FINM3093: Investments

Lecture 2

Dr Sherry Zhou
BNU-HKBU United International College

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Outline (Textbook Chapter 5)
• Present tools for estimating expected returns and risk from the
historical record
• Interest rates and investments in safe assets
• Scenario analysis of risky investments and the data inputs necessary to
conduct it

• Develop statistical tools needed to make inferences from historical

time series of portfolio returns

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Effective Annual Rate (EAR) and Annual
Percentage Rate (APR)
• Effective annual rates (EAR) explicitly account for compound interest

• Annualized rates on short-term investments (by convention, with

holding periods < 1 year) often are reported using simple rather than
compound interest. These are called annual percentage rates, or
APRs.

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Effective Annual Rate (EAR) and Annual
Percentage Rate (APR)

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Effective Annual Rate (EAR) and Annual
Percentage Rate (APR)

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Continuous Compounding
• As n gets ever larger, we effectively approach continuous
compounding (CC). APR denoted by rcc.

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Interest Rates and Inflation Rates
• If you expect that rates will increase by more than the consensus
view, you __________ (will/will not) do investment in long-term fixed-
income securities.
• Increases in interest rates tend to be _______ (good/bad) news for
the stock market.

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Interest Rates and Inflation Rates
• Fundamental factors that determine the level of interest rates:
1. Supply of funds from savers, primarily households
2. Demand for funds from businesses to be used to finance investments in
plant, equipment, and inventories
3. Government’s net demand for funds
4. Expected rate of inflation

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Real and Nominal Rates of Interest
• A nominal interest rate is the growth rate of your money
• A real interest rate is the growth rate of your purchasing power

𝑟𝑛𝑜𝑚 = Nominal Interest Rate

𝑟𝑟𝑒𝑎𝑙 = Real Interest Rate
𝑖 = Inflation Rate
𝑟𝑛𝑜𝑚 − 𝑖
1 + 𝑟𝑟𝑒𝑎𝑙 1 + 𝑖 = 1 + 𝑟𝑛𝑜𝑚 ⟹ 𝑟𝑟𝑒𝑎𝑙 =
1+𝑖
𝑁𝑜𝑡𝑒 : 𝑟𝑟𝑒𝑎𝑙 ≈ 𝑟𝑛𝑜𝑚 − 𝑖

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Equilibrium real rate of interest

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Interest Rates and Inflation
• We expect higher nominal interest rates when inflation is higher

• If E(i) denotes current expectations of inflation, the Fisher hypothesis

is

rnom = rreal + E ( i )

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Interest Rates and Inflation
• Fisher equation
• Predicts the nominal rate of interest should track the inflation rate,
leaving the real rate somewhat stable
• Appears to work far better when inflation is more predictable and
investors can more accurately gauge the nominal interest rate they
require to provide an acceptable real rate of return

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T-Bill Rates, Inflation Rates and Real Rates,
1926-2018

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Interest Rates and Inflation, 1926-2018

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Risk and Risk Premiums
• Sources of investment risk
• Macroeconomic fluctuations
• Changing fortunes of various industries
• Firm-specific unexpected developments
• Holding period return (HPR), or realized rate of return

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Risk and Risk Premiums
• Expected returns • p(s) = probability of each scenario
• r(s) = HPR in each scenario
E (r ) =  p( s )  r ( s ) • s = scenario
s
• Variance (VAR)

 =  p ( s )   r ( s ) − E ( r ) 
2 2

• Standard Deviation (STD)

STD =  2

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Risk and Risk Premiums

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Excess Returns and Risk Premiums
• Risk premium is the difference between the expected HPR and
the risk-free rate
• Provides compensation for the risk of an investment
• Risk-free rate is the rate of interest that can be earned with
certainty
• Commonly taken to be the rate on short-term T-bills
• Difference between actual rate of return and risk-free rate is
called excess return
• Risk aversion dictates the degree to which investors are willing to
commit funds to stocks
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Learning from Historical Returns
• Expected Returns and the Arithmetic Average

• The Geometric (Time-Weighted) Average Return

Spreadsheet 5.2
Terminal value = (1 + r1)(1+r2)…(1+r5) = 1.0275
g = 1.02751/5 – 1 = 0.0054 = .54% (cell F14)

• If returns come from a normal distribution,

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Learning from Historical Returns

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Learning from Historical Returns
• Estimated variance
• Expected value of squared deviations (biased downward)
n
ˆ 2 =  r (s ) − r 2
1
n s =1
• Unbiased estimated variance

• Unbiased estimated standard deviation

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Learning from Historical Returns
• Investors price risky assets so that the risk premium will be
commensurate with the risk of expected excess returns
• Best to measure risk by the standard deviation of excess, not total, returns

• The Reward-to-Volatility (Sharpe) Ratio

• Evaluates performance of investment managers

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When Higher-Frequency Observations are
Used
• Do more frequent observations lead to more accurate estimates?
• Observation frequency has no impact on the accuracy of mean
estimates.
• It is the duration of a sample time series (as opposed to the number
of observations) that improves accuracy.
• The accuracy of estimates of the standard deviation can be made
more precise by increasing the number of observations.

