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Chap 005

Chapter Five introduces key concepts of risk, return, and historical financial data, focusing on factors influencing interest rates and the Fisher Effect. It covers methods for calculating holding period returns, risk measures, and the implications of different return distributions. The chapter also analyzes historical returns on various assets, emphasizing the importance of understanding risk premiums and the limitations of traditional risk measurements.

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9 views3 pages

Chap 005

Chapter Five introduces key concepts of risk, return, and historical financial data, focusing on factors influencing interest rates and the Fisher Effect. It covers methods for calculating holding period returns, risk measures, and the implications of different return distributions. The chapter also analyzes historical returns on various assets, emphasizing the importance of understanding risk premiums and the limitations of traditional risk measurements.

Uploaded by

mianh818.neu
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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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CHAPTER FIVE

INTRODUCTION TO RISK, RETURN, AND THE HISTORICAL RECORD

CHAPTER FIVE
INTRODUCTION TO RISK, RETURN, AND THE HISTORICAL
RECORD

CHAPTER OVERVIEW
This chapter includes two major sections. The first section of the chapter describes the major factors
influencing the level of interest rates and discusses the Fisher Effect. The second part of the chapter
investigates holding period returns for different holding periods and presents information on historical
risk/return data on different types of financial assets and presents statistical calculations of risk and
returns measures, both ex post and ex ante.

LEARNING OBJECTIVES
After covering the chapter, the students should be able to describe the major factors that influence the
level of interest rates and be able to apply the Fisher effect to interest rates and inflation. Students should
be able to calculate risk and return statistical measures, such as holding period returns, average returns,
expected returns, and standard deviations, ex post and ex ante.

PRESENTATION OF MATERIAL
5.1 Determinants of the Level of Interest Rates

The chapter begins with the list of the major factors that influence interest rates. It introduces the
important relationship between nominal rates and real rates (Equation 5.2). Figure 5.1 displays a graph
of the supply and demand for loanable funds. The graph shows the impact that a greater demand for
funds would have on rates given no change in the supply of funds. The equilibrium for the nominal rate
of interest is presented by the Fisher equation (Equation 5.4). Please note that this may be the first time
students have seen the expectations operator, so a review of its meaning and use may be helpful. The
impact of taxes on the real rate of interest is presented at the end of this section (Equation 5.5).
5.2 Comparing Rates of Return for Different Holding Periods
The formula for developing historical rates of returns on zero-coupon is shown in equation 5.6. The
return is measured for the total number of years or periods. Example 5.2 demonstrates the calculation of
the return for various holding periods.

Once the holding period returns are calculated, returns can be expressed as Effective Annual Rates and
Annual Percentage Rates. The formulas to calculate EARs and APRs are presented here. It is advised
that instructors discuss the different ways EAR and APR will be presented in the financial world and
their implications.

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CHAPTER FIVE
INTRODUCTION TO RISK, RETURN, AND THE HISTORICAL RECORD

5.3 Bills and Inflation, 1926-2005


Historical analysis of real rates of return shows disparity over sub periods from 1926 to 2005. While the
average real rate of return on T-bills for the entire period was 0.72 percent, real rates are larger in late
periods. Figure 5.3 shows that T-bill rates are much closer to inflation rates in later periods.

5.4 Risk and Risk Premiums


The formula for calculation of a single holding period rate of return and a sample calculation are
presented at the beginning of this section (Equation 5.10). The formulas used in the calculation of mean
(Equation 5.11) and variance (Equation 5.12) for a scenario along with sample calculations are presented
as well. Scenario means and variances should be contrasted with historical means and variances to
enhance the students understanding of significant differences in the concepts. While historical returns are
used for estimating future returns, scenario analysis is a different process.

5.5 Time Series Analysis of Past Rates of Return


When working with historical data each of the observed holding period returns, they are assumed to have
equal probabilities. Average returns can be measured using a simple numerical average or a geometric
average. The text contains an excellent discussion of how the geometric and arithmetic averages differ
and issues related to measuring standard deviation of returns over time.

Investors measure returns in the form of excess returns or risk premiums over the risk free asset. The
Shape Ratio measures the added risk premium or excess return on a portfolio relative to standard
deviation of excess returns.

5.6 The Normal Distribution


The normal distribution is presented in Figure 5.4. When distributions are normal they have a bell
shaped curve that allows complete description of the portfolio by examining the mean and standard
deviation.

5.7 Deviations From Normality and Risk Measures


The normal distribution is symmetric and has small probabilities of occurrences in the tails of the
distributions. Two departures from normal distributions that are observed with returns are the existence
of skewed distributions and the existence of fat-tailed distributions.

Variance, while the standard for risk measurement, is not without its shortcomings. This section presents
a series of alternative risk measures. Value at Risk, Expected Shortfall and the Sortino Ratio are three
risk measures which can complement variance.

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


The historical record on investments is presented in Figure 5.6. The material presents results for large
stocks that include portfolios of domestic only and a world portfolio comprised of stocks from over 40

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CHAPTER FIVE
INTRODUCTION TO RISK, RETURN, AND THE HISTORICAL RECORD

countries. The world bond portfolio is comprised of government bond indexes from over 16 countries.
The analysis also contains U.S. Government Bonds and T-Bills.
Returns and standard deviations for selected countries are displayed in Figure 5.7. The figure shows
nominal returns and real returns for equity along with a comparison of nominal equity and bond rates of
return for the various countries.

5.9 Long Term Investments


When estimating long-term risk premiums, return distributions can be asymmetric with a significant
positive skew. When compounding returns, the distribution of returns is lognormally distributed and not
normally distributed. To adjust for this, using continuous compounding the terminal value is restated
using equation 5.23.

Figures 5.10 through 5.12 present analysis of simulated returns using the bootstrapping method. Figure
5.10 shows that returns on both large and small stocks depart from the assumption of normal
distributions. Figures 5.11 and 5.12 show that over the long haul, stocks are indeed more risky and that
terminal values can be less than risk-free securities.

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