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Discussion 2

This document summarizes key concepts from sections 5.4 and 5.5 of an investment textbook. Section 5.4 discusses holding period return, expected return, variance, standard deviation, excess return, and risk premium. Section 5.5 discusses arithmetic average return, geometric average return, estimating variance and standard deviation from historical data, and the Sharpe ratio for measuring risk-adjusted return. Key formulas are provided for calculating these metrics. The concepts are important for evaluating investment performance, risk, and constructing optimal portfolios.

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Anh Lê Thị Lan
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10 views4 pages

Discussion 2

This document summarizes key concepts from sections 5.4 and 5.5 of an investment textbook. Section 5.4 discusses holding period return, expected return, variance, standard deviation, excess return, and risk premium. Section 5.5 discusses arithmetic average return, geometric average return, estimating variance and standard deviation from historical data, and the Sharpe ratio for measuring risk-adjusted return. Key formulas are provided for calculating these metrics. The concepts are important for evaluating investment performance, risk, and constructing optimal portfolios.

Uploaded by

Anh Lê Thị Lan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

Holding period return: lợi suất nắm giữ

Expected Return: tssl kỳ vọng


Variance: phương sai
Standard Deviation: độ lệch chuẩn
Excess return: lợi nhuận thặng dư?
Risk premium: phần bù rủi ro
Arithmetic average return: trung bình cộng
Geometric average return: trung bình nhân
DISCUSSION 2:
Hi all, We will learn expected and time-series historical returns (part 5.4 and 5.5).
Because this contents have been learnt in Advanced Corporate Finance, so you can read
on your own. However, to make sure you all remember and understand, you are required
to summarize key points of 5.4 and 5.5 here.
Following points should be included:
5.4
- Holding period return
Holding Period Return (HPR) is a financial metric used to calculate the total return an
investor earns on an investment over a specific period of time, considering both capital
appreciation (or depreciation) and any income generated from the investment, such as
dividends or interest. It is expressed as a percentage and is calculated using the formula:
(Ending price of a share−Beginning price+Cash dividend )
HPR=
Beginning price

Where:
 Ending price is the value of the investment at the end of the holding period.
 Beginning price is the value of the investment at the start of the holding period.
 Cash dividend is a payment that a company makes to its shareholders from its
profits, distributed in the form of cash during the holding period.
HPR provides insight into the overall performance of an investment, taking into account
both changes in value and income generated. It is a useful tool for assessing the
effectiveness of an investment strategy over a specific time frame.
- Expected return, Variance and Standard deviation
1. Expected return
According to Investopedia, the expected return is the profit or loss that an
investor anticipates on an investment that has known historical rate of return. It is
calculated by multiplying potential outcomes by the chances of them occurring and then
totaling these results.
The expected rate of return is a probability-weighted average of the rates of return in each
scenario. Calling p (s) the probability of each scenario and r (s) the HPR in each scenario,
where scenarios are labeled or “indexed” by s, we write the expected return as
E ( r )=∑ p ( s ) r ( s) (1)
s

2. Variance and Standard deviation


The standard deviation of a portfolio measures how much the investment returns deviate
from the mean of the probability distribution of investments.
The standard deviation of the rate of return (σ ) is a measure of risk. It is defined as the
square root of the variance, which in turn is the expected value of the squared deviations
from the expected return. The higher the volatility in outcomes, the higher will be the
average value of these squared deviations. Therefore, variance and standard deviation
provide one measure of the uncertainty of outcomes. Symbolically,
σ 2=∑ p ( s ) [r ( s ) −E ( r ) ]2
s

- Excess return and risk premium


Excess Returns and Risk Premiums are concepts that revolve around the compensation
investors expect for undertaking the risk associated with investing in assets that are not
risk-free, such as stocks.
1. Excess Returns
Excess returns refer to the difference between the actual return of a risky asset (like
stocks) and the return of a risk-free asset, usually represented by the risk-free rate, which
is the rate of return on a low-risk investment like government bonds. It's a measure of
how well an investment performed over and above what could have been earned from a
risk-free investment.
2. Risk Premiums
Risk premiums represent the additional return that investors demand for holding a risky
asset instead of a risk-free asset. This premium compensates investors for the uncertainty
and potential losses associated with taking on risk. It's calculated as the difference
between the expected return of a risky asset and the risk-free rate. A positive risk premium
implies that investors expect to be rewarded for their willingness to bear the extra risk.
These concepts are crucial in finance because they provide insights into the balance
between risk and return. Investors generally require a higher return for holding riskier
assets, and risk premiums quantify that difference in expected returns. They help investors
make informed decisions by evaluating potential investments based on the level of risk
they are comfortable with and the potential rewards they seek.
Excess returns and risk premiums play a significant role in portfolio construction and
asset allocation strategies, as investors often seek a balance between riskier, potentially
higher-returning assets and safer, lower-returning assets.

5.5
- Arithmetic average return and Geometric (Time-Weighted) average return
1. Arithmetic average return
Arithmetic Average Return, also known as the arithmetic mean return, is a measure used
to calculate the average return of an investment or portfolio over a specific period of time.
It is computed by adding up the individual returns for each period and then dividing by
the total number of periods.
When we use historical data, we treat each observation as an equally likely “scenario.” So
if there are n observations, we substitute equal probabilities of 1/ n for each p (s) in
Equation (1). The expected return, E (r), is then estimated by the arithmetic average of the
sample rates of return:
n n
1
E ( r )=∑ p ( s ) r ( s )= ∑ r (s )
s=1 n s=1

2. Geometic (Time-Weighted) average return


The geometric mean is the average of a set of products, the calculation of which is
commonly used to determine the performance results of an investment or portfolio. It is
technically defined as “the nth root product of n numbers.” The geometric mean must be
used when working with percentages, which are derived from values, while the
standard arithmetic mean works with the values themselves. Denote this rate by g, so that
1
g= [ ( 1+r 1 ) × ( 1+r 2 ) × …× ( 1+r n ) ] −1 n

The larger the swings in rates of return, the greater the discrepancy between the arithmetic
and geometric averages, that is, between the compound rate earned over the sample period
and the average of the annual returns. If returns come from a normal distribution, the
expected difference is exactly half the variance of the distribution, that is,
1 2
E [ Geometric average ] =E [ Arithmetic average ] − σ
2

- Variance and standard deviation based on historical data


When thinking about risk, we are interested in the likelihood of deviations from the
expected return. In practice, we usually cannot directly observe expectations, so we
estimate the variance by averaging squared deviations from our estimate of the expected
return, the arithmetic average, r .
Using historical data with n observations and eliminate the bias by multiplying the
arithmetic average of squared deviations by the factor n/(n-1), we could estimate variance
and standard deviation as
n n
n 1 1 2
)× ∑ [r ( s )−r ] = ∑ [ r ( s )−r ]
2 2
σ^ =(
n−1 n s=1 n−1 s =1

√
n
1
∑
2
σ^ =
n−1 s=1
[ r ( s ) −r ]

- Sharpe ratio
The Sharpe ratio compares the return of an investment with its risk. It's a mathematical
expression of the insight that excess returns over a period of time may signify more
volatility and risk, rather than investing skill.
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 a portfolio by the
ratio of risk premium to SD of excess returns.
Risk premium
Sharpe ratio=
SD of excess return

The Sharpe ratio will be higher when annualized from higher frequency returns. In
general, the Sharpe ratio of a long-term investment over T years, we multiply the
numerator by T and the denominator by √ T .

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