Olala

Essentials of Investments
2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 1
Chapter 6
Risk and Return: Past
and Prologue
Fourth
Edition
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Bodie Kane Marcus 2
Rates of Return: Single Period

HPR
P P D
P

1 0 1
0
HPR = Holding Period Return
P
1
= Ending price
P
0
= Beginning price
D
1
= Dividend during period one
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Bodie Kane Marcus 3
Rates of Return: Single Period
Example
Ending Price = 24
Beginning Price = 20
Dividend = 1

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

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Bodie Kane Marcus 4
Data from Text Example p. 154
1 2 3 4
Assets(Beg.) 1.0 1.2 2.0 .8
HPR .10 .25 (.20) .25
TA (Before
Net Flows 1.1 1.5 1.6 1.0
Net Flows 0.1 0.5 (0.8) 0.0
End Assets 1.2 2.0 .8 1.0

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Bodie Kane Marcus 5
Returns Using Arithmetic and
Geometric Averaging
Arithmetic
r
a
= (r
1
+ r
2
+ r
3
+ ... r
n
) / n
r
a
= (.10 + .25 - .20 + .25) / 4
= .10 or 10%
Geometric
r
g
= {[(1+r
1
) (1+r
2
) .... (1+r
n
)]}
1/n
- 1
r
g
= {[(1.1) (1.25) (.8) (1.25)]}
1/4
- 1
= (1.5150)
1/4
-1 = .0829 = 8.29%
Fourth
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Bodie Kane Marcus 6
Dollar Weighted Returns
Internal Rate of Return (IRR) - the
discount rate that results present value
of the future cash flows being equal to
the investment amount
Considers changes in investment
Initial Investment is an outflow
Ending value is considered as an inflow
Additional investment is a negative flow
Reduced investment is a positive flow
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Bodie Kane Marcus 7
Dollar Weighted Average Using Text
Example
Net CFs 1 2 3 4
$ (mil) - .1 - .5 .8 1.0

Solving for IRR
1.0 = -.1/(1+r)
1
+ -.5/(1+r)
2
+ .8/(1+r)
3
+
1.0/(1+r)
4
r = .0417 or 4.17%

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Bodie Kane Marcus 8
Quoting Conventions
APR = annual percentage rate
(periods in year) X (rate for period)
EAR = effective annual rate
( 1+ rate for period)
Periods per yr
- 1
Example: monthly return of 1%
APR = 1% X 12 = 12%
EAR = (1.01)
12
- 1 = 12.68%
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Bodie Kane Marcus 9
Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness

* If a distribution is approximately normal,
the distribution is described by
characteristics 1 and 2
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Bodie Kane Marcus 10
r
Symmetric distribution
Normal Distribution
s.d. s.d.
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r
Negative Positive
Skewed Distribution: Large Negative
Returns Possible
Median
Fourth
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r Negative Positive
Skewed Distribution: Large Positive
Returns Possible
Median
Fourth
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Subjective returns
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states
Measuring Mean: Scenario or
Subjective Returns
E ( r ) = p ( s ) r ( s )
S
s

Fourth
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Numerical Example: Subjective or
Scenario Distributions
State Prob. of State r
in
State
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
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Standard deviation = [variance]
1/2
Measuring Variance or Dispersion of
Returns
Subjective or Scenario
Variance =
S
s
p ( s ) [ r
s
- E ( r )]
2

Var =[(.1)(-.05-.15)
2
+(.2)(.05- .15)
2
...+ .1(.35-.15)
2
]
Var= .01199
S.D.= [ .01199]
1/2
= .1095
Using Our Example:
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Real vs. Nominal Rates
Fisher effect: Approximation
nominal rate = real rate + inflation premium
R = r + i or r = R - i
Example r = 3%, i = 6%
R = 9% = 3% + 6% or 3% = 9% - 6%
Fisher effect: Exact
r = (R - i) / (1 + i)
2.83% = (9%-6%) / (1.06)

