Chapter 5: Risk, Return, and the Historical Record

Determinants of the Level of Interest Rates

Forecasts of interest rates directly determine expected returns in the fixed-

income market.
When rates increase, you want to stay away from longer-term fixed-income
securities.
Forecasting interest rates is one of the most difficult parts of applied
macroeconomics.

Why are increases in the interest rates bad news for the stock market?
Because the cost of borrowing for companies is higher, making growth potentials
lower.

Why do decreases in interest rates make it more attractive to invest in stocks

rather than bonds?
Because the new bonds will be with lower coupon rate, existing bonds prices will
increase because they give higher coupon than market.
Stocks will be more attractive than bonds because the cost of borrowing will be
lower, which means more growth for firms that will increase firm’s value and
firm’s stock.

Interest rates determinants:

1- Supply of funds from savers (Households)
2- Demand for funds (Businesses)
3- Government net demand for funds (Actions of the Federal Reserve)
4- Expected rate of inflation

How will a government deficit affect interest rates?

The government will borrow, and they will issue bonds to banks and they will
increase the interest rates to make the banks more attracted to lend and buy the
bonds the government issued.
What will the government do to stimulate the economy?
They will buy back the bonds which will increase the money supply, this will lower
the interest rates because the supply is higher than the demand, and the inflation
will be higher because of higher money supply. The government will then take
action to lower the inflation.

Real and Nominal Rates of Interest

The nominal interest rate: The growth rate of your money

The real interest rate: The growth rate of your purchasing power.
The real rate of interest is the nominal rate reduced by the loss of purchasing
power resulting from inflation.

Conventional fixed rate income investments promise a nominal rate of interest.

However, because future inflation is uncertain, the real rate of return that you
will earn is risky even if the nominal rate is risk-free. You can only infer expected
real rate of return by adjusting the nominal by expected inflation, because the
profit might be wiped due to inflation because of how uncertain it is.

As the inflation rate increases, investors will demand higher nominal rates of
return.
The Fisher Equation: rn = rr + E(i)

We can’t rely on the real rates when we define the returns of investment, we
need the nominal rate which takes inflation into account.

When real interest rates are high:

The supply of household savings will be high because households will choose to
postpone some current consumption and set aside or invest more of their
disposable income for future use.

When interest rates are low:

Businesses will want to invest in physical capital, and firms will undertake more
projects the lower the interest rate on the funds is needed to finance those
projects.

Taxes and the Real Rate of Interest

Tax liabilities are based on nominal income

Given a tax rate (t) and nominal interest rate (rn), the real after-tax rate is:
Because you pay taxes on even the portion of interest earnings the is
compensation for inflation, your after-tax real return falls by the tax rate times
the inflation rate.

Comparing Rates of Return for Different Holding Periods.

Zero-coupon bonds are sold at a discount from par value, and they provide the
entire return from the difference between the purchasing price and ultimate
repayment of par value.

Higher maturity bonds provide lower price to make it attractive to buy, and they
provide the greater total return.

To compare the returns on these investments, we express the total return as a

rate of return for a common period. Therefore, we compare it to a one-year
period using EAR.
EAR: Percentage increase in funds invested per 1-year. (Takes compounding into
consideration)

This equation is used where T is considered years, if I want to use months instead
of years it will be
1+rf 12/n
Annual Percentage Rate
APR: Annualizing using simple interest (does not take compounding into account)

They’re mostly used for short-term investments that are less than a year.

Bills and Inflation

EAR is higher due to compounding. The more frequent the compounding is, the
higher the difference.

The nominal rate here is determined mostly by the inflation rate.

Moderate inflation can offset most of the nominal gains on low-risk investments,
you might find that the dollar growth is high, but the actual real return isn’t that
high. A dollar invested in T-bills from 1926–2012 grew to $20.25 but with a real
value of only $1.55.
All returns were wiped away due to inflation when T-bill was not taking inflation
into account and they were only using the real rate. Once they started taking
inflation into account, the returns started moving with the inflation, so the return
was not wiped away.