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The Normal Distribution

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Deviations from Normality and Tail Risk
Skewness Kurtosis
• Standard measure of asymmetry • Kurtosis concerns the likelihood
in the probability distribution of of extreme values on either side
returns is called the skew of the of the mean at the expense of a
distribution smaller likelihood of moderate
deviations
• Measures the degree of fat tails
 (R − R) 
3
Skew = Average  
 ˆ 3
  ( R − R )4 
Kurtosis = Average  −3

 ˆ
4


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Skewness and Kurtosis
Normal and Skewed Distributions Normal and Fat-Tailed Distributions

(mean = 6%, SD = 17%) (mean = .1, SD = .2)

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Normality and Risk Measures: Downside Risk
• Value at risk (VaR)
• The loss corresponding to a very low percentile of the entire return
distribution, for example, the 5th or 1st percentile return.
VaR(1%, normal) = Mean – 2.33 SD
• Expected shortfall (ES) / Conditional tail expectation (CTE)
• Expected loss on a security conditional on returns being in the left tail of the
probability distribution
• Using a sample of historical returns, we would estimate the 1% ES by
identifying the worst 1% of all observations and taking their average

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Normality and Risk Measures: Downside Risk
• Lower partial standard deviation (LPSD)
• Computed like the usual standard deviation, but using only “bad” returns, i.e.,
negative deviations from the risk-free rate (rather than negative deviations
from the sample average).
• Sortino ratio
• Ratio of average excess returns to LPSD
• Relative frequency of large, negative 3-sigma returns
• Compare the fraction of observations with returns 3 or more standard
deviations below the mean to the relative frequency of negative 3-sigma
returns in a normal distribution with the same mean and standard deviation
• Most useful for large samples observed at a high frequency

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Historic Returns on Risky Portfolios

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Normality and Long-Term
Investments (*)
• Lognormal distribution
• Probability distribution that
characterizes a variable
whose log has a normal (bell-
shaped) distribution
• Use of continuously
compounded returns instead
of effective annual returns

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Summary
• Effective annual rate (EAR) and Annual percentage rate (APR)
• EAR: accounts for compound interest
• APR: on short-term investments; reported using simple interest

• Continuous compounding

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Summary
• EAR and APR
• When comparing investments with different horizons, the ____________
provides the more accurate comparison.
a) arithmetic average
b) effective annual rate
c) average annual return
d) historical annual average
• If an investment provides a 2.1% return quarterly, its effective annual rate is
______________.

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Summary
• Real and nominal rates of interest
• A nominal interest rate is the growth rate of your money.
• A real interest rate if the growth rate of your purchasing power.
𝑟𝑛𝑜𝑚 − 𝑖
1 + 𝑟𝑟𝑒𝑎𝑙 1 + 𝑖 = 1 + 𝑟𝑛𝑜𝑚 ⟹ 𝑟𝑟𝑒𝑎𝑙 = 𝑟𝑟𝑒𝑎𝑙 ≈ 𝑟𝑛𝑜𝑚 − 𝑖
1+𝑖

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Summary
• Real and nominal rates of interest
• Which of the following statement(s) is(are) true?
I. The real rate of interest is determined by the supply and demand for funds.
II. The real rate of interest is determined by the expected rate of inflation.
III. The real rate of interest can be affected by actions of the Fed.
IV. The real rate of interest is equal to the nominal interest rate plus the expected
rate of inflation.

a) I and II only
b) I and III only
c) III and IV only
d) II and III only
e) I, II, III, and IV only
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Summary
• Risk and risk premium
• Holding period return (HPR), or realized rate of return

• Risk premium is the difference between the expected HPR and the risk-free
rate.
• Excess return is the difference between actual rate of return and the risk-free
rate.

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Summary
• Expected returns • p(s) = probability of each scenario
• r(s) = HPR in each scenario
E (r ) =  p( s )  r ( s ) • s = scenario
s
• Variance (VAR)
 =  p ( s )   r ( s ) − E ( r ) 
2 2

• Standard Deviation (STD)

STD =  2

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Summary
• Arithmetic average and geometric average return

• Unbiased estimated variance

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Summary
• Reward-to-volatility (Sharpe) ratio

• The best measure of a portfolio’s risk adjusted performance is the _________.

a) return
b) standard deviation
c) Sharpe measure
d) All of them

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Summary
• Skewness and kurtosis
• Skewness measures the asymmetry of a distribution
• Kurtosis measures the degree of fat tails

 ( R − R )3   ( R − R )4 
Skew = Average   Kurtosis = Average   −3
ˆ  ˆ
3 4
  

• When a distribution is positively skewed,

a) standard deviation overestimates risk.
b) standard deviation correctly estimates risk.
c) standard deviation underestimates risk.
d) the tails are fatter than in a normal distribution.

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Summary
• Downside risk measures
• Value at risk (VaR); Expected shortfall (ES); Lower partial standard deviation
(LPSD); Sortino ratio; Relative frequency of large, negative 3-sigma returns
• When assessing tail risk by looking at the 5% worst-case scenario, the VaR is the
a) most realistic, as it is the most complete measure of risk.
b) most pessimistic, as it is the most complete measure of risk.
c) most optimistic, as it is the most complete measure of risk.
d) most optimistic, as it takes the highest return (smallest loss) of all the cases.

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