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Annual Holding Period Returns
From Figure 6.1 of Text
Geom Arith Stan.
Series Mean% Mean% Dev.%
Lg Stk 11.01 13.00 20.33
Sm Stk 12.46 18.77 39.95
LT Gov 5.26 5.54 7.99
T-Bills 3.75 3.80 3.31
Inflation 3.08 3.18 4.49
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Annual Holding Period Risk
Premiums and Real Returns
Risk Real
Series Premiums% Returns%
Lg Stk 9.2 9.82
Sm Stk 14.97 15.59
LT Gov 1.74 2.36
T-Bills --- 0.62
Inflation --- ---
Fourth
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Possible to split investment funds
between safe and risky assets
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
Allocating Capital Between Risky &
Risk-Free Assets
Fourth
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Allocating Capital Between Risky &
Risk-Free Assets (cont.)
Issues
Examine risk/ return tradeoff
Demonstrate how different degrees of risk
aversion will affect allocations between
risky and risk free assets
Fourth
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r
f
= 7%
s
rf
= 0%
E(r
p
) = 15%
s
p
= 22%
y = % in p (1-y) = % in r
f
Example Using the Numbers in
Chapter 6 (pp 171-173)
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E(r
c
) = yE(r
p
) + (1 - y)r
f
r
c
= complete or combined portfolio
For example, y = .75
E(r
c
) = .75(.15) + .25(.07)
= .13 or 13%
Expected Returns for Combinations
Fourth
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E(r)
E(r
p
) = 15%
r
f
= 7%
22%
0
P
F
Possible Combinations
s
Fourth
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p
c
=
Since
r
f
y
Variance on the Possible Combined
Portfolios
= 0, then
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c
= .75(.22) = .165 or 16.5%
If y = .75, then
c
= 1(.22) = .22 or 22%
If y = 1
c
= 0(.22) = .00 or 0%
If y = 0
Combinations Without Leverage
Fourth
Edition
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Using Leverage with Capital
Allocation Line
Borrow at the Risk-Free Rate and invest
in stock
Using 50% Leverage
r
c
= (-.5) (.07) + (1.5) (.15) = .19

s
c
= (1.5) (.22) = .33
Fourth
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E(r)
E(r
p
) = 15%
r
f
= 7%
= 22%
0
P
F
P
) S = 8/22
E(r
p
) - r
f
= 8%
CAL
(Capital
Allocation
Line)
s
Fourth
Edition
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Risk Aversion and Allocation
Greater levels of risk aversion lead to
larger proportions of the risk free rate
Lower levels of risk aversion lead to
larger proportions of the portfolio of
risky assets
Willingness to accept high levels of risk
for high levels of returns would result in
leveraged combinations
Fourth
Edition
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Quantifying Risk Aversion
p f p A r r E s 005 .
E(r
p
) = Expected return on portfolio p
r
f
= the risk free rate
.005 = Scale factor
A x s
p
= Proportional risk premium
The larger A is, the larger will be the
added return required for risk
Fourth
Edition
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Quantifying Risk Aversion
r r E
A
p
f p
2
.005
) (
Rearranging the equation and solving for A

Many studies have concluded that
investors average risk aversion is
between 2 and 4
Fourth
Edition
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Chapter 7
Efficient
Diversification
Fourth
Edition
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r
p
= W
1
r
1
+

W
2
r
2
W
1
= Proportion of funds in Security 1
W
2
= Proportion of funds in Security 2
r
1
= Expected return on Security 1
r
2
= Expected return on Security 2

Two-Security Portfolio: Return
W
i
S
i =1
n
= 1
Fourth
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s
p
2

= w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)
s
1
2
= Variance of Security 1
s
2
2
= Variance of Security 2
Cov(r
1
r
2
) = Covariance of returns for
Security 1 and Security 2
Two-Security Portfolio: Risk
Fourth
Edition
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Covariance
r
1,2
= Correlation coefficient of
returns

