McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 History of Interest Rates and Risk Premiums.

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McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 History of Interest Rates and Risk Premiums

5-2 Factors Influencing Rates Supply Households Demand Businesses Government’s Net Supply and/or Demand Federal Reserve Actions

5-3 Q0Q0 Q1Q1 r0r0 r1r1 Funds Interest Rates Supply Demand Interest Rates Supply Q0Q0 Q1Q1 r0r0 r1r1 Funds Demand »Level of Interest Rates

5-4 Fisher effect: Approximation nominal rate = real rate + inflation premium R = r + i or r = R - i Example r = 3%, i = 6% R = 9% = 3% + 6% or 3% = 9% - 6% Fisher effect: Exact r = (R - i) / (1 + i) 2.83% = (9%-6%) / (1.06) Empirical Relationship: Inflation and interest rates move closely together Real vs. Nominal Rates

5-5 HPR = Holding Period Return P 0 = Beginning price P 1 = Ending price D 1 = Dividend during period one Rates of Return: Single Period

5-6 Ending Price =48 Beginning Price = 40 Dividend = 2 HPR = ( )/ (40) = 25% Rates of Return: Single Period Example

5-7 1) Mean: most likely value 2) Variance or standard deviation 3) Skewness * If a distribution is approximately normal, the distribution is described by characteristics 1 and 2. Characteristics of Probability Distributions

5-8 Symmetric distribution mean s.d. Normal Distribution

5-9 Subjective returns p(s) = probability of a state r(s) = return if a state occurs 1 to s states Mean Scenario or Subjective Returns

5-10 StateProb. of Stater in State E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35) E(r) =.15 Scenario or Subjective Returns: Example

5-11 Standard deviation = [variance] 1/2 Subjective or Scenario Var =[(.1)( ) 2 +(.2)( ) ( ) 2 ] Var= S.D.= [.01199] 1/2 =.1095 Using Our Example : Variance or Dispersion of Returns

5-12 Table 5.2 History of T-bill Rates, Inflation and Real Rates for Generations,

5-13 Figure 5.2 Interest Rates and Inflation,

5-14 Geometric Average Returns TV = Terminal Value of the Investment g= geometric average rate of return

5-15 Geom.Arith.Stan. SeriesMean%Mean%Dev.% Sm Stk Lg Stk LT Gov T-Bills Inflation Annual Holding Period Returns (Arithmetic)

5-16 Risk Real SeriesPremiums%Returns% Sm Stk Lg Stk LT Gov T-Bills Inflation Risk Premiums Real Returns

5-17 Figure 5.6 Histograms of Rates of Return for

5-18 Table 5.3 History of Rates of Returns of Asset Classes for Generations,

5-19 Table 5.4 History of Excess Returns of Asset Classes for Generations,

5-20 Figure 5.7 Nominal and Real Equity Returns Around the World,

5-21 Figure 5.8 Standard Deviations of Real Equity and Bond Returns Around the World,