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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:

RISK AND RETURN I

Finance 321

Frank LaMay

QUESTIONS
1. The arithmetic average is the average return that the investment itself produces each year. It treats every
years result independently, and doesnt reflect any carryover or accumulation of return from year to year.
The only way an investor can earn the arithmetic average over several years would be to start fresh each
year, i.e., begin each year with the same amount of money invested.
The geometric average is the average compound return an investor earns from an investment. It assumes
that one years result carries over to the next year, i.e., that the investors balance at the end of the first
year is the beginning balance for the second, etc. It can be thought of as the result you would get from a
buy and hold strategy in which you put an amount of money into an investment at the beginning of a
period and dont make deposits or withdrawals during the investment period.
Note that whenever there is any variability in returns from year to year (which is true for most investments)
the geometric average will be lower than the arithmetic average.
The dollar weighted average is the actual return an individual investor earns on an investment. Like the
geometric average, it reflects compounding from year to year, but it also reflects the impact of the
investors decisions to make deposits and withdrawals: whether the investor adds cash or removes cash,
how much she adds or removes, and when. For example, if an investor makes a large deposit right before
the investment earns very high returns (favorable timing), the dollar weighted average will be higher than
the geometric average; the opposite happens if the investor makes a large deposit right before the
investment earns low returns. Similarly, if an investor withdraws a large amount right before a period of
high returns, that will make the dollar weighted average lower than the geometric average; on the other
hand, withdrawals before periods of low return will increase the dollar weighted average.
2. The standard deviation is a measure of how much the yearly returns on the stock market varied from the
average return.
3.
a.

One way of thinking about the expected return is that it is a forward-looking average. The text
says: You can think of [the expected return] as the average holding period return you would
earn if you were to repeat an investment in the asset many times. If you invested in this stock
over a number of years and your assumptions about returns and probabilities remained valid,
youd expect your average return to be the expected return (or very close).

b.

The standard deviation is a measure of how much the yearly returns on the stock would vary from
the expected return. (Remember that the expected return is a kind of average; you would almost
never earn the expected return in any given year.)

c.

The standard deviation allows us to talk about confidence intervals e.g., we could say that about
two-thirds of the time (68.26% to be exact) youd expect this stocks return to be between (15%)
(expected return minus one standard deviation) and 45% (expected return plus one standard
deviation).

4. Treasury bills are considered risk-free and are the foundation on which other rates of return are built.
Investors know what rate of return they can get without taking on risk (the risk-free rate) and for risky
investments they require a risk premium over and above the risk-free rate.
5. Excess return is the difference between an investments return and the risk-free rate. Its the risk premium
or reward that investors receive for bearing the investments risk. The idea applies to historical returns
(that is, how much excess return did investors get on a risky investment) and to expected returns (how
excess return do they expect to get on a risky investment in the future).

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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

6. One possible explanation for high returns on risky investments is high risk premiums; the other is high
risk-free rates. Its possible that during the several years the risk-free rate and other interest rates were
quite high, and that the risky investments did not offer much of a risk premium.
7. The Sharpe measure captures the risk premium an investment offers relative to its risk. Because it captures
reward per unit of risk it allows us to compare the risk premiums across investments or portfolios.

PROBLEMS
1.
Price
Beginning Year-end
(a)
75.00
60.00
90.00

Change
(b)

60.00
90.00
80.00

Dividend
(c)

(15.00)
30.00
(10.00)

2.00
2.10
2.10

Total $ Return
(d) = (b) + (c)
(13.00)
32.10
(7.90)

Arithmetic average =

% Return
(d) / (a)
(0.17)
0.54
(0.09)
0.27
0.09

Geometric average return:


1

(1 r1 )(1 r2 )(1 r3 ) ... (1 rN )N 1


1
3

[(1 (.17))(1 .54) (1 .(09))] 1


1
3

[(.83)(1.54)(.91)] 1
[1.163162].33333 1
0516
.05 r

See question #1 above for discussion of difference between arithmetic and geometric averages.
2. a. The three month holding return (HPR) on the Treasury bill is:
End Price end value of intermediate cash flows - start price 10,000 9,700