Cov(r
1
r
2
) = r
1,2
s
1
s
2
s
1
= Standard deviation of
returns for Security 1
s
2
= Standard deviation of
returns for Security 2
Fourth
Edition
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Correlation Coefficients: Possible
Values
If r = 1.0, the securities would be
perfectly positively correlated
If r = - 1.0, the securities would be
perfectly negatively correlated
Range of values for r
1,2
-1.0 < r < 1.0
Fourth
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s
2
p
= W
1
2
s
1
2
+ W
2
2
s
2
2
+ 2W
1
W
2
r
p
= W
1
r
1
+

W
2
r
2
+ W
3
r
3

Cov(r
1
r
2
)
+ W
3
2
s
3
2

Cov(r
1
r
3
) + 2W
1
W
3

Cov(r
2
r
3
) + 2W
2
W
3
Three-Security Portfolio
Fourth
Edition
Irwin / McGraw-Hill
r
p
= Weighted average of the
n securities
s
p
2
= (Consider all pair-wise
covariance measures)
In General, For an n-Security
Portfolio:
Fourth
Edition
Irwin / McGraw-Hill
E(r
p
) = W
1
r
1
+

W
2
r
2
Two-Security Portfolio
s
p
2

= w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)
s
p

= [w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)]
1/2
Fourth
Edition
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r = 0
E(r)
r = 1
r = -1
r = -1
r = .3
13%
8%
12% 20%
St. Dev
TWO-SECURITY PORTFOLIOS WITH
DIFFERENT CORRELATIONS
Fourth
Edition
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Portfolio Risk/Return Two Securities:
Correlation Effects
Relationship depends on correlation
coefficient
-1.0 < r < +1.0
The smaller the correlation, the greater
the risk reduction potential
If r = +1.0, no risk reduction is possible
Fourth
Edition
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1
1
2

- Cov(r
1
r
2
)
W
1
=
+

- 2Cov(r
1
r
2
)
2
W
2
= (1 - W
1
)
Minimum Variance Combination
2
2
2
E(r
2
) = .14 = .20 Sec 2
12
= .2
E(r
1
) = .10 = .15 Sec 1
2
Fourth
Edition
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W
1
=
(.2)
2
- (.2)(.15)(.2)
(.15)
2
+ (.2)
2
- 2(.2)(.15)(.2)
W
1
= .6733
W
2
= (1 - .6733) = .3267
Minimum Variance
Combination: r = .2
Fourth
Edition
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r
p
= .6733(.10) + .3267(.14) = .1131
p
= [(.6733)
2
(.15)
2
+ (.3267)
2
(.2)
2
+
2(.6733)(.3267)(.2)(.15)(.2)]
1/2
p
= [.0171]
1/2
= .1308
Minimum Variance: Return and Risk
with r = .2
Fourth
Edition
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W
1
=
(.2)
2
- (.2)(.15)(.2)
(.15)
2
+ (.2)
2
- 2(.2)(.15)(-.3)
W
1
= .6087
W
2
= (1 - .6087) = .3913
Minimum Variance
Combination: r = -.3
Fourth
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r
p
= .6087(.10) + .3913(.14) = .1157
p
= [(.6087)
2
(.15)
2
+ (.3913)
2
(.2)
2
+
2(.6087)(.3913)(.2)(.15)(-.3)]
1/2
p
= [.0102]
1/2
= .1009
Minimum Variance: Return and Risk
with r = -.3
Fourth
Edition
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Extending Concepts to All Securities
The optimal combinations result in
lowest level of risk for a given return
The optimal trade-off is described as the
efficient frontier
These portfolios are dominant
Fourth
Edition
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E(r)
The minimum-variance frontier of
risky assets
Efficient
frontier
Global
minimum
variance
portfolio
Minimum
variance
frontier
Individual
assets
St. Dev.
Fourth
Edition
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Extending to Include Riskless Asset
The optimal combination becomes
linear
A single combination of risky and
riskless assets will dominate
Fourth
Edition
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E(r)
CAL (Global
minimum variance)
CAL (A)
CAL (P)
M
P
A
F
P P&F A&F
M
A
G
P
M
s
ALTERNATIVE CALS
Fourth
Edition
Irwin / McGraw-Hill
Dominant CAL with a Risk-Free
Investment (F)
CAL(P) dominates other lines -- it has the
best risk/return or the largest slope
Slope = (E(R) - Rf) / s
[ E(R
P
) - R
f
) / s
P
] > [E(R
A
) - R
f
) / s
A
]
Regardless of risk preferences
combinations of P & F dominate
Fourth
Edition
Irwin / McGraw-Hill
Single Factor Model
r
i
= E(R
i
) +
i
F + e
i
= index of a securities particular return
to the factor
F= some macro factor; in this case F is
unanticipated movement; F is commonly
related to security returns
Assumption: a broad market index like the
S&P500 is the common factor
Fourth
Edition
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Single Index Model
Risk Prem
Market Risk Prem
or Index Risk Prem
i
= the stocks expected return if the
markets excess return is zero
i
(r
m
- r
f
)

