Interest Rates and Risk Premiums Chapter 5 - PowerPoint PPT Presentation

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Interest Rates and Risk Premiums Chapter 5

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Interest Rates and Risk Premiums - Chapter 5. Investor Objectives ... Federal Reserve Actions (Alan Greenspan) Level of Interest Rates. Real vs. Nominal Rates ... – PowerPoint PPT presentation

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Title: 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

6
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

7
Return Calculations
  • Geometric Average accounts for compound rate of
    returns (accounts for linked returns)
  • Arithmetic Average Simple Mean, used for
    forecasting (assumes independent returns)

8
Risk
  • Uncertainty about future returns
  • Quantified by Standard Deviation and Variance

9
Source of Risk
  • Interest Rate
  • Exchange Rate
  • Default Risk
  • Business Risk
  • Market Risk

10
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

11
Normal Distribution
  • Symmetric Distribution

s.d
s.d.
Mean
12
Measuring Mean Scenario or Subjective Returns
p(s) probability of state r(s) return if state
occurs 1 to s states
13
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
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