.031
Start price
9,700

The annualized holding period return is:

AHPR (1 HPR)
(1.031)

1
.25

1 (1.031) 4 1 1.1299 1 .1299

(b) For the mutual fund, the four-year holding period return (HPR) is:

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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

End Price end value of intermediate cash flows - start price 1,800 1,000

.80
Start price
1,000
and the annualized holding period return (AHPR) is:
AHPR (1 HPR)
(1.8)

1 (1.8) .25 1 1.1583 1 .1583

(c) For the stock, the three-year holding period return (HPR) is:

End Price end value of intermediate cash flows - start price 7,000 9,000

.222
Start price
9,000
and the annualized holding period return (AHPR) is:

AHPR (1 HPR)
(1 .222)

1 (.778) .333 1 .9197 1 . .0803 .08

(Note: Since the number of shares didnt change over the three years, youd get the same result by
calculating the return on one share i.e., using the price per share of 90 at the beginning and 70 at the
end to calculate the holding period return.)

3. (a)

.05 (.25) .20 .10


.025
4
(b)
1

(1 r1 )(1 r2 )(1 r3 ) ... (1 rN )N 1


1

[(1 .05)(1 (.25)) (1 .20)(1 10)] 4 1


[(1.05)(.75)(1.2)(1.1)].25 1
[1.0395].25 1
.0097 r
.01 r

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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

(c)
2006

Starting value
$ return
Ending value

2007

2008

2009

2010

5%

-25%

20%

10%

2,000
100
2,100

Net inflow
(Net deposits/withdrawals)
(at year-end)

2,000

Arithmetic average
Geometric average

2,000
(500)
1,500

2,500
500
3,000

(100)

1,000

200

1
100

2
(1,000)

3
(200)

3,200
320
3,520

2.5%
1.0%
0
(2,000)

Cash flows

4
3,520

Dollar-weighted return
4.0%
(EXCEL IRR FUNCTION applied to cash flows above)

4. The dollar weighted return is different because it reflects the amount and timing of the deposits you
made: you withdrew money before the year with the worst return (2008), made a large deposit just
before the year with the strongest return (2009) and made another deposit before the year with the
second strongest return (2010). This is an example of favorable market timing (something which is
hard to achieve other than by luck).
5.
The average return is

.58 (.20) .13 .20


.1775 .178
4

The standard deviation is .32:


Standard
2

Year
1
2
3
4

Return (
(
(
(

.58
(.20)
.13
.20

Variance

Deviation
Average
.178
.178
.178
.178

Deviation

=
)

.1616

.1429

.0023

.0005
.3073

)
)
)

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Variance

.10243

.320

SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

6. (a) The expected return is .105 and the standard deviation is ~.25:
Probability
Very good year
Good yeaer
Mediocre year
Poor year

.20
.30
.30
.20

Probability
x Return

Return
.45
.20
.05
(.30)

.090
.060
.015
(.060)
.105

Probability
Very good year

.20

Return
x (

.45

Deviation
Expected
Return
-

.105

=
)

.02378

Good year

.30

x (

.20

.105

.00271

Mediocre year

.30

x (

.05

.105

.00091

.03281

Poor year

.20

x (

(.30)

.105

VARIANCE .06020
STANDARD DEVIATION .24535
(square root of variance)
~.245 rounded

(b) The standard deviation is a measure of the risk of an investment in the fund. It reflects the
volatility that you expect in yearly returns for the fund how much the yearly result on the fund
is likely to vary from its expected return. Using the idea of confidence intervals, you could
estimate that about two-thirds of the time (actually 68% of the time), the funds result in any year
will be in a range of .35 [expected return + one standard deviation] to (.14) [expected return one
standard deviation]. You could estimate a 95% confidence interval by adding or subtracting two
standard deviations.
(c)

VaR r 1.64485
.105 1.64485(.245)
.105 .403
.298
(d) The VaR indicates that 5% of the time wed expect the return on this fund to be below .298 (i.e.,
the probability that its return will be below .298 is 5%). Put differently, it indicates that 95% of
the time wed expect the return on this fund to be above .298 (i.e., the probability that its return
will be better than .298 is 95%).

