AP ECON 4410 Week 1, September 14 and 16, 2015

Department of Economics
Topic: Risk and Return I

Instructor: Dr. David K. Lee

York University

Readings: Chapters 10 and 11

Chapter 10: Risk and Return: Lessons from Market History

Returns

Dollar Return = Dividend + Change in Market Value

percentage return

dollar return
beginning market val ue

dividend change in market val ue

beginning market val ue

dividend yield capital gains yield

Returns: Example

Suppose you bought 100 shares of XYC Inc. one year ago today at $25. Over the last
year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of
the year, the stock sells for $30. How did you do?

Quite well. You invested $25 100 = $2,500. At the end of the year, you have shares
worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000
$2,500).

Your percentage gain for the year is

20.8%

$520
$2,500

Holding Period Returns

The holding period return is the return that an investor would get when holding an
investment over a period of n years, when the return during year i is given as ri:

holding period return

(1 r1 ) (1 r2 ) (1 rn ) 1
Holding Period Return: Example

Year Return
1
10%
2
-5%
3
20%
4
15%

Your holding period return

(1 r1 ) (1 r2 ) (1 r3 ) (1 r4 ) 1
(1.10) (.95) (1.20) (1.15) 1
.4421 44.21%
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Year Return
1
10%
2
-5%
3
20%
4
15%

Geometric average return

(1 rg ) 4 (1 r1 ) (1 r2 ) (1 r3 ) (1 r4 )
rg 4 (1.10) (.95) (1.20) (1.15) 1
.095844 9.58%

So, our investor made 9.58% on his money for four years, realizing a holding period
return of 44.21%

1.4421 (1.095844) 4
Arithmetic average return

r1 r2 r3 r4
4

10% 5% 20% 15%

10%
4

The geometric average is not the same thing as the arithmetic average.

Return Statistics

The history of capital market returns can be summarized by describing the

average return

( R1 RT )
T

the standard deviation of those returns

( R1 R ) 2 ( R2 R ) 2 ( RT R ) 2
SD VAR
T 1

the frequency distribution of the returns.

Average Stock Returns and Risk-Free Returns

The Risk Premium is the additional return (over and above the risk-free rate) resulting
from bearing risk.

One of the most significant observations of stock and bond market data is this long-run
excess of security return over the risk-free return.

The average return on T-bills was 5.97%.

The average excess return from Canadian common shares for the period 1957
through 2013 was:
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4.46% = 10.43% 5.97%

The average excess return from Canadian long-term bonds for the period 1957
through 2013 was:
2.41% = 8.38% 5.97%

Risk Premia

Suppose that the current rate for one-year Treasury bills is 2%.

What is the expected return on the market of Canadian stocks?

Recall that the average excess return from Canadian common stocks for the period
1957 through 2013 was 4.46%.

Given a risk-free rate of 2%, we have an expected return on the market of Canadian
common shares of: 6.46% = 4.46% + 2%

Risk Statistics

The measures of risk that we discuss are variance and standard deviation.

The variance, and its square root, standard deviation measure variability.

Its interpretation is facilitated by a discussion of the normal distribution.

Normal Distribution Figure 10.6

The probability that a yearly return will fall within 16.64-percent of the mean of 10.43percent will be approximately 2/3.

The probability that a yearly return will fall within 34.10-percent (217.05) of the mean
of 10.43-percent will be 0.9544.

The probability that a yearly return will fall within 51.15-percent (317.05) of the mean
of 10.43-percent will be 0.9974.
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More on Average Returns

Arithmetic average return earned in an average period over multiple periods

Represents the return earned in a typical year

Geometric average average compound return per period over multiple periods

Represents actual return earned each year, compounded annually

Forecasting Return
To address the time relation in forecasting returns, use Blumes formula:

T 1
N T
R(T )
Geometric Average
Arithmetic Average
N 1
N 1

where, T is the forecast horizon and N is the number of years of historical data we are
working with. T must be less than N.

2008: A Year of Financial Crisis

2008: one of the worst years for stock investment in history.

Many of the worlds major markets declined more than those in the US and Canada.

On the other hand, government bond values increased.

What lessons should investors take away?

Stocks have significant risk.

Losses on a diversified portfolio of stocks and bonds would have been much
smaller.

