) + (1 - y)r
f
yo
rp
+ (1-y)o
rf
Return for complete or combined portfolio
0.75
(.75 x .14) + (.25 x .05)
5-59
Complete portfolio


Varying y results in E[r
C
] and o
C
that are ______
___________ of E[rp] and rf and o
rp
and o
rf
respectively.
E(r
c
) = yE(r
p
) + (1 - y)rf
o
c
= yo
rp
+ (1-y)o
rf
linear
combinations
This is NOT generally the case for
the o of combinations of two or
more risky assets.
5-60
E(r)
E(r
p
) = 14%
r
f
= 5%
22%
0
P
F
Possible Combinations
o
E(r
p
) = 11.75%
16.5%
y =.75
y = 1
y = 0
5-61
E(r)
E(r
p
) = 14%
r
f
= 5%
22%
0
P
F
Possible Combinations
o
E(r
p
) = 11.75%
16.5%
y =.75
y = 1
y = 0
5-62
Combinations Without Leverage

Since
rf
= 0

c
= y
p

If y = .75, then

c
=

If y = 1

c
=

If y = 0

c
=
r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
75(.22) = 16.5%
1(.22) = 22%
0(.22) = 0%
E(r
c
) = yE(r
p
) + (1 - y)rf
y = .75
E(r
c
) =

y = 1
E(r
c
) =

y = 0
E(r
c
) =
(.75)(.14) + (.25)(.05) = 11.75%
(1)(.14) + (0)(.05) = 14.00%
(0)(.14) + (1)(.05) = 5.00%
5-63
Using Leverage with Capital
Allocation Line
Borrow at the Risk-Free Rate and invest in stock
Using 50% Leverage
E(r
c
) =

o
c
=
r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
r
f
= 5% r
f
= 5%
o
rf
= 0% o
rf
= 0%
E(r
p
) = 14% E(r
p
) = 14%
o
rp
= 22% o
rp
= 22%
y = % in r
p
y = % in r
p
(1-y) = % in rf (1-y) = % in rf
(1.5) (.14) + (-.5) (.05) = 0.185 = 18.5%
(1.5) (.22) = 0.33 or 33%
E(r
C
) =18.5%
33%
y = 1.5
y = 1.5
y = 0
5-64
Risk Aversion and Allocation
Greater levels of risk aversion lead investors to
choose larger proportions of the risk free rate




Lower levels of risk aversion lead investors to
choose larger proportions of the portfolio of risky
assets
Willingness to accept high levels of risk for high
levels of returns would result in
leveraged combinations
E(r E(r
C C
) =18.5% ) =18.5%
33% 33%
E(r E(r
C C
) =18.5% ) =18.5%
33% 33%
y = 0
y = 1.5
5-65
E(r)
E(r
p
) = 14%
r
f
= 5%
= 22%
0
P
F
o
rp
) Slope = 9/22
E(r
p
) - r
f
= 9%
CAL
(Capital
Allocation
Line)
o
P or combinations of
P & Rf offer a return
per unit of risk of
9/22.
5-66
Quantifying Risk Aversion
( )
2
5 . 0
p
f p A r r E o =
E(r
p
) = Expected return on portfolio p
r
f
= the risk free rate
0.5 = Scale factor
A x o
p
2
= Proportional risk premium
The larger A is, the larger will be the
_________________________________________ investors added return required to bear risk
5-67
Quantifying Risk Aversion
Rearranging the equation and solving
for A
Many studies have concluded that
investors average risk aversion is
between _______

r r E
A
p
f p
2
.5 0
) (

=
2 and 4
5-68
Using A
What is the maximum
A that an investor
could have and still
choose to invest in the
risky portfolio P?
Maximum A =

r r E
A
p
f p
2
.5 0
) (

=

0.22 0.5
0.05 0.14
A
2
=

=
3.719
3.719
5-69
A and Indifference Curves


The A term can used to create indifference curves.
Indifference curves describe different combinations of
return and risk that provide equal utility (U) or
satisfaction.
U = E[r] - 1/2Ao
p
2
Indifference curves are curvilinear because they exhibit
diminishing marginal utility of wealth.
The greater the A the steeper the indifference curve and all
else equal, such investors will invest less in risky assets.

