Chapter 05 - Learning About Return and Risk from the Historical Record

CHAPTER5:LEARNINGABOUTRETURNANDRISK
FROMTHEHISTORICALRECORD
PROBLEMSETS
1.

TheFisherequationpredictsthatthenominalratewillequaltheequilibriumrealrate
plustheexpectedinflationrate.Hence,iftheinflationrateincreasesfrom3%to5%
whilethereisnochangeintherealrate,thenthenominalratewillincreaseby2%.On
theotherhand,itispossiblethatanincreaseintheexpectedinflationratewouldbe
accompaniedbyachangeintherealrateofinterest.Whileitisconceivablethatthe
nominalinterestratecouldremainconstantastheinflationrateincreased,implyingthat
therealratedecreasedasinflationincreased,thisisnotalikelyscenario.

2.

Ifweassumethatthedistributionofreturnsremainsreasonablystableovertheentire
history,thenalongersampleperiod(i.e.,alargersample)increasestheprecisionofthe
estimateoftheexpectedrateofreturn;thisisaconsequenceofthefactthatthestandard
errordecreasesasthesamplesizeincreases.However,ifweassumethatthemeanofthe
distributionofreturnsischangingovertimebutwearenotinapositiontodeterminethe
natureofthischange,thentheexpectedreturnmustbeestimatedfromamorerecent
partofthehistoricalperiod.Inthisscenario,wemustdeterminehowfarback,
historically,togoinselectingtherelevantsample.Here,itislikelytobe
disadvantageoustousetheentiredatasetbackto1880.

3.

Thetruestatementsare(c)and(e).Theexplanationsfollow.
Statement(c):Let =theannualstandarddeviationoftheriskyinvestmentsand 1 =
thestandarddeviationofthefirstinvestmentalternativeoverthetwoyearperiod.Then:
1 2

Therefore,theannualizedstandarddeviationforthefirstinvestmentalternativeisequal
to:
1

2
2

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Chapter 05 - Learning About Return and Risk from the Historical Record

Statement(e):Thefirstinvestmentalternativeismoreattractivetoinvestorswithlower
degreesofriskaversion.Thefirstalternative(entailingasequenceoftwoidentically
distributedanduncorrelatedriskyinvestments)isriskierthanthesecondalternative(the
riskyinvestmentfollowedbyariskfreeinvestment).Therefore,thefirstalternativeis
moreattractivetoinvestorswithlowerdegreesofriskaversion.Notice,however,thatif
youmistakenlybelievedthattimediversificationcanreducethetotalriskofa
sequenceofriskyinvestments,youwouldhavebeentemptedtoconcludethatthefirst
alternativeislessriskyandthereforemoreattractivetomoreriskaverseinvestors.This
isclearlynotthecase;thetwoyearstandarddeviationofthefirstalternativeisgreater
thanthetwoyearstandarddeviationofthesecondalternative.

4.

Forthemoneymarketfund,yourholdingperiodreturnforthenextyeardependsonthe
levelof30dayinterestrateseachmonthwhenthefundrollsovermaturingsecurities.
Theoneyearsavingsdepositoffersa7.5%holdingperiodreturnfortheyear.Ifyou
forecastthattherateonmoneymarketinstrumentswillincreasesignificantlyabovethe
current6%yield,thenthemoneymarketfundmightresultinahigherHPRthanthe
savingsdeposit.The20yearTreasurybondoffersayieldtomaturityof9%peryear,
whichis150basispointshigherthantherateontheoneyearsavingsdeposit;however,
youcouldearnaoneyearHPRmuchlessthan7.5%onthebondiflongterminterest
ratesincreaseduringtheyear.IfTreasurybondyieldsriseabove9%,thenthepriceof
thebondwillfall,andtheresultingcapitallosswillwipeoutsomeorallofthe9%
returnyouwouldhaveearnedifbondyieldshadremainedunchangedoverthecourseof
theyear.

5.

a.

Ifbusinessesreducetheircapitalspending,thentheyarelikelytodecreasetheir
demandforfunds.ThiswillshiftthedemandcurveinFigure5.1totheleftand
reducetheequilibriumrealrateofinterest.

b.

