Risk and Return Past and Prologue Essay Example

Risk and Return: Past and Prologue Essay CHAPTER 05 RISK AND RETURN: PAST AND PROLOGUE 1. The 1% VaR will be less than -30%. As percentile or probability ofa return declines so does the magnitude of that return. Thus, a 1 percentile probability will produce a smaller VaR than a 5 percentile probability. 2. The geometric return represents a compounding growth number and will artificially inflate the annual performance of the portfolio. 3. No. Since all items are presented in nominal figures, the input should also use nominal data. 4. Decrease. Typically, standard deviation exceeds return. Thus, an underestimation f 4% in each will artificially decrease the return per unit of risk. To return to the proper risk return relationship the portfolio will need to decrease the amount of risk free investments. 5. Using Equation 5. 6, we can calculate the mean of the HPR as: E(r) = = (0. 3 C] 0. 44) + (0. 4 0 0. 14) + [0. 3 (-0. 16)] = 0. 14 or using Equation 5. 7, we can calculate the variance as: var(r) = 02 = [0. 3 + [0. 4 + [0. 3 (-0. 16-0. 14)2] -0. 054 Taking the square root of the variance, we get SD(r) = 0 = 23. 24% = 0. 2324 or 6. We use the below equation to calculate the holding period return of each cenario: HPR = a. The holding period returns for the three scenarios are: Boom: = Normal: (43-40+ Recession: (34-40+0. 0)/40 = -0. 1375 = -13. 75% E(HPR) = = [(1/3) 0. 30] + [(1/3) 0. 10] + [(1/3) (-0. 1375)] -0. 0875 or 8. 75% var(HPR) = [(1/3) (0. 30 0. 0875)2] + [(1/3) (0. 10 0. 0875)2] + [(1/3) (-0. 1375 0. 0875)2] = 0. 031979 SD(r) = = = 0. 1788 or 17. 88% = 0. 5 017. 88% = 8. 94% 7. a. Time-weighted average returns are based on year-by-year rates of retu rn. Year Return = [(Capital gains + Dividend)/Price] 2010-2011 (110- 100 + or 14. 00% 2011-2012 (90- 110 + -0. 1455 or -14. 5% 2012-2013 (95-90+4)/90- 0. 10 or 10. 00% Arithmetic mean: [0. 14 + (-0. 1455) + 0. 10]/3 = 0. 0315 or 3. 5% Geometnc mean: = 0. 0233 or 2. 33% b. Date 111/20101/1/2011 1/1/20121/112013 Net cash Flow -300 -208 110 396 Time Net Cash flow Explanation O -300 Purchase of three shares at $100 per share 1 -208 Purchase of two shares at $110, plus dividend income on three shares held 2 110 Dividends on five shares, plus sale of one share at $90 3 396 Dividends on four shares, plus sale of four shares at $95 per share The dollar-weighted return is the internal rate of return that sets the sum of the resent value of each net cash flow to zero: 0=-$300 ++ + Dollar-weighted return = Internal rate of return = 8. . Given that A = 4 and the projected standard deviation of the market return = 20%, we can use the below equation to solve for the expected market risk premium: A = 4 † E(rM) AOM2 = 4 (0. 20)0 = 0. 16 or b. solve E(rM) 0. 09 = AOM2 = A (0. 20)0 , we can get A = 0. 09/0. 04 = 2. 25 c. Increased risk tolerance means decreased risk aversion (A), which results in a decline in risk premiums. 9. From Table 5. 4, we find that for the period 1926 2010, the mean excess return for 00 over T-bills 7. 98%. 10. We will write a custom essay sample on Risk and Return: Past and Prologue specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Risk and Return: Past and Prologue specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Risk and Return: Past and Prologue specifically for you FOR ONLY $16.38 $13.9/page Hire Writer To answer this question with the data provided in the textbook, we look up the real returns of the large stocks, small stocks, and Treasury Bonds for 1926-2010 from Table 5. 2, and the real rate of return of T-Bills in the same period from Table 5. 3: Total Real Return Geometric Average Large Stocks: 6. 43% small stocks: 8. 54% Long-Term T-Bonds: 2. 06% Total Real Return Arithmetic Average Large Stocks: 8. 00% small stocks: 13. 91% Long-Term T-Bonds: 1 . 76% T-Bills: 0. 68% (Table 5. 3) 11. a. The expected cash flow is: (0. 5 $50,000) + (0. $100,000 With a nsk remium of 10%, the required rate of return is 15%. Therefore, if the value of the portfolio is X, then, in order to earn a 15% expected return: solving x 00(1 + 0. 15) = $100,000, we get x = $86,957 b. If the portfolio is purchased at $86,957, and the expected payoff is $100,000, then the expected rate of return, E(r), is: The portfolio price is set to equate the expected return with the required rate of return. c. If the ris k premium over T-bills is now 15%, then the required return is: The value of the portfolio (X) must satisfy:x 00(1 + 0. 