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Transcript of FIN 523 CH5
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Investments, 8th editionBodie, Kane and Marcus
Slides by Susan HineSlides by Susan Hine
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 5CHAPTER 5 Learning AboutLearning AboutReturn and RiskReturn and Risk
