1. History of Interest Rates and Risk Premiums
Chapter 5

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

3. Level of Interest RatesQ0 Q1 r0 r1
Funds
Demand
Supply
Supply r1 r0
Demand Q0 Q1
Funds

4. Real vs. Nominal Rates 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

5. Rates of Return: Single Period
HPR = Holding Period Return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one

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

7. Characteristics of Probability Distributions
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.

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

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

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

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

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

13. Risk Premiums Real Returns
Risk Real
Series Premiums% Returns%
Sm Stk
Lg Stk
LT Gov
T-Bills
Inflation