= the component of return due to
movements in the market index
(r
m
- r
f
)

= 0
e
i
= firm specific component, not due to market
movements

a

e r r r r
i f m
i
i f i

a
Fourth
Edition
Irwin / McGraw-Hill
Let: R
i
= (r
i
- r
f
)
R
m
= (r
m
- r
f
)
Risk premium
format
R
i
= a
i
+
i
(R
m
)

+ e
i

Risk Premium Format
Fourth
Edition
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Estimating the Index Model
Excess Returns (i)
Security
Characteristic
Line
.
.
.
.
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.
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.
. .
.
. .
.
. .
.
. .
. .
. .
Excess returns
on market index
R
i
= a
i
+
i
R
m
+ e
i
Fourth
Edition
Irwin / McGraw-Hill
Components of Risk
Market or systematic risk: risk related to the
macro economic factor or market index
Unsystematic or firm specific risk: risk not
related to the macro factor or market index
Total risk = Systematic + Unsystematic
Fourth
Edition
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Measuring Components of Risk
s
i
2
=
i
2
s
m
2
+ s
2
(e
i
)
where;
s
i
2
= total variance
i
2
s
m
2
= systematic variance
s
2
(e
i
) = unsystematic variance

Fourth
Edition
Irwin / McGraw-Hill
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk/Total Risk = r
2

i
2
s

m
2
/ s
2
= r
2

i
2
s
m
2
/
i
2
s
m
2
+ s
2
(e
i
) = r
2

Examining Percentage of Variance
Fourth
Edition
Irwin / McGraw-Hill
Advantages of the Single Index Model
Reduces the number of inputs for
diversification
Easier for security analysts to specialize
Fourth
Edition
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Chapter 8
Capital Asset Pricing
and Arbitrage
Pricing Theory
Fourth
Edition
Irwin / McGraw-Hill
Capital Asset Pricing Model (CAPM)
Equilibrium model that underlies all modern
financial theory
Derived using principles of diversification
with simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
Fourth
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Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded
financial assets
No taxes, and transaction costs
Fourth
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Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations
Fourth
Edition
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Resulting Equilibrium Conditions
All investors will hold the same portfolio
for risky assets market portfolio
Market portfolio contains all securities
and the proportion of each security is its
market value as a percentage of total
market value
Fourth
Edition
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Risk premium on the market depends
on the average risk aversion of all
market participants
Risk premium on an individual security
is a function of its covariance with the
market
Resulting Equilibrium Conditions
(cont.)
Fourth
Edition
Irwin / McGraw-Hill
E(r)
E(r
M
)
r
f
M
CML
s
m
Capital Market Line
s
Fourth
Edition
Irwin / McGraw-Hill

