Professional Documents
Culture Documents
Rob Schonlau
Last updated Sept 8, 2014
Now that you know some of your options, the next logical
discussion would be about how you should go about choosing
between the various assets. But before we can do that we need to
first review/learn some tools and measures.
Lecture 3 outline
Gross Returns
Gross returns above 100% are good. Gross returns below 100%
indicate losses.
Net Returns
For example, an account that says it pays a 10% APR will not
actually grow your deposit by 10% over a year if there is
compounding during that year.
These formulas are used when you have a single cash flow to move
through time as opposed to a stream of cash flows.
PV = present value
FV = future value
r = annual interest rate (APR)
n = number of compounding intervals per year
= 1 +
1+
= 1 +
10
11
1001.05 105
3
After the third year, what is the value of investment? 100 1.05 115.76
115.76/100-1 = 15.76%
13
Example: EAR
Suppose you pay 1% interest on your credit card
balance each month. What is the EAR?
Step 1: Break the problem into its individual pieces:
ER1mo = 1% and ER12mo = unknown
2 different units of time (1month vs 12 months)
Step 2: Assume you will make two $1 investments over a 12 month
period: one that will grow at the ER1mo rate each month and the
other that will grow at the ER12mo rate over the year. Note that ER12mo
= EAR. In this example the future values would be:
FV = 1(1+ER1mo)12 = 1(1+.01)12 and FV = 1(1+ER12mo)1
Step 3: Set the future value of the two investments equal so that you
can back out the unknown rate.
1(1+.01)12 = 1(1+ER12mo)1
16
Example: APR
Assume a bank charges 5% semi-annually.
What is the APR?
5% is the effective 6 month rate. Because interest is applied
every six months this means that n=2. APRs dont account
for compound interest.
Effective 6 month rate = r/n and .05= r/2 which means that r
= 10%.
What is the effective annual return (EAR) on the loan?
(1+ r/n ) n*y -1 = (1.05)2*1 -1 = 10.25%
17
Concept check
(Q1) What is the difference between APR and EAR?
(Q2) If you have an initial investment of $1 and an effective
annual rate of growth of 10%, what is your investment worth at the
end of 1 year?
(Q3) Assume you have an initial investment of $100 and an
account that provides an APR of 10% with quarterly compounding.
What is your investment worth at the end of 1 year? What is the
EAR?
18
19
20
Arithmetic average
Assume you have 10 years of annual return data (r1, r2, , r10) for an
asset and you want to summarize the annual historical returns for
this asset. The arithmetic average is calculated as the simple
average of the 10 yearly returns.
Arithmetic average =
1 +2 ++10
10
Geometric average
1 + 1 1 + 2 1 +
1/
Note that the product within the brackets is the cumulative return
over the n periods that the investor experienced and includes the
effects of compound interest.
22
Rearrange terms: =
1=
1 +
1 + 1 1 + 2 1 +
1/
1
23
Dollar-weighted returns
24
Lecture 3 outline
25
26
What is risk?
Risk is related to the probability of obtaining outcomes that are far
different than the expected value. In some sense risk measures
the likely variability of the possible results.
In this class we will use measures of dispersion (standard
deviation, variance) as proxies of risk. We will refine our measures
of risk in subsequent lectures.
Expected Return
28
29
1926-2009
Geometric Ave
Arithmetic Ave
Standard Deviation
1968-2009
Geometric Ave
Arithmetic Ave
Standard Deviation
Large Stocks
(World)
9.43
11.23
19.27
Large
Stocks
(US)
9.57
11.63
20.56
Small
Stocks
(US)
11.6
17.43
37.18
LT Bonds
(US)
5.37
5.69
8.45
Large Stocks
(World)
9.9
11.77
19.36
Large
Stocks
(US)
9.32
10.89
17.95
Small
Stocks
(US)
10
13.47
27.41
LT Bonds
(US)
7.96
8.44
10.34
30
Frequency (# of years)
S&P 500
Small Stocks
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Annual Return
31
>100%
33