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Unit 4 - IAPM

This document discusses concepts related to risk and return in investments. It defines key terms like return, risk, nominal and real interest rates, taxes, and risk premium. Return consists of current and capital returns and is the primary motivation for investment. Risk refers to the possibility that the actual outcome differs from expected. Sources of risk include business, interest rate, and market risk. The document also outlines factors that determine interest rate levels and how to calculate real rates of return accounting for inflation and taxes.

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72 views17 pages

Unit 4 - IAPM

This document discusses concepts related to risk and return in investments. It defines key terms like return, risk, nominal and real interest rates, taxes, and risk premium. Return consists of current and capital returns and is the primary motivation for investment. Risk refers to the possibility that the actual outcome differs from expected. Sources of risk include business, interest rate, and market risk. The document also outlines factors that determine interest rate levels and how to calculate real rates of return accounting for inflation and taxes.

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PRAGASM PROG
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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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Unit 4

Risk and Return


Contents
• Concept and Calculation of Risk and Return
• Measuring Historical and Expected Risk and Return
• Normal Distribution and Deviation from Normality
Return
• Return is the primary motivating force that drive investment.
• It represents the reward for undertaking investment.
• It consists of two components:
• Current Return
• Capital Return
• Total Return = Current Return + Capital Return
Risk
• Risk refers to the possibility that the actual outcome of an investment
will differ from its expected outcome.
• Sources of Risk:
• Business Risk
• Interest Rate Risk
• Market Risk
Determinants of the Level of Interest Rates
• The level of interest rates is perhaps the most important
macroeconomic factor to consider in one’s investment analysis.
• Forecasts of interest rates directly determine expected returns in the
fixed-income market.
• Factors that determine the level of 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 demand for funds as modified by actions of the Federal
Reserve Bank.
• The expected rate of inflation.
Real and Nominal Rates of Interest
• An interest rate is a promised rate of return denominated in some
unit of account (dollars, yen, euros, or even purchasing power units)
over some time period (a month, a year, 20 years, or longer).
• we need to distinguish between a nominal interest rate—the growth
rate of your money—and a real interest rate—the growth rate of your
purchasing power.
• If we call rnom the nominal interest rate, rreal the real rate, and i the
inflation rate, then we conclude:
Real and Nominal Rates of Interest
• A common approximation to this relation is:
rreal ≈ rnom – i

• The exact relationship is:


Real and Nominal Rates of Interest
Taxes and the Real Rate of Interest
• Given a tax rate (t) and a nominal interest rate, rnom, the after-tax
interest rate is rnom(1 − t).
• The real after-tax rate is approximately the after-tax nominal rate
minus the inflation rate:
Taxes and the Real Rate of Interest
• If, for example, you are in a 30% tax bracket and your investments
provide a nominal return of 12% while inflation runs at 8%, your
before-tax real rate is approximately 4%, and you should, in an
inflation-protected tax system, net an after-tax real return of 4%(1
− .3) = 2.8%.
• But the tax code does not recognize that the first 8% of your return is
only compensation for inflation—not real income.
• Your after-tax nominal return is 12%(1 − .3) = 8.4%, so your after-tax
real interest rate is only 8.4% − 8% = .4%. As predicted by Equation,
your after-tax real return has fallen by it = 8% × .3 = 2.4%
Effective Annual Rate
• Effective Annual Rate (EAR), defined as the percentage increase in
funds invested over a 1-year horizon.
• For a 1-year investment, the EAR equals the total return, rf (1), and
the gross return, (1 + EAR), is the terminal value of a $1 investment.
Continuous Compounding

• where e is approximately 2.71828.


• Therefore, to find rcc from EAR, we can use:
ln (1 + EAR) = rcc
Risk and Risk Premium
• Holding-Period Returns:

• Expected Return and Standard Deviation:


Risk and Risk Premium
• Variance of HPR is:

• Standard Deviation is the square root of Variance.


Risk and Risk Premium
• Excess Returns and Risk Premiums:
• We measure the reward as the difference between the expected HPR on the
index stock fund and the risk-free rate, that is, the rate you would earn in risk-
free assets such as T-bills, money market funds, or the bank. We call this
difference the risk premium on common stocks.
• The difference in any particular period between the actual rate of
return on a risky asset and the actual risk-free rate is called the excess
return.
• Therefore, the risk premium is the expected value of the excess
return, and the standard deviation of the excess return is a measure
of its risk.
Risk and Risk Premium

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