M = Market portfolio
r
f
= Risk free rate
E(r
M
) - r
f
= Market risk premium

E(r
M
) - r
f
= Market price of risk

= Slope of the CAPM
Slope and Market Risk Premium
M
s
Fourth
Edition
Irwin / McGraw-Hill
Expected Return and Risk on
Individual Securities
The risk premium on individual
securities is a function of the individual
securitys contribution to the risk of the
market portfolio
Individual securitys risk premium is a
function of the covariance of returns
with the assets that make up the market
portfolio
Fourth
Edition
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E(r)
E(r
M
)
r
f
SML
M

= 1.0
Security Market Line
Fourth
Edition
Irwin / McGraw-Hill
SML Relationships
= [COV(r
i
,r
m
)] / s
m
2
Slope SML = E(r
m
) - r
f
= market risk premium

SML = r
f
+ [E(r
m
) - r
f
]
Fourth
Edition
Irwin / McGraw-Hill
Sample Calculations for SML
E(r
m
) - r
f
= .08 r
f
= .03

x
= 1.25
E(r
x
) = .03 + 1.25(.08) = .13 or 13%

y
= .6
e(r
y
) = .03 + .6(.08) = .078 or 7.8%
Fourth
Edition
Irwin / McGraw-Hill
E(r)
R
x
=13%
SML
m

1.0
R
m
=11%
R
y
=7.8%
3%
x

1.25
y

.6
.08
Graph of Sample Calculations
Fourth
Edition
Irwin / McGraw-Hill
E(r)
15%
SML

1.0
R
m
=11%
r
f
=3%
1.25
Disequilibrium Example
Fourth
Edition
Irwin / McGraw-Hill
Disequilibrium Example
Suppose a security with a of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
Underpriced: offering too high of a rate
of return for its level of risk
Fourth
Edition
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Security Characteristic Line
Excess Returns (i)
SCL
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
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. .
.
. .
.
. .
.
. .
. .
. .
Excess returns
on market index
R
i
= a
i
+
i
R
m
+ e
i
Fourth
Edition
Irwin / McGraw-Hill
Using the Text Example p. 245, Table
8.5:
Jan.
Feb.
.
.
Dec
Mean
Std Dev
5.41
-3.44
.
.
2.43
-.60
4.97
7.24
.93
.
.
3.90
1.75
3.32
Excess
Mkt. Ret.
Excess
GM Ret.
Fourth
Edition
Irwin / McGraw-Hill
Estimated coefficient
Std error of estimate
Variance of residuals = 12.601
Std dev of residuals = 3.550
R-SQR = 0.575

-2.590
(1.547)
1.1357
(0.309)
r
GM
- r
f
= + (r
m
- r
f
)
Regression Results:
Fourth
Edition
Irwin / McGraw-Hill
Arbitrage Pricing Theory
Arbitrage - arises if an investor can
construct a zero investment portfolio
with a sure profit
Since no investment is required, an
investor can create large positions to
secure large levels of profit
In efficient markets, profitable arbitrage
opportunities will quickly disappear
Fourth
Edition
Irwin / McGraw-Hill
Arbitrage Example from Text pp. 255-
257
Current Expected Standard
Stock Price$ Return% Dev.%
A 10 25.0 29.58
B 10 20.0 33.91
C 10 32.5 48.15
D 10 22.5 8.58
Fourth
Edition
Irwin / McGraw-Hill
Arbitrage Portfolio
Mean Stan. Correlation
Return Dev. Of Returns
Portfolio
A,B,C 25.83 6.40 0.94

D 22.25 8.58
Fourth
Edition
Irwin / McGraw-Hill
Arbitrage Action and Returns
E. Ret.
St.Dev.
* P
* D
Short 3 shares of D and buy 1 of A, B & C to form
P
You earn a higher rate on the investment than
you pay on the short sale
Fourth
Edition
Irwin / McGraw-Hill
APT and CAPM Compared
APT applies to well diversified portfolios and
not necessarily to individual stocks
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio
APT can be extended to multifactor models

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Essentials of Investments

2001 The McGraw-Hill Companies, Inc. All rights reserved.

Rearranging the equation and solving for A

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