II. Portfolio Theory

A.  Risk and Return

1.  Interest rates

a. Factors affecting interest rates

(1) Supply of funds from savers

(2) Demand for funds from businesses

(3) Government’s net demand for funds

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 b. Equilibrium

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2.  Rates of return

a. Holding period return

• Return for a particular holding period

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b.  Return over multiple periods

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(1)  Arithmetic average

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(2)  Geometric average

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(3)  Dollar-weighted return

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c.  Annualizing rates of return

(1) Annual percentage rates

• Annualized return on short-term investments (< one year) using simple interest

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(2) Effective annual rate

• Percentage increase in funds invested over a 1-year horizon

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 3. Risk and risk premiums

a. Expected return

• Measure of central tendency

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b. Standard deviation

• Measure of variation

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c.  The Normal distribution

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• Return on a portfolio of two or more assets whose returns are normally distributed also will be normally distributed

• Normal distribution is completely described by its mean and standard deviation

• Standard deviation is the appropriate measure of risk for a portfolio of assets with normally distributed returns

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d. Risk premiums and risk aversion

• Most people are risk averse - reluctant to accept risk

• Need to be compensated for taking on risk

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• Risk-free rate - rate that can be earned with certainty

  • Use Treasury bill rate

     

    - Government won't default

    - Short-term reduces risk due to interest rate fluctuations

    • Other money market instruments relatively safe too

• Risk premium - difference between expected HPR and the risk free rate

• Excess return - returns in excess of T-bill rate

• Price of risk - ratio of portfolio risk premium to variance

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e. Reward-to-volatility (Sharpe) ratio

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4.  Inflation and real rates of return

• Nominal interest rate - interest rate not adjusted for inflation

• Real interest rate - excess of interest rate over inflation rate

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5.  Asset allocation across risky and risk-free portfolios

• Choose portfolio among broad classes of investments

• Capital allocation line - shows risk-return combinations available by varying the capital allocation