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Chapter 11: Risk and Return: The Capital Asset Pricing Model
Expected Return, Variance, and Covariance

Consider the following two risky asset worlds. There is a 1/3 chance of each state of
the economy and the only assets are a stock fund and a bond fund.

Scenario Probability
Recession
33.3%
Normal
33.3%
Boom
33.3%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund
-7%
17%
12%
7%
28%
-3%

Stock fund
Rate of
Squared
Return Deviation
-7%
3.24%
12%
0.01%
28%
2.89%
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
1.00%
7%
0.00%
-3%
1.00%
7.00%
0.0067
8.2%

E ( rS ) 1 ( 7%) 1 (12%) 1 ( 28%)

3
3
3
E ( rS ) 11%

E (rB ) 1 (17%) 1 (7%) 1 (3%)

3
3
3
E (rB ) 7%

(11% 7%) 2 3.24% (11% 12%) 2 .01% (11% 28%) 2 2.89%

1
2.05% (3.24% 0.01% 2.89%)
14.3%
3

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0.0205

Note that stocks have a higher expected return than bonds and higher risk. Let us turn
now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50%
invested in stocks.

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.160%
0.003%
0.123%

9.0%
0.0010
3.08%

The rate of return on the portfolio is a weighted average of the returns on the stocks
and bonds in the portfolio:

14.3% 0.0205

Note that stocks have a higher expected return than bonds and higher risk. Let us turn
now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
The rate of return on the portfolio is a weighted average of the returns on the stocks
and bonds in the portfolio:

rP wB rB wS rS

5% 50% ( 7%) 50% (17%)

9.5% 50% (12%) 50% (7%)

12.5% 50% ( 28%) 50% (3%)

The expected rate of return on the portfolio is a weighted average of the expected
returns on the securities in the portfolio.

E (rP ) wB E (rB ) wS E (rS )

9% 50% (11%) 50% (7%)

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The variance of the rate of return on the two risky assets portfolio is

P2 (w B B ) 2 (w S S ) 2 2(w B B )(w S S ) BS

where BS is the correlation coefficient between the returns on the stock and bond
funds.

% in stocks

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

P ortfolio Return

The Efficient Set for Two Assets

Portfolo Risk and Return Combinations

12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
0.0%

5.0%

10.0%

15.0%

20.0%

Portfolio Risk (standard deviation)

We can consider other portfolio weights besides 50% in stocks and 50% in bonds

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Portfolio Return

Portfolo Risk and Return Combinations

12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Two-Security Portfolios with Various Correlations

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The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify the opportunity set of riskreturn combinations of various portfolios.
Given the opportunity set we can identify the minimum variance portfolio
The section of the opportunity set above the minimum variance portfolio is the
efficient frontier.

Diversification

Diversification can substantially reduce the variability of returns without an equivalent

reduction in expected returns.

This reduction in risk arises because worse than expected returns from one asset are
offset by better than expected returns from another.

However, there is a minimum level of risk that cannot be diversified away, and that is
the systematic portion.

The variance (risk) of a single securitys return can be broken down into:

Systematic (Market) Risk

Economy-wide random events that affect almost all assets to a certain degree

Unsystematic (diversifiable) Risk

Random events that affect single security or small groups of securities
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The Effect of Diversification:

unsystematic risk will significantly diminish in large portfolios
systematic risk is not affected by diversification since it affects all securities in any large
portfolio

Riskless Borrowing and Lending

In addition to stocks and bonds, consider a world that also has risk-free securities like Tbills.

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Definition of Market Equilibrium Portfolio

Homogenous expectations results from the simplifying assumption that all investors
have access to similar sources of information.

If this is so, then everyone would have the same efficient set of risky assets.

However, in reality, investors have different risk-free rates due to their investment
horizons.

As a result, the CML shifts as seen in the next slide.

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Definition of Risk When Investors Hold the Market Portfolio

Researchers have shown that the best measure of the risk of a security in a large
portfolio is the beta (b)of the security.

Beta measures the responsiveness of a security to movements in the market portfolio.

Cov( Ri , RM )

2 ( RM )

Relationship between Risk and Expected Return (CAPM)

Expected Return on the Market:

R M RF Market Risk Premium

Expected return on an individual security:

R i RF i ( R M RF )

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Expected Return on an Individual Security

the Capital Asset Pricing Model (CAPM)

R i RF i ( R M RF )

Assume = 0, then the expected return is RF.

Assume = 1, then

Ri R M

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