Professional Documents
Culture Documents
Management
Instructor: Attila Odabasi
Learning Objectives
Time Value of Money Review
How to calculate the return on an investment using
different methods.
The historical returns on various important types of
investments.
The historical risks of various important types of
investments.
The relationship between risk and return.
1-2
5-4
TVM
FV function is a relationship between four
variables: FVn, V, r, t. Given three variables, you
can solve for the fourth:
FVt
Present Value
V
(1 r ) t
FVt
r
V
t
1/ t
ln( FVt / V )
ln(1 r )
5-5
r mt
$V (1 ) ,
m
r
periodic return
m
Continuous compounding:
r mt
FVt lim $V (1 ) $Ve r t
m
m
where e1 2.71828
5-6
Example
If the simple annual percentage rate is 10% then
the value of $1000 at the end of one year (t =1)
for different values of m is given in the table
below.
Compounding
Frequency
1 year (r = 10%)
Annually (m = 1)
1100.00
Quarterly (m = 4)
1103.81
Weekly (m = 52)
1105.06
Daily (m = 365)
1105.16
Continuously (m = )
1105.17
5-7
$V (1 EAR) $V 1
APR
1 EAR 1
APR
EAR 1
APR
1 EAR
m
APR
1/ m
1
(1 EAR)
m
Continuous Compounding
EAR of APR with continuous compounding:
(1 EAR ) e APR
EAR e APR 1
or equivalently
APR ln(1 EAR)
P0
P0
11
1-15
1
Pt 2
Pt 2
Relationship to one - month returns
P P
rt (2) t t 1 1 (1 rt )(1 rt 1 ) 1
Pt 1 Pt 2
1 rt (2) (1 rt )(1 rt 1 ) 1 rt rt 1 rt rt 1
rt (2) rt rt 1 rt rt 1
two - month gross return the product of two one - month gross returns
Single - period simple returns are not additive
5-16
1 1.125 1 0.125
80
80
The two one - month returns are :
85 80
rt 1
1.0625 1 0.0625
80
90 85
rt
1.0588 1 0.058823
85
The two - month gross return is equal to :
1 rt (2) (1 rt )(1 rt 1 ) 1.0625 1.058823 1.1250
The two - month siple return is not equal to :
rt ( 2) (rt rt 1 ) 0.1250 0.0588 5-17
0.0625
18
19
r cc
cc
1 rt
Pt
ln(1 rt ) ln(
)
Pt 1
r cc
r cc
1 rt
5-21
r t=
Multi-period cc Returns
Pt
r (2) ln(1 rt (2)) ln
Pt 2
cc
rt (2) ln
Pt 1 Pt 2
cc
Pt
P
ln t 1
Pt 1
Pt 2
rtcc (2) rtcc rtcc1
rtcc (2) ln
5-23
5-24
rt
Re al
CPI t
al
Pt Re al Pt Re
1
al
Pt Re
1
Pt
P
t 1
CPI t CPI t 1
P CPI t 1
t
1
Pt 1
Pt 1 CPI t
CPI t 1
1 rt
1
1 t
5-25
85
90
Re al
P
85, Pt
89.1089
1
1.01
and the real monthly return is
89.1089 85
Re al
rt
0.0483
85
Re al
t 1
5-26
1 0.0483
1.01
Notice that simple real return is almost, but not quite
equal to the simple nominal return minus the inflation rate
rt Re al rt t 0.0588 0.01 0.0488
5-27
Re al
Pt k CPI t
1000
1
20
1 20 3.639997 1 0.0667
Pt CPI t k
103.67 2.65
28
100
T-bill Rate
0.04
State of the
market
Excellent
Good
Poor
Crash
Expected
Value
Variance of
HPR
Std of HPR
Risk
Premium
Cash
Dividen
Prob Y-E Price d
0.25 126.50
4.50
0.45 110.00
4.00
0.25
89.75
3.50
0.05
46.00
2.00
Squared
Sqrd
Deviations Deviation
Deviation
from the
s from
Excess s from
HPR mean
Mean
Returns Mean
0.3100
0.2124
0.0451 0.2700
0.0729
0.1400
0.0424
0.0018 0.1000
0.0100
-0.0675
-0.1651
0.0273 -0.1075
0.0116
-0.5200
-0.6176
0.3815 -0.5600
0.3136
<-{=SUMPRODUCT(B5:B8,E5:E8)
0.0976 }
<-{=SUMPRODUCT(B5:B8,G5:G8
0.0380 )}
0.1949<-- =SQRT(E11)
<-{=SUMPRODUCT(B5:B8,H5:H8
5-30
0.0576 )}
Period
2000
2001
2002
2003
2004
2005
Implicitly
Assumed
Prob = 1/5
0.2
0.2
0.2
0.2
0.2
100.000
88.110
68.638
88.330
97.940
102.749
HPR
(decimal)
-0.1189
-0.2210
0.2869
0.1088
0.0491
Squared
Deviation
0.0196
0.0586
0.0707
0.0077
0.0008
Gross
HPR=
1 + HPR
0.8811
0.7790
1.2869
1.1088
1.0491
Wealth
Index
100.000
88.110
68.638
88.330
97.940
102.749
Arithmetic
Average
<-0.0210 =AVERAGE(D4:D8)
Expected Value
Standard
Deviation
Standard
Deviation
0.0210<-- =SUMPRODUCT(B4:B8,D4:D8)
<-0.1774 =SUMPRODUCT(B4:B8,E4:E8)^0.5
0.1774<-- =STDEV.P(D4:D8)
<-0.0054 =GEOMEAN(F4:F8)-1
0.0054<-- =((G8/G3)^0.2)-1
5-31
5-34
Characteristics of Probability
Distributions
1. Mean: __________________________________
_
Arithmetic average & usually most likely
2. Median: _________________
Middle observation
3. Variance or standard deviation:
Dispersion of returns about the mean
4. Skewness:_______________________________
Long tailed distribution, either side
5. Leptokurtosis: ______________________________
Too many observations in the tails
Expected Return:
n
yearly return
i1
1-36
VAR(r) 2
i
i 1
N 1
1-37
Kurtosis
Equation 5.19
Equation 5.20
r r
skew average
^
r r
kurtosis average ^
5-38
r = average
is an incomplete
risk measure
Median
Negative
Positive
Median
Negative
Positive
Implication?
Leptokurtosis
is an incomplete risk
measure
Arith.
Excess
11.43
7.68
11.43
17.26
13.51
5.56
5.92
2.17
5.60
1.85
LT Bond
Geometric 5.31
mean:
Sharpe
SD Kurt. Skew.
Ratio
18. 1.03 -0.16
0.396
28
20. -0.10 -0.26
0.371
67
0.81
37. 1.60
0.362
26
0.77
9.0 1.10
0.239
5
0.80
0.51
8.0
Deviations
from 0.231
1normality?
3.0
8
Arithmetic Average
.1100
.1726
.1143
Geometric Average
.0920
.1143
.0934
Difference
.0180
.0483
.0209
Historical
Variance
.0186
.0694
.0214
Risk Premium
SD of excess return
E[ri ] r f
ri r f
Observations:
Returns appear normally distributed
E(Geomean)=E(arith Mean) var
Except small stocks, equation is nearly satisfied.
Overall, no serious deviations from normality
observed.
1-54