INVESTMENT SETTING

MEASURES OF HISTORICAL RATES OF RETURN

Holding Period Return:
HPR= ENDING VALUE OF INVESTMENT
BEGINNING VALUE OF INVESTMENT

A value greater than 1.0 reflects an increase in your wealth

a value less than 1.0 means you suffered an decline in wealth
a HPR of zero indicates that you lost all your money.

Holding Period Yield:

HPR-1
ANNUAL BASIS
Annual HPR= (ending/beginning)(1/n)
Annual HPY=(ending/beginning)-1
Example:
Your investment of 250,000 in stock A is worth 350,000 in two years while the investment of
112,000 in stock B is worth 100,000 in six months. What are the Annual HPRs and HPYs on
these two stocks?
STOCK A
Annual HPR= (350,000/250,000)(1/2)
= 1.1832
Annual HPY= 1.1832-1
= 18.32%
STOCK B
Annual HPR?
Annual HPY?

CALCULATING MEAN HISTORICAL RATES OF RETURN

ARITHMETIC MEAN RETURN (AM)
AM= HPY/ n
*where
HPY= the sum of all the HPYs
n= number of years
GEOMETRIC MEAN RETURN (GM)
GM= [ HPR]1/n-1
*Where HPR = the product of all the HPRs
Example:
Suppose you invested 100,000 3 years ago and it is worth 110,040 today. What are your
arithmetic and geometric average returns?
Year
1

Beg. Value
100,000

Ending value
115,000

HPR
1.15

HPY
.15

2
3

115,000
138,000

138,000
110,040

1.20
.80

.20
-.20

EXPECTED RETURN
You go to bank and ask where to put your money. Which one is better?
States of the
economy
Good
average
Bad

probability

Return A

Return B

45%
40%
15%

15%
8%
-11%

16%
9%
-13%

Return A
(0.45

0.15) + (0.4

= 0.083

0.08) + (0.15

0.09) + (0.15

-0.13)

-0.11)

100%

Expected return= 8.3%

Return B
(0.45

0.16) + (0.4

=0.0885

100%

Expected return= 8.85%

Now lets determine the standard deviation

Formula: return (A)
=

probability (returnexpexted return)z

z

0.110.083
z
0.080.083 + 0.15
z
SD =
0.45 ( o .150.083 ) +0.40

SD =

0.07611

= 0.087
= 8.7%
Return B

100%

SD =

0.45 ( 0.160.0885 ) +0.4 ( 0.090.0885 ) +0.15 ( 0.130.0885 )

SD =

0.0946

SD = 0.097

100% = 9.7%

3 KEY COMPONENTS OF TOTAL REQUIRED RATE OF RETURN

1. Real rate of return
2. Inflation expectation
3. Risk premium

REAL RISK FREE RATE VS NOMINAL RISK FREE RATE

REAL RISK FREE RATE (RRFR)

Assumes no inflation.
Assumes no uncertainty about future cash flows.
Influenced by the time preference for consumption of income and investment
opportunities in the economy.

Formula:
R1= [(1 + NRFR)

(1 + rate of inflation)]-1

Example:
Determine the real risk free rate if the nominal risk free rate is 8% and the inflation
rate is 3%.
R1 = [(1 + NRFR)
= [(1 + 8%)
= [(1.08)

(1 + Rate of inflation)]-1

(1 + 3%)]-1
(1.03)-1

R1 = 4.85%
NOMINAL RISK FREE RATE (NRFR)

Conditions in the capital market

Expected rate of return

Formula:
Rnominal = (1 + RRFR)
= ( 1 + 3%)

(1 + rate of inflation) 1

( 1 + 3%) - 1

= (1.03)
Rnominal = 6.09%

(1.03) 1