Increasedhouseholdsavingwillshiftthesupplyoffundscurvetotherightand
causerealinterestratestofall.

c.

OpenmarketpurchasesofU.S.TreasurysecuritiesbytheFederalReserveBoard
isequivalenttoanincreaseinthesupplyoffunds(ashiftofthesupplycurveto
theright).Theequilibriumrealrateofinterestwillfall.

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Chapter 05 - Learning About Return and Risk from the Historical Record

6.

7.

a.

TheInflationPlusCDisthesaferinvestmentbecauseitguaranteesthepurchasing
poweroftheinvestment.Usingtheapproximationthattherealrateequalsthenominal
rateminustheinflationrate,theCDprovidesarealrateof1.5%regardlessofthe
inflationrate.

b.

Theexpectedreturndependsontheexpectedrateofinflationoverthenextyear.Ifthe
expectedrateofinflationislessthan3.5%thentheconventionalCDoffersahigher
realreturnthantheInflationPlusCD;iftheexpectedrateofinflationisgreaterthan
3.5%,thentheoppositeistrue.

c.

Ifyouexpecttherateofinflationtobe3%overthenextyear,thentheconventional
CDoffersyouanexpectedrealrateofreturnof2%,whichis0.5%higherthanthereal
rateontheinflationprotectedCD.Butunlessyouknowthatinflationwillbe3%with
certainty,theconventionalCDisalsoriskier.Thequestionofwhichisthebetter
investmentthendependsonyourattitudetowardsriskversusreturn.Youmightchoose
todiversifyandinvestpartofyourfundsineach.

d.

No.Wecannotassumethattheentiredifferencebetweentheriskfreenominalrate(on
conventionalCDs)of5%andtherealriskfreerate(oninflationprotectedCDs)of
1.5%istheexpectedrateofinflation.Partofthedifferenceisprobablyariskpremium
associatedwiththeuncertaintysurroundingtherealrateofreturnontheconventional
CDs.Thisimpliesthattheexpectedrateofinflationislessthan3.5%peryear.

E(r)=[0.3544.5%]+[0.3014.0%]+[0.35(16.5%)]=14%
2=[0.35(44.514)2]+[0.30(1414)2]+[0.35(16.514)2]=651.175
=25.52%
Themeanisunchanged,butthestandarddeviationhasincreased,astheprobabilitiesof
thehighandlowreturnshaveincreased.

8.

Probabilitydistributionofpriceandoneyearholdingperiodreturnfora30yearU.S.
Treasurybond(whichwillhave29yearstomaturityatyearsend):
Economy
Boom
NormalGrowth
Recession

Probability

YTM

0.20
0.50
0.30

11.0%
8.0%
7.0%

Price

Capital
Gain

$74.05 $25.95
$100.00
$0.00
$112.28 $12.28

5-3

Coupon
Inte
HPR
rest
$8.00 17.95%
$8.00
8.00%
$8.00 20.28%

Chapter 05 - Learning About Return and Risk from the Historical Record

9.

E(q)=(00.25)+(10.25)+(20.50)=1.25
q=[0.25(01.25)2+0.25(11.25)2+0.50(21.25)2]1/2=0.8292

10.

(a)Withprobability0.9544,thevalueofanormallydistributedvariablewillfall
withintwostandarddeviationsofthemean;thatis,between40%and80%.

11.

FromTable5.3,theaverageriskpremiumforlargecapitalizationU.S.stocksforthe
period19262005was:(12.15%3.75%)=8.40%peryear
Adding8.40%tothe6%riskfreeinterestrate,theexpectedannualHPRfortheS&P
500stockportfoliois:6.00%+8.40%=14.40%

12.

Theaverageratesofreturnandstandarddeviationsarequitedifferentinthesubperiods:
STOCKS
Standard
Mean
Skewness
Kurtosis
Deviation
19262005
12.15%
20.26%
0.3605
0.0673
19762005
13.85%
15.68%
0.4575
0.6489
19261941
6.39%
30.33%
0.0022
1.0716

Mean
19262005
19762005
19261941

5.68%
9.57%
4.42%

BONDS
Standard
Skewness
Deviation
8.09%
0.9903
10.32%
0.3772
4.32%
0.5036

Kurtosis
1.6314
0.0329
0.5034

Themostrelevantstatisticstouseforprojectingintothefuturewouldseemtobethe
statisticsestimatedovertheperiod19762005,becausethislaterperiodseemstohave
beenadifferenteconomicregime.After1955,theU.S.economyenteredtheKeynesian
era,whentheFederalgovernmentactivelyattemptedtostabilizetheeconomyandto
preventextremesinboomandbustcycles.Notethatthestandarddeviationofstock
returnshasdecreasedsubstantiallyinthelaterperiodwhilethestandarddeviationof
bondreturnshasincreased.
13.