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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

7. For stocks:

rP rF .08 .02 .06

.32
P
.19
.19

For bonds:

rP rF .05 .02 .03

1.00
P
.03
.03

The Sharpe ratio for stocks is much lower for these fifteen years than the longer-term ratio (which was
.40 on a rounded basis), while the ratio for bonds is much higher than the longer-term ratio. Over short
periods of time, investment results can vary significantly from longer-term patterns.
8. The approximation is rnominal i = .07 - .03 = .04.
The exact calculation is 1 rreal

1 rno min al 1.07

1.0388
1 i
1.03
rreal = .0388

The exact calculation takes into account the compounding of inflation, while the approximation
ignores compounding.
The approximation is less useful (i.e., the difference between the approximation and the exact
calculation is bigger) when inflation and returns are high.
The approximation is also less useful when youre thinking about the impact of returns over a long
period of time: a small difference in your estimate of the real return can have a big impact if it
compounds over many years. For example, if you are estimating how much your retirement account
will be worth 40 years from now, a .5% difference in the estimate of your expected real return will
have a big impact on your answer.

EXTRA PRACTICE PROBLEMS


9.

(a)

.07 .30 (.20) .05


.055
4

(b)
1

(1 r1 )(1 r2 )(1 r3 ) ... (1 rN )N 1


1

[(1 .07)(1 .30) (1 (.20))(1 .05)] 4 1


[(1.07)(1.30)(.8)(1.05)].25 1
[1.16844].25 1
.0397 r
.04 r

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SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay

(c)
2011

Starting value
$ return
Ending value
Net inflow
(Net deposits/withdrawals)
(at year-end)

5,000

Arithmetic average
Geometric average

2012

2013

2014

2015

7%

30%

-20%

5%

5,000
350
5,350

4,850
1,455
6,305

7,305
(1,461)
5,844

6,044
302
6,346

(500)

1,000

200

1
500

2
(1,000)

3
(200)

5.5%
4.0%
0
(5,000)

Cash flows

4
6,346

Dollar-weighted return
3.0%
(EXCEL IRR FUNCTION applied to cash flows above)

10.
The average return is (.25) .08 .40 .10 .0825
4
The standard deviation is .266:
Standard
2

Deviation
Return - Average

Year

Variance
=
2

.1106

.0000

.1008

.0003
.2117

(.25)

.0825

.08

.0825

3
4

(
(

.40

.10

.0825
.0825

)
)

Variance

11. (a) The expected return is .114 and the standard deviation is ~.284:
Probability
Very good year
Good yeaer
Mediocre year
Poor year

.20
.30
.30
.20

Return

Deviation

Probability
x Return

.50
.25
.03
(.35)

.100
.075
.009
(.070)
.114

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.07056

.266

SOLUTIONS FOR QUESTIONS AND PROBLEMS #1:


RISK AND RETURN I

Finance 321

Frank LaMay
2

Probability
Very good year
Good year

.20
.30

Mediocre year
Poor year

.30
.20

Return
x (
x (
x (
x (

.50
.25
.03
(.35)

Deviation
Expected
Return
-

.114
.114
.114
.114

=
2

.02980

.00555

.00212

.04306

)
)
)
)

VARIANCE .08052
STANDARD DEVIATION .28377
(square root of variance)
~.284 rounded

(b) The standard deviation measures the risk of an investment: it reflects the volatility that you expect
in yearly returns for the fund how much the yearly result on the fund is likely to vary from its
expected return. Using the idea of confidence intervals, you could estimate that about two-thirds
of the time (actually 68% of the time), the funds result in any year will be in a range of .398
[expected return + one standard deviation] to (.17) [expected return one standard deviation].

(c)
VaR r 1.64485
.114 1.64485(.284)
.114 .4671374
.3531374
.353

(d) The VaR indicates that 5% of the time wed expect the return on this fund to be below .353 (i.e.,
the probability that its return will be below .353 is 5%). Put differently, it indicates that 95% of
the time wed expect the return on this fund to be above .353 (i.e., the probability that its return
will be better than .353 is 95%).

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