The smaller the A the flatter the indifference curve and all
else equal, such investors will invest more in risky assets.
5-70
Indifference Curves
Investors want
the most
return for the
least risk.
Hence
indifference
curves higher
and to the left
are preferred.
I
2
I
1
I
3
U = E[r] - 1/2Ao
p
2
1 2 3
I I I
5-71
E(r)
r
f
= 5%
0
P
F
CAL
(Capital
Allocation
Line)
o
A=3
A=3
Q
S
5-72
E(r)
r
f
= 5%
0
P
F
CAL
(Capital
Allocation
Line)
o
A=2
A=3
S
T
5-73
5.6 Passive Strategies and
the Capital Market Line
5-74
A Passive Strategy
Investing in a broad stock index and a risk
free investment is an example of a passive
strategy.

The investor makes no attempt to actively find
undervalued strategies nor actively switch
their asset allocations.

The CAL that employs the market (or an index
that mimics overall market performance) is
called the Capital Market Line or CML.
5-75
Excess Returns and Sharpe Ratios
implied by the CML
Excess Return or Risk
Premium
Time
Period Average o
Sharpe
Ratio
1926-2008 7.86 20.88 0.37
1926-1955 11.67 25.40 0.46
1956-1984 5.01 17.58 0.28
1985-2008 5.95 18.23 0.33
The average risk premium implied by the CML for
large common stocks over the entire time period is
7.86%.
How much confidence do we have that this
historical data can be used to predict the risk
premium now?
5-76
Active versus Passive Strategies
Active strategies entail more trading costs than
passive strategies.
Passive investor free-rides in a competitive
investment environment.
Passive involves investment in two passive
portfolios
Short-term T-bills
Fund of common stocks that mimics a broad
market index
Vary combinations according to investors
risk aversion.

5-77
Selected Problems
5-78
Problem 1



V
(12/31/2004)
= V
(1/1/1998)
x (1 + GAR)
7

= $100,000 x (1.05)
7
=
$140,710.04

5-79
Problem 2




a. The holding period returns for the three scenarios are:
Boom:
Normal:
Recession:
E(HPR) =
o
2
(HPR)
(50 40 + 2)/40 = 0.30 = 30.00%
(43 40 + 1)/40 = 0.10 = 10.00%
(34 40 + 0.50)/40 = 0.1375 = 13.75%
[(1/3) x 30%] + [(1/3) x 10%] + [(1/3) x (13.75%)] = 8.75%
] 8.75%) (13.75% x [(1/3) ] 8.75%) (10% x [(1/3) ] 8.75%) (30% x [(1/3)
2 2 2
(HPR)
2
= + + = 0.031979

17.88%
(HPR)
=
5-80
Problem 2 Cont.





b. E(r) =

o =
(0.5 x 8.75%) + (0.5 x 4%) = 6.375%
0.5 x 17.88% = 8.94%

Risky E[r
p
] = 8.75%
Risky o
p
= 17.88%
5-81
Problems 3 & 4




3. For each portfolio: Utility = E(r) (0.5 4 o
2
)





We choose the portfolio with the highest utility value,
which is Investment 3.
Investment E(r) o U
1 0.12 0.30 -0.0600
2 0.15 0.50 -0.3500
3 0.21 0.16 0.1588
4 0.24 0.21 0.1518

5-82
Problems 3 & 4 Cont.





4. When an investor is risk neutral, A = _ so that the portfolio with the
highest utility is the portfolio with the _______________________.
So choose ____________.
highest expected return
0
Investment 4

5-83
Problem 5






(95 90 + 4)/90 = 10.00%
2009-2010
(90 110 + 4)/110 = 14.55%
2008-2009
(110 100 + 4)/100 = 14.00%
2007-2008
Return = [(capital gains + dividend) /
price]
a. TWR
Year

3
10.00% 14.55% 14.00%
AAR =
+ +
=
3.15%
1 10] 0.1455)x1. [1.14x(1 GAR
1/3
= =
2.33%
Dividends on four shares,
plus sale of four shares at $95 per
share
396
Dividends on five shares,
plus sale of one share at $90
110
Purchase of two shares at $110,
plus dividend income on three
shares held
-208
Purchase of three shares at $100
per share
-300
3
2
1
0
Explanation
Cash
flow
Time

IRR) (1
$396
IRR) (1
$110
IRR) (1
$208
IRR) (1
$300
$0
3 2 1 0
=
+
+
+
+
+

+
+

=
-0.1661%
b. DWR
a
.

T
W
R