1 R
R i 0.80 0.70
1

0.0588 5.88%
1 i
1 i
1.70

b.

rRi=80%70%=10%
Clearly,theapproximationgivesarealHPRthatistoohigh.

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Chapter 05 - Learning About Return and Risk from the Historical Record

14.

FromTable5.2,theaveragerealrateonTbillshasbeen:0.72%
a.
Tbills:0.72%realrate+3%inflation=3.72%
b.

Expectedreturnonlargestocks:
3.72%Tbillrate+8.40%historicalriskpremium=12.12%

c.

Theriskpremiumonstocksremainsunchanged.Apremium,thedifference
betweentworates,isarealvalue,unaffectedbyinflation.

15.

Realinterestratesareexpectedtorise.Theinvestmentactivitywillshiftthedemand
forfundscurve(inFigure5.1)totheright.Thereforetheequilibriumrealinterestrate
willincrease.

16.

a.

ProbabilityDistributionoftheHPRontheStockMarketandPut:

Stateofthe
Economy
Boom
NormalGrowth
Recession

Probability
0.30
0.50
0.20

STOCK
EndingPrice
HPR
+Dividend
$134
34%
$114
14%
$84
16%

PUT
EndingValue
$0.00
$0.00
$29.50

HPR
100%
100%
146%

Rememberthatthecostoftheindexfundis$100pershare,andthecostoftheput
optionis$12.
b.

Thecostofoneshareoftheindexfundplusaputoptionis$112.Theprobability
distributionoftheHPRontheportfoliois:

Stateofthe
Economy
Boom
NormalGrowth
Recession
c.

Probability
0.30
0.50
0.20

EndingPrice
+Put+
$4Dividend
$134.00
$114.00
$113.50

HPR
19.6%
1.8%
1.3%

=(134112)/112
=(114112)/112
=(113.50112)/112

BuyingtheputoptionguaranteestheinvestoraminimumHPRof1.3%regardless
ofwhathappenstothestock'sprice.Thus,itoffersinsuranceagainstaprice
decline.

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Chapter 05 - Learning About Return and Risk from the Historical Record

17.

TheprobabilitydistributionofthedollarreturnonCDpluscalloptionis:
Stateofthe
Economy
Boom
NormalGrowth
Recession

Probability
0.30
0.50
0.20

EndingValue
ofCD
$114.00
$114.00
$114.00

EndingValue
ofCall
$19.50
$0.00
$0.00

Combined
Value
$133.50
$114.00
$114.00

CFAPROBLEMS
1.

Theexpecteddollarreturnontheinvestmentinequitiesis$18,000comparedtothe$5,000
expectedreturnforTbills.Therefore,theexpectedriskpremiumis$13,000.

2.

E(r)=[0.2(25%)]+[0.310%]+[0.524%]=10%

3.

E(rX)=[0.2(20%)]+[0.518%]+[0.350%]=20%
E(rY)=[0.2(15%)]+[0.520%]+[0.310%]=10%

4.

X2=[0.2(2020)2]+[0.5(1820)2]+[0.3(5020)2]=592
X=24.33%
Y2=[0.2(1510)2]+[0.5(2010)2]+[0.3(1010)2]=175
X=13.23%

5.

E(r)=(0.920%)+(0.110%)=19%

6.

Theprobabilitythattheeconomywillbeneutralis0.50,or50%.Givenaneutral
economy,thestockwillexperiencepoorperformance30%ofthetime.Theprobability
ofbothpoorstockperformanceandaneutraleconomyistherefore:
0.300.50=0.15=15%

7.

E(r)=(0.115%)+(0.613%)+(0.37%)=11.4%

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