Before 1952 they did not consider the inflation in the t-bill rate, so the t-bill rate
was the real rate and that’s why the return was wiped away, it was under and
close to zero.
But when they considered it, we can see that the t-bill starts moving with the
inflation (the higher the inflation the higher the t-bill rate is)

5.4 Risk and Risk Premiums

Holding Period Returns

The realized rate of return on your investment will depend on:
1- The price per share at year’s end
2- Cash dividends you will collect over the year
When calculating the HPR and HPY
HPY= HPR-1, and this value can be negative
HPR= ending value/ beginning value, using this equation the value cannot be
negative. However, it can be negative when calculated using the previous
equation.
Market weight= beginning market value / total value
Weighted HPY = HPY* Market weight
Expected Return and the Standard Deviation

p(s) = Probability of a state

r(s) = Return if a state occurs
s = State
True means and variances are unobservable because we don’t actually know
possible scenarios like the one in the examples. Scenarios are not easy to define.
So, we must estimate the means and the variances.

Expected Returns and the Arithmetic Average

When we use historical data, we treat each observation as an equally likely

scenario. The expected return E(r) is then estimated by the arithmetic average of
the sample rates of return.

Arithmetic average provides an unbiased estimate of the expected future return.

Geometric (Time-Weighted) Average: Assigns weight of each investment

Geometric Average gives a more realistic result, especially when there’s volatility.

However, if it’s normally distributed, the geometric and the arithmetic will be
almost the same.
Estimated Variance

Unbiased estimated standard deviation

Reward-to-Volatility (Sharpe) Ratio

Investors price risky assets so that the risk premium will be commensurate with
the risk of that expected excess return, which is why it’s better to measure risk by
standard deviation of the excess, not total, return.

Sharpe Ratio=

Excess Return: The difference in any particular period between the actual rate of
return on a risky asset and the actual risk-free rate
Risk Premium: The difference between the expected HPR on a risky asset and the
risk-free rate

The Sharpe ratio is one of the most important measures for portfolio performance
The portfolio performance will be good when it has a higher risk premium, or it
has a low SD.

The Normal Distribution

Investment management is easier when returns are normal.
The normal distribution is symmetric, which means the probability of any positive
deviation above the mean is equal to the negative deviation of the same
magnitude.
When assets with normally distributed returns are mixed to construct a portfolio,
the portfolio return will also be normally distributed and symmetric.
Future scenarios can be estimated using only the mean and the standard
deviation
The dependence of returns across securities can be summarized using only the
pairwise correlation coefficients

Deviations from Normality

What if excess returns are not normally distributed?

1- The standard deviation will no longer be a complete measure of risk
2- Sharpe ratio is not a complete measure of portfolio performance
3- Need to consider skewness and kurtosis
Negatively skewed means that there are high extreme negative values
Positively skewed means that there are high extreme positive values

For positively skewed you’re getting excess return than what you’re expecting,
but it’s at a higher risk because you might not get what you expect, and it could
turn negative later on.
Kurtosis happens at the end tails, where the likelihood of extreme values on
either side is higher at the expense of a smaller likelihood of moderate deviations.
There is more probability mass at the tails than predicted by the normal
distribution.

Even though the symmetry is preserved, the SD will underestimate the likelihood
of extreme events: large losses as well ass large gains.

When we have skewness or kurtosis Sd is not enough measure of risk, so we have

to consider these as measures:
1- Value at Risk (VaR)
2- Expected Shortfall (ES)
3- Lower Partial Standard Deviation (LPSD) and the Sortino Ratio (Replaces
Sharpe)

Historic Returns on Risky Portfolios

The second half of the 20th century, politically and economically the most stable
sub-period, offered the highest average returns

Small tech companies have high growth, therefore high risk and high return.
Average realized returns have generally been higher for stocks of small rather
than large capitalization firms.

Firm capitalization is highly skewed to the right: Many small but a few gigantic
firms.

Normal distribution is generally a good approximation of portfolio returns

However, negative skew is present in some of the portfolios some of the time,
and positive kurtosis is present in all portfolios all the time.
Nominal returns are high because they’re driven by inflation.

Equities are riskier, therefore have higher STD.

Terminal Value with Continuous Compounding

When the continuously compounded rate of return on an asset is normally

distributed, the effective rate of return will be lognormally distributed, and the
overall rate of investment will also be normally distributed.
When we construct the portfolio, we need to evaluate the portfolio to make sure
that we are performing well, we have to define of each investment and how it is
contributing to the portfolio, and we have to evaluate the overall portfolio and we
see there are measures for evaluating portfolio performance.