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Week 3 Lecture BFF3121 - Chapter 5 & 6

Chapter 5 discusses risk and return calculations including nominal vs real interest rates, holding period return, and the Sharpe ratio for measuring risk-adjusted return. Chapter 6 examines investors' risk aversion and how it affects capital allocation between risky and risk-free assets. The capital allocation line and capital market line are introduced as models for passive portfolio strategies based on an investor's risk tolerance.

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25 views14 pages

Week 3 Lecture BFF3121 - Chapter 5 & 6

Chapter 5 discusses risk and return calculations including nominal vs real interest rates, holding period return, and the Sharpe ratio for measuring risk-adjusted return. Chapter 6 examines investors' risk aversion and how it affects capital allocation between risky and risk-free assets. The capital allocation line and capital market line are introduced as models for passive portfolio strategies based on an investor's risk tolerance.

Uploaded by

Jeremy Lobo
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Week 3 Lecture: BFF3121: Chapter 5 & 6

Chapter 5: Risk, Return and Historical Record


Topic overview:

 Nominal Vs Real Interest Rate


 HPR, EAR and APR (Including applications)
 Risk and Return Calculations:
o Based on Economic State and Probabilities
o Based on Historical Return (Time Series)
 Sharpe Ratio

Return: difference in price of investment/asset over time. Value as a % or price change. E.g.
I invest 100, I got $5 = 5% ROI
Risk: chance that losses occur and impact investment performance
Realised rates of return: actual rates earned over a period. Calculate based on historical
data transactions made.

Interest rates:
 Determines ER of fixed income securities

What determines I/R?


1. Supply of funds from savers, households
2. Demand for funds from businesses to be used to finance investments in plant,
equipment, and inventories.
3. Govt demand for funds modified by actions of RBA
4. Expected rate of inflation

Nominal & Real Interest Rates:


1. Define these rates.
Nominal interest rate = growth rate of your money
Real interest rate = growth rate of your purchasing power
2. How do we calculate them?

Real interest rate: Fisher equation:

Approximate real interest rate =

NOTE: FOR ASSIGNMENT: UNDERSTAND EXACT REAL INTEREST RATE AND REAL
INTEREST RATE

Examples:

Equilibrium Nominal Rate of Interest:


Inflation rate increases = investors demand higher nominal rates of return

E(i) = Fisher equation


Taxes and the Real Rate of Interest:
Tax liabilities: based on nominal income.
Tax rate: based on investor’s tax bracket.
As a result of having to pay tax on the interest earnings that may be simply due to
inflation compensation, someone’s after tax return falls by the tax rate times the
inflation rate.

Holding Period Return (HPR)


 Return generated during holding period of investment
Calculation:

Examples:
Example 1:

How much is capital gain?


110-100 = 10 / 100 = 10%

How much is dividend yield?


4/100 = 4%

Example 2:

How much is capital gain?


3/25 = 12%
How much is dividend yield?
0/25 = 0%

Example 3:
How much is capital gain?

How much is dividend yield? GIVEN IN QUESTION


2.81%

IMPORTANT SLIDE FOR ASSIGNMENT:

Return, Risk and Risk Premium:

HPR =

Two important components of HPR:


1. Capital gain = P0 > P1 = Capital loss, P1 > Po = Capital gain income
2. Dividend yield = How much you earned as dividend / How much you invested

HPR = Capital gain + dividend yield


COMMON EXAM QUESTION: CALCULATE SEPRARETLY THE CAPITAL GAIN
AND CAPITAL DIVIDEND YIELD

Measuring return over different holding periods: The case of Zero Coupon
Bonds

 Zero-coupon bond: one CF to owner – FV on maturity E.g. $100


 Investor buys for less than FV (discount)
 P(T) = price paid today for zero coupon bond with maturity (T)
 FV = $100

Ending value / Beginning value – 1

OR

Effective Annual Return (EAR):

 Investors compare returns over years


 EAR: % increase in funds invested over 1 year

HPR = r(T)

EXAMPLES:
Example 1:

HPR = FV / SELLING AMOUNT - 1

EAR = (1 + I/R)1/25 years - 1

Annual Percentage Rate (APR):


 Rates of short-term investments annualised using simple interest

EXAMPLE:

To find APR from EAR:

Expected Return and SD (risk):


Excess Return and Risk Premium:

Risk Premium = difference between expected HPR and risk-free rate


Risk-free rate = rate of interest that can be earned with certainty – taken on short-
term T bills.
Excess return = actual rate of return – risk-free rate
Risk-aversion = dictates degree to which investors are willing to commit funds to
stocks.

Historical Returns: Arithmetic and Geometric Mean


Infer from time series data the E(R) and S(D)
NOTE: IN YOUR ASSIGNMENT, YOU USE TIME SERIES OF HISTORICAL DATA TO
ANALYSE THE PERFORMANCE OF A STOCK

ARITHMETIC MEAN: EXAMPLE

STEP 1: HPR
HPR2017: (1,200,000/1,000,000) – 1 = 20%

GEOMETRIC MEAN:

Variance and Standard Deviation of Historical Returns:


Sharpe ratio: Reward-to-Volatility ratio

What risk-return trade-off do they offer?

Higher the ratio = The better the value

(E(R) – Rf)/ Risk

EXAMPLE:

Chapter 6: Risk Aversion and Capital Allocation to Risky Assets


Topic overview:
 Investors' Risk Aversion
 Utility Scores and Capital Allocation
 Portfolio Construction: Risky and Risk-free assets
 Risk Tolerance and Asset Allocation
 CAL and CML

The Risk-Free Asset:

 Only govt. issues default issue-free bond


 Security = risk-free with guaranteed real return IF:
1. It’s price is indexed
2. Maturity = investor’s holding period
 T-bills & MM instruments = risk-free asset

Constructing Portfolio: Risky and Risk-free Asset

Usually any investor, if you want to diversify yourself, you will be splitting your
investment into varieties of combination of risky and risk free asset.

Diversification enables us to achieve greater amount of reduction in our risk


exposure.

Split investment amount between risky and risk free assets

Total return of portfolio E(Rc) = Risky + Risk free portfolio


E.G. W1 x R1 + W2 X W2

Example:

What is the standard deviation of complete portfolio?


 SD = 0
 Any portfolio with a risk free asset = 0

Capital Allocation Line (CAL):


Risk tolerance and asset allocation:
 Involves trade off between risk and return
 Differences in risk aversion leads to different capital allocation choices
 Investing 0% = no risk = 7% risk-free rate
 Investing 10% = more risk = 7.8% risky return
 Continues until Q4

Passive strategies: CML

Active strategy = hands-on approach, ongoing buying/selling activity based on


security analysis

Passive strategy = neutral diversification strategy; e.g. investing in well-diversified


portfolio of stock such as an index fund.

Why do investors go for passive strategies?


1. Active strategies are expensive
2. Passive strategies have the free-rider benefit (active investors drive prices to
equilibrium and so well-diversified portfolio is a fair buy)

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