Lecture 8: historical returns, expected return, variance, standard deviation

Chapter 7

What is a historical return (HPR)?

The formula used to calculate the percentage return for a single period

What are the 4 types of assets?

1. Cash → short term, risk-free, liquid

2. Bonds → risk of interest rate, not default, longer maturity than cash

3. Large stocks → risk of default, debtholders paid first then equity holders

4. Small stocks → ownership of shares in publicly held small corporations

What is the market cap?

Market cap = number of shares x price

What kind of treasuries are more riskier than others?

1. Small stocks most risky → more returns

2. Large stocks

3. Government bonds

4. treasury bills

What is variance and standard deviation?

The spread of a return → measure of how the return may deviate from its average (mean) value

• standard deviation represents the spread of a normal distribution

What is the formula for variance?

What is the formula for the average return (the mean)?

Why would investors buy more risky securities?

Investors don’t like risk

• want to be compensated for risk

• more compensation in exchange for higher risk (risk premium)

Why do we care about historical returns?

Historical data is a good predictor of future returns

• past data to forecast the future

• historical average return to estimate expected future return

• historical standard deviation to estimate future standard deviation

What are some issues with historical data?

Issues with the sample → you can get different mean, standard deviation, variance depending on the period of sample used

• need a lot of data (long sample period)

• single stocks can be biased

What is the formula for expected returns and risk?

What are portfolio measures? (positive & negative weights)

Portfolio: combination of securities

• Positive weight: buy security

• Negative weight: sell security