5-1

Chapter 5

History of Interest Rates

and Risk Premiums
()
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-2

Factors Influencing Rates

Supply
- Households
Demand
- Businesses
Governments Net Supply and/or
Demand
- Federal Reserve Actions
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-3

Level of Interest Rates

Interest Rates
Supply
r1
r0
Demand
Q0 Q1

McGraw-Hill/Irwin

Funds
Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-4

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: (1+R)=(1+r)(1+i)
=(1+0.03)(1+0.06)=1.0918
r = (R - i) / (1 + i)
3.00% = (9.18%-6.00%) / (1.06)
2.83% =(0.09-0.06)/1.06
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Rates of Return: Single Period

()

5-5

P
1 P 0 + D1
HPR =
P0
HPR = Holding Period Return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-6

Rates of Return:
Single Period Example

Ending Price =

48

Beginning Price =

40

Dividend =

HPR = (48 - 40 + 2 )/ (40) = 25%

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Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-7

(ex-dividend)

78
(77)

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5-8

1. :
P = Pt-1 - Dt
2.:
P=
(Pt-1+*%+10*%) /
(1+%+%+%)
3.:
P=
(Pt-1+*% +10*% - Dt)
/ (1+%+%+%)

McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-9

Pt*(1+%+%)+Dt
=

----------------------------------------- - 1
(Pt-1+*%)

Pt =t
Pt-1 =t-1
Dt =t

McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-10

Hint:10
.
:7473
6020%
1.2(
)5%74
?
?
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-11

Answer:

:
=(60+10*0.05-1.2)/(1+20%+5%)
=59.3/1.25=47.44
~47.4
:7%:50.7 ~ 50.5
:7%:44.08 ~ 44.1
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-12

:
=(50.5*(1+20%)+1.2)/60-1
= 3%
*
:
:
=(60-1.2)/(1+20%+0%)
=49
: 49*1.07=52.43~52
:(52*(1+0.2)+1.2)/60 1=6%
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-13

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.
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-14

Normal Distribution

s.d.

s.d.

mean
Symmetric distribution
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Measuring Mean:
Scenario or Subjective Returns

5-15

Subjective returns
s

E (r ) = p s r s
1

p(s) = probability of a state

r(s) = return if a state occurs
1 to s states

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Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-16

State
Prob. of State
r in State
1
.1
-.05
2
.2
.05
3
.4
.15
4
.2
.25
5
.1
.35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Measuring Variance or
Dispersion of Returns

5-17

Subjective or Scenario

( ) (

= p s r s E( r )
2

Standard deviation = [variance]1/2

Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095
McGraw-Hill/Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Annual Holding Period Returns

From Figure 6.1 of Text

5-18

Geom.
Series
Mean%
Sm Stk 12.6
Lg Stk
11.1
LT Gov
5.1
T-Bills
3.8
Inflation 3.1
McGraw-Hill/Irwin

Arith.
Mean%
18.8
13.1
5.4
3.8
3.2

Stan.
Dev.%
39.7
20.2
8.1
3.3
4.5

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5-19

Annual Holding Period Risk Premiums

and Real Returns

Risk
Series
Premiums%

15.0

9.3
1.6

--
--McGraw-Hill/Irwin

Real
Returns%
15.6
9.9
2.2
0.6
---

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.