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D - Tutorial 3 (Solutions)

This document provides a summary of Chapter 5 from a finance tutorial. It discusses key concepts related to risk, return, and the historical record, including: 1) Determinants of interest rates including real rates, nominal rates, and the relationship between inflation and interest rates. 2) Methods for comparing rates of return over different holding periods, such as effective annual rate and annual percentage rate. 3) Historical data on interest rates and inflation from 1926-2009. 4) Concepts of risk including standard deviation, excess returns, and risk premiums. 5) Methods for analyzing historical rates of return through time series analysis, including arithmetic average, geometric average, variance, and standard deviation.

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45 views8 pages

D - Tutorial 3 (Solutions)

This document provides a summary of Chapter 5 from a finance tutorial. It discusses key concepts related to risk, return, and the historical record, including: 1) Determinants of interest rates including real rates, nominal rates, and the relationship between inflation and interest rates. 2) Methods for comparing rates of return over different holding periods, such as effective annual rate and annual percentage rate. 3) Historical data on interest rates and inflation from 1926-2009. 4) Concepts of risk including standard deviation, excess returns, and risk premiums. 5) Methods for analyzing historical rates of return through time series analysis, including arithmetic average, geometric average, variance, and standard deviation.

Uploaded by

Alfie
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 PDF, TXT or read online on Scribd
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Tutorial 3

THE UNIVERSITY OF HONG KONG


The School of Economics and Finance
FINA2802_FINA2320_D – Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 5 Introduction to Risk, Return, and the Historical Record

 5.1 Determinants of the Level of Interest Rate


 Real and Nominal Rates of Interest
 Nominal interest rate (R) measures the growth rate of money.
 Real interest rate (r) measures the growth rate of purchasing power.

𝐑≈𝐫+𝐢
↓
r≈R−i
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 ≈ 𝐑𝐞𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 + 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞
 Approximate relationship between interest rates.

(𝟏 + 𝐑) = (𝟏 + 𝐫)(𝟏 + 𝐢)
↓
R−i
r=
1+i
 Exact relationship between interest rates.
 Approximation rule overstates real rate by the factor 1 + i.

 The Equilibrium Real Rate of Interest


 fundamental factors that determine the level of real interest rates:
- The supply of funds from savers, primarily households.
- The demand for funds from businesses to be used to finance investments in
plant, equipment, and inventories (real assets or capital formation).
- The government’s net supply of or demand for funds as modified by actions
of the central bank.

 The Equilibrium Nominal Rate of Interest


𝐑 ≈ 𝐫 + 𝐄(𝐢)
 If real rates are stable, change in nominal rates should predict change in inflation
rates.

Tutorial 3
Tutorial 3

 5.2 Comparing Rates of Return for Different Holding Periods


 Effective Annual Rate (EAR): annualized interest rate using compound interest.
𝟏 + 𝐄𝐀𝐑 = (𝟏 + 𝐓𝐑 𝐓 )𝐧
 If Total Return period is less than a year.

(𝟏 + 𝐄𝐀𝐑)𝐓 = 𝟏 + 𝐓𝐑 𝐓
 If Total Return period is more than a year.

 Annual Percentage Rate (APR): annualized interest rate using simple interest.
𝐀𝐏𝐑 = 𝐓𝐑 𝐓 × 𝐧
 If Total Return period is less than a year.

𝐓𝐑 𝐓
𝐀𝐏𝐑 =
𝐓
 If Total Return period is more than a year.

 Relationships between APR and EAR


𝐀𝐏𝐑 𝐧
𝟏 + 𝐄𝐀𝐑 = (𝟏 + )
𝐧
 If Total Return period is less than a year.

(𝟏 + 𝐄𝐀𝐑)𝐓 = 𝟏 + 𝐀𝐏𝐑 × 𝐓
 If Total Return period is more than a year.

