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History of Interest Rates and Risk Premiums: Bodie Kane Marcus

This document contains excerpts from Chapter 5 of the textbook "Investments" by Bodie, Kane, and Marcus. It discusses factors that influence interest rates such as supply and demand, and defines concepts like nominal rates, real rates, and the Fisher effect. It also covers probability distributions and how to calculate the mean, variance, and standard deviation of returns using scenario analysis. Tables are included showing annual returns and risk premiums for different asset classes.

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Atiqul Hasan
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107 views13 pages

History of Interest Rates and Risk Premiums: Bodie Kane Marcus

This document contains excerpts from Chapter 5 of the textbook "Investments" by Bodie, Kane, and Marcus. It discusses factors that influence interest rates such as supply and demand, and defines concepts like nominal rates, real rates, and the Fisher effect. It also covers probability distributions and how to calculate the mean, variance, and standard deviation of returns using scenario analysis. Tables are included showing annual returns and risk premiums for different asset classes.

Uploaded by

Atiqul Hasan
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 13

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Chapter 5

History of Interest Rates and Risk Premiums


Irwin/McGraw-Hill

5-1

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Factors Influencing Rates


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

Irwin/McGraw-Hill

5-2

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Level of Rates
Interest Rates Supply

r1 r0
Demand Q0 Q1
Irwin/McGraw-Hill

Funds
5-3
The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

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
Irwin/McGraw-Hill

5-4

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Rates of Return: Single Period

P P D HPR P
1 0 0

HPR = Holding Period Return P0 = Beginning price

P1 = Ending price
D1 = Dividend during period one
Irwin/McGraw-Hill

5-5

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Rates of Return: Single Period Example


Ending Price = Beginning Price = Dividend = 48 40 2

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

Irwin/McGraw-Hill

5-6

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

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
Irwin/McGraw-Hill

5-7

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Normal Distribution

s.d.

s.d.

r Symmetric distribution
Irwin/McGraw-Hill

5-8

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Measuring Mean: Scenario or Subjective Returns


Subjective returns E(r) = p (s ) r(s )
s

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

Irwin/McGraw-Hill

5-9

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Numerical Example: Subjective or Scenario Distributions


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
Irwin/McGraw-Hill

5-10

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Measuring Variance or Dispersion of Returns


Subjective or Scenario 2 Variance = p (s ) [rs - E(r)]
s

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
Irwin/McGraw-Hill

5-11

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Annual Holding Period Returns From Figure 6.1 of Text


Geom. Series Mean% Lg Stk 10.5 Sm Stk 12.6 LT Gov 5.0 T-Bills 3.7 Inflation 3.1
Irwin/McGraw-Hill

Arith. Mean% 12.5 19.0 5.3 3.8 3.2

Stan. Dev.% 20.4 40.4 8.0 3.3 4.5

5-12

The McGraw-Hill Companies, Inc., 1999

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Annual Holding Period Risk Premiums and Real Returns


Series Lg Stk Sm Stk LT Gov T-Bills Inflation
Irwin/McGraw-Hill

Risk Premiums% 8.7 15.2 1.5 ----5-13

Real Returns% 9.3 15.8 2.1 0.6 -- The McGraw-Hill Companies, Inc., 1999

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