Interest Rates and Risk Premiums Chapter 5

1
Interest Rates and Risk Premiums - Chapter 5
2
Investor Objectives

• Generate Highest Return Possible
• Minimize Risk

3
Factors Influencing Rates

• Supply
• Households
• Demand
• Businesses
• Governments net supply and/or demand
• Federal Reserve Actions (Alan Greenspan)

4
Level of Interest Rates
5
Real vs. Nominal Rates

• Key is inflation
• Real Rates nominal rates less inflation
• Rates are typically quoted in nominal terms
• Only when Real rates expand does purchasing power
  increase

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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
• Fisher Effect Exact
• Nominal rate real rate inflation premium
• r (R i)/ (1 I)
• Example
• 2.83 (9-6) / 1.06
• Empirical relationship Inflation and interest
  rates move closely together

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Return Calculations

• Geometric Average accounts for compound rate of
  returns(accounts for linked returns)
• Arithmetic Average Simple Mean, used for
  forecasting (assumes independent returns)

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Risk

• Uncertainty about future returns
• Quantified by Standard Deviation and Variance

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Source of Risk

• Interest Rate
• Exchange Rate
• Default Risk
• Business Risk
• Market Risk

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Characteristics of Probability Distribution

• Mean most likely value
• Variance or standard deviation
• Skewness
• If distribution is approximately normal, the
  distribution is described by characteristics 1
  and 2

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Normal Distribution

• Symmetric Distribution

s.d
s.d.
Mean
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Measuring Mean Scenario or Subjective Returns
p(s) probability of state r(s) return if state
occurs 1 to s states
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Measuring Variance

• Standard Deviation variance1/2
• Using our example
• Var (.1) (-.05-.15)2(.2)(.05-.15)2(.1)(.35-
  .15)2
• Var .01199
• SD 9.01199)1/2 .1095