 5.3 Bills and Inflation, 1926–2009

 5.4 Risk and Risk Premiums


 Holding Period Return is the realized return.
𝐄𝐧𝐝𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞 − 𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞 + 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐇𝐏𝐑 =
𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞

 Expected Return and Standard Deviation (Scenario Analysis)


𝐄(𝐫) = ∑ 𝐩(𝐬)𝐫(𝐬)
𝐬
𝛔 = ∑ 𝐩(𝐬)[𝐫(𝐬) − 𝐄(𝐫)]𝟐 → 𝛔 = √𝛔𝟐
𝟐
𝐬

 Excess Returns and Risk Premiums


𝐑𝐢𝐬𝐤 𝐏𝐫𝐞𝐦𝐢𝐮𝐦 = 𝐄(𝐫) − 𝐫𝐟
 It is the expected excess return

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Tutorial 3

 5.5 Time Series Analysis of Past Rates of Return


 Expected Returns and Arithmetic Average (Time Series Analysis)
𝐧
𝟏
𝐄(𝐫) = ∑ 𝐫(𝐬)
𝐧
𝐬=𝟏

 The Geometric Average Return (Time Series Analysis)


(1 + g)n = (1 + r1 ) × (1 + r2 ) × ⋯ × (1 + rn ) = Terminal Value
𝐠 = 𝐓𝐞𝐫𝐦𝐢𝐧𝐚𝐥 𝐕𝐚𝐥𝐮𝐞𝟏/𝐧 − 𝟏

 Variance and Standard Deviation (Time Series Analysis)


𝐧
𝟏
𝟐
𝛔 = ∑[𝐫(𝐬) − 𝐄(𝐫)]𝟐 → 𝛔 = √𝛔𝟐
𝐧−𝟏
𝐬=𝟏

 The Reward-to-Volatility (Sharpe) Ratio


𝐑𝐢𝐬𝐤 𝐏𝐫𝐞𝐦𝐢𝐮𝐦
𝐒𝐡𝐚𝐫𝐩𝐞 𝐑𝐚𝐭𝐢𝐨 =
𝛔𝐞𝐱𝐜𝐞𝐬𝐬 𝐫𝐞𝐭𝐮𝐫𝐧

 5.6 The Normal Distribution


 Normal distribution is completely characterized by expected return and SD.
 The normal distribution is symmetric, the probability of any positive deviation above
the mean is equal to that of a negative deviation of the same magnitude.

 5.7 Deviations from Normality and Risk Measures


 Skewness
∑𝐧𝐢=𝟏[𝐑 𝐢 − 𝐄(𝐫)]𝟑⁄𝐍
𝐒𝐤𝐞𝐰 =
̂𝟑
𝛔
 A measure of asymmetry called skew.
 When skew is zero, return is normally distributed.
 When skew is positive, return is skewed to the right (SD overestimates risk).
 When skew is negative, return is skewed to the left (SD underestimates risk).

 Kurtosis
∑𝐧𝐢=𝟏[𝐑 𝐢 − 𝐄(𝐫)]𝟒 ⁄𝐍
𝐊𝐮𝐫𝐭𝐨𝐬𝐢𝐬 = −𝟑
̂𝟒
𝛔
 A measure of degree of fat tails called kurtosis.
 When kurtosis is positive, fat tails would be observed.

 Value at Risk (VaR)


VaR (0.05, normal distribution) = Mean + (-1.65) SD
 It is a measure of loss associated with extreme negative returns.
 highest return of the worst cases.
 5% VaR means that 95% of returns will be above VaR and 5% of returns will be

Tutorial 3
Tutorial 3

below VaR.

 Expected Shortfall (ES)


 also called conditional tail expectation (CTE)
 average return of the worst cases

 Lower Partial Standard Deviation and the Sortino Ratio


 Investors are more concerned about negative returns.
 An alternative to risky investment is a risk-free investment.
𝟏
𝐋𝐏𝐒𝐃 = √ ∑ [𝐫𝐭 − 𝐫𝐟 ]𝟐
𝐧−𝟏
𝐫𝐭 <𝐫𝐟
𝐑𝐢𝐬𝐤 𝐏𝐫𝐞𝐦𝐢𝐮𝐦
𝐒𝐨𝐫𝐭𝐢𝐧𝐨 𝐑𝐚𝐭𝐢𝐨 =
𝐋𝐏𝐒𝐃

 5.8 Historical Returns on Risky Portfolios: Equities and Long-Term Government Bonds

Tutorial 3
Tutorial 3

PROBLEM SET 1 (APRs and EARs)


You observed that 4 bond mutual funds past performance from the prospectus as follows:
Inception Length Cumulative Performance
Fund A 1 Quarter 1.8%
Fund B 6 Months 3.6%
Fund C 1 Year 7.5%
Fund D 3 Years 24%

What rates you would expect to see for the 4 funds in an advertisement campaign if law
regulation stipulates annualized simple interest to be offered to investors?
APR A = 1.8% × 4 = 𝟕. 𝟐%
APR B = 3.6% × 2 = 𝟕. 𝟐%
APR C = 𝟕. 𝟓%
24%
APR D = = 𝟖%
3

Which of the fund(s) you will choose if you expect their future performance is similar to the
past performance?
EAR A = (1 + 1.8%)4 − 1 = 𝟕. 𝟒%
EAR B = (1 + 3.6%)2 − 1 = 𝟕. 𝟑𝟑%
EAR C = 𝟕. 𝟓%
(1 + EAR D )3 = 1 + 24% → EAR D = 𝟕. 𝟒𝟑%

You will choose Fund C as its EAR is the highest.

Tutorial 3
Tutorial 3

PROBLEM SET 2 (Scenario Analysis)


Purchase Price of Stock X = $100
T-bill Rate = 0.04

State of the Year-end Cash


Economy Probability Price Dividends
Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00

What is the expected return of stock X?

Ending Price − Beginning Price + Dividend


HPR =
Beginning Price

$126.5 + $4.5 − $100


HPR Excellent = = 31%
$100
$110 + $4 − $100
HPR Good = = 14%
$100
$89.75 + $3.5 − $100
HPR Poor = = −6.75%
$100
$46 + $2 − $100
HPR Crash = = −52%
$100

E(r) = ∑ p(s)r(s)
s
E(rx ) = 31% × 0.25 + 14% × 0.45 + (−6.75%) × 0.25 + (−52%) × 0.05
= 𝟗. 𝟕𝟔%

What is the variance and standard deviation of stock X?


σ2 = ∑ p(s)[r(s) − E(r)]2 → σ = √σ2
s
σ2 = 0.25[31% − 9.76%]2 + 0.45[14% − 9.76%]2 + 0.25[−6.75% − 9.76%]2
+0.05[−52% − 9.76%]2
σ2 = 𝟎. 𝟎𝟑𝟕𝟗𝟕 → σ = √σ2 = 𝟏𝟗. 𝟒𝟗%

What is the risk premium of stock X?


Risk Premium = 9.76% − 4% = 𝟓. 𝟕𝟔%

Tutorial 3
Tutorial 3

PROBLEM SET 3 (Time Series Analysis)

S & P 500 Index


Fund
Period HPR
2001 -0.1189
2002 -0.2210
2003 0.2869
2004 0.1088
2005 0.0491

What is the arithmetic average return and geometric average return?


−0.1189 − 0.2210 + 0.2869 + 0.1088 + 0.0491
E(r) =
5
= 𝟐. 𝟏𝟎%

(1 + g)5 = (1 − 0.1189)(1 − 0.2210)(1 + 0.2869)(1 + 0.1088)(1 + 0.0491)


g = 0.54%

What is the variance and standard deviation of the fund return?


n
1
2
σ = ∑[r(s) − E(r)]2 → σ = √σ2
n−1
s=1

[−0.1189 − 0.021]2 + [−0.221 − 0.021]2 + [0.2869 − 0.021]2 + [0.1088 − 0.021]2 + [0.0491 − 0.021]2
σ2 =
5−1

σ2 = 𝟎. 𝟎𝟑𝟗𝟑𝟑 → σ = 𝟏𝟗. 𝟖𝟑%

Tutorial 3
Tutorial 3

PROBLEM SET 4 (Measuring Downside Risk)


Over the past 88 years, the worst annual returns that you observed are
-0.84%, -2.58%, -6.94%, -11.28%, -17.56%, -25.03%, -25.69%, -33.49%. They are also the
returns below the risk-free rate 0.75%.

What is the 5% VaR and 5% Expected Shortfall?

5% of 88 observations is 4.4.

5% VaR is between -17.56% and -11.28%.


The difference between fourth lowest and the fifth lowest is 6.28%
6.28% × 0.4 = 2.512%
Therefore, -17.56% + 2.512% = -15.05%

1 1 1 1
ES = × −33.49% + × −25.69% + × −25.03% + × −17.56%
4.4 4.4 4.4 4.4
0.4
+ × −11.28%
4.4

= −𝟐𝟒. 𝟏𝟔%

Tutorial 3

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