20) = $100, OOO X = $83333 d. For a given expected cash flow, portfolios that command greater risk premiums must sell at lower prices. The extra discount in the purchase price from the expected value is to compensate the investor for bearing additional risk. 12. a. Allocating 70% of the capital in the risky portfolio P, and 30% in risk-free asset, the client has an expected return on the complete portfolio calculated by adding up the expected return of the risky proportion (y) and the expected return of the proportion (1 y) of the risk-free investment: E(rC) = y 0 E(rP) + (1 -y) 0 rf = (0. 7 0. 17) + (0. 3 0. 07) = 0. or per year The standard deviation of the portfolio equals the standard deviation of the risky fund times the fraction of the complete portfolio invested in the risky fund: DC = y OOP = 0. 7 0 0. 27 = 0. 189 or 18. 9% per year b. The investment proportions of the clients overall portfolio can be calculated by the proportion of risky portfolio in the complete portfolio times the proportion Security Investment Proportions T-Bills 30. 0% stock A stock B stockC 0. 7040% = 28. 0% c. We calculate the reward-to-variability ratio (Sharpe ratio) using Equation 5. 14. For the risky portfolio: s For the clients overall portfolio: 3. = 0. 704 a. -Y)orf 0. 17+(1 -Y) 0 0. 07 = 0. 15 or per year Solving for y, we get y = = 0. 8 Therefore, in order to achieve an expected rate of return of 1 5%, the client must invest 80% of total funds in the risky portfolio and 20% in T-bills. the proportion of risky asset in the whole portfolio times the proportion allocated in each stock. Security Stock A stock C Investment Proportions 20. 0% 0. 8 21 0. 8 0 = 26. 4% 0. 8 = 32. 0% d. The standard deviation of the complete portfolio is the standard deviation of the risky portfolio times the fraction of the portfolio invested in the risky asset: DC = y 0. 8 0. 27 = 0. 216 or 21. % per year 14. a. Standard deviation of the complete portfolio= DC = y 0 0. 27 If the client wants the standard deviation to be equ al or less than 20%, then: y = (0. 20/0. 27) = 0. 7407 = 74. 07% b. +0. 7407 0. 10 15. a. Slope of the CML = = 0. 24 See the diagram below: = 0. 1441 or 14. 41% b. Your fund allows an investor to achieve a higher expected rate of return for any given standard deviation than would a passive strategy, i. e. , a higher expected return for any given level of risk. 16. a. With 70% of his money in your funds portfolio, the client has an expected rate of eturn of 14% per year and a standard deviation of 18. % per year. If he shifts that money to the passive portfolio (which has an expected rate of return of 13% and standard deviation of 25%), his overall expected return and standard deviation would become: E(rc) = rf+ 0. 7 rn In this case, 7% and E(rM) = 13%. Therefore: E(rc) = 0. 07 + (0. 7 0. 06) = 0. 112 or 11. 2% The standard deviation of the complete portfolio using the passive portfolio would be: OC = 0. 7 00M = 0. 7 0. 25 = 0. 175 or 17. 5% Therefore, the shift entails a decline in the mean from 14% to 1 1. 2% and a decline in he standard deviation from 18. 9% to 17. 5%. Since both mean return and standard deviation fall, it is not yet clear whether the move is beneficial. The disadvantage of the shift is apparent from the fact that, if your client is willing to accept an expected return on his total portfolio of 1 1. 2%, he can achieve that return with a lower standard deviation using your fund portfolio rather than the passive portfolio. To achieve a target mean of 1 1. 2%, we first write the mean of the complete portfolio as a function of the proportions invested in your fund portfolio, y: + y (17% = + ooy Because our target is E(rC) = 1 1. %, the proportion that must be invested in your fund is determined as follows: 11. 2% = + ooy = = 0. 42 The standard deviation of the portfolio would be: oc = y 0 = 0. 42 0 = 11. 34% Thus, by using your portfolio, the same 1 1. 2% expected rate of return can be achieved with a standard deviation of only 1 1. 34% as opposed to the standard deviation of 17. 5% using the passive portfolio. b. The fee would reduce the reward-to-variability ratio, i. e. , the slope of the CAL. Clients will be indifferent between your fund and the passive portfolio if the slope of Slope of CAL with fee = Slope of CML (which requires no fee) = Setting these slopes equal and solving for f: 0. 24 = 6. 48% 6. 48% = 3. 52% per year 17. Assuming no change in tastes, that is, an unchanged risk aversion, investors perceiving higher risk will demand a higher risk premium to hold the same portfolio they held before. If we assume that the risk-free rate is unaffected, the increase in the risk premium would require a higher expected rate of return in the equity market. 18. Expected return for your fund = T-bill rate + risk premium = 6% + 10% = 16% Expected return of clients overall portfolio = (0. 16%) + (0. 4 0 6%) = 12% Standard deviation of clients overall portfolio = 0. 6 0 14% = 8. 4% 19. Reward to volatility ratio = = 0. 7143 20. Excess Return (%) a. In three out of four time frames presented, small stocks provide worse ratios than large stocks. b. Small stocks show a declining trend in risk, but the decline is not stable. 21 . For geometric real returns, we take th e geometric average return and the real geometric return data from Table 5. 2 and then calculate the inflation in each time frame using the equation: Inflation rate = (1 + Nominal rate)/(l + Real rate) 1. The VaR is not calculated, since the values used to determine the VaR in Table 5. 4 are not provided. Comparing with the excess return statistics in Table 5. 4, in three out of four time frames the arithmetic real return is larger than the excess return, and the standard deviation of the real return in each time frame is lower than that of the excess Comparing the nominal rate with the real rate of return, the real rates in all time frames and their standard deviation are lower than those of the nominal returns. Comparison The combined market index represents the Fama-French market factor (Mkt). It is better diversified than the S 500 index since it contains approximately ten times as many stocks. The total market capitalization of the additional stocks, however, is relatively small compared to the S 500. As a result, the performance of the value- weighted portfolios is expected to be quite similar, and the correlation of the excess returns very high. Even though the sample contains 84 observations, the standard deviation of the annual returns is relatively high, but the difference between the two indices is very small. When comparing the continuously compounded excess returns, e see that the difference between the two portfolios is indeed quite small, and the correlation coefficient between their returns is 0. 99. Both deviate from the normal distribution as seen from the negative skew and positive kurtosis. Accordingly, the VaR (5% percentile) of the two is smaller than what is expected from a normal distribution with the same mean and standard deviation. This is also indicated by the lower minimum excess return for the period. The serial correlation is also small and indistinguishable across the portfolios. As a result of all this, we expect the risk premium of the two portfolios to be similar, s we find from the sample. It is worth noting that the excess return of both portfolios has a small negative correlation with the risk-free rate. Since we expect the risk-free rate to be highly correlated with the rate of inflation, this suggests that equities are not a perfect hedge against inflation. More rigorous analysis of this point is important, but beyond the scope of this question. CFA 1 Answer: V(12/31/2011) = (1/1/2005) O (1 + = $100,000 (1. 05)7 = $140,710. 04 CFA2 Answer: a. and b. are true. The standard deviation is non-negative. CFA3 Answer: c. Determines most of the portfolios return and volatility over time. Answer: Investment 3. For each portfolio: Utility = E(r) Investment E(r) 0 Utility 02) 1 0. 12 2 0. 15 3 0. 21 4 0. 24 0. 30 0. 50 0. 16 0. 21 -0. 0600 -0. 3500 0. 1588 0. 1518 We choose the portfolio with the highest utility value. CFA 5 Answer: Investment 4. When an investor is risk neutral, A = O so that the portfolio with the highest utility is the portfolio with the highest expected return. CFA 6 Answer: b. Investors aversion to risk. CFA 7 Answer: = [0. 2 0 (-0. 20)] + (0. 5 0 0. 18) + (0. 3 0. 50) = 0. 20 or E(rY) = [0. 2 (-0. 15)] + (0. 5 0. 20) + (0. 0. 10) = 0. 10 or CFA8 OX2 = [0. 2 0 (-0. 0 0. 20)2] + [0. 5 0 (0. 18 0. 20)2] + [0. 3 0 (0. 50 0. 20)2] 0. 2433 = 24. 33% OY2 = [0. 2 0 (-0. 15 0. 10)2] + [0. 5 (0. 20 0. 10)2] + [0. 3 (0. 10 0. 10)2] 0. 1323= 13. 23% CFA 9 E(r) = (0. 9 0. 20) + (0. 1 00. 10) = 0. 19 or 19% CFA 10 = 0. 0592 ox = 0. 0175 = The probability is 0. 5 that the st ate of the economy is neutral. Given a neutral economy, the probability that the performance of the stock will be poor is 0. 3, and the probability of both a neutral economy and poor stock performance is: 0. 3 0. 5=0. 15 E(r) = (0. 1 00. 15) + (0. 6 0. 13) + (0. 3 0. 07) = 0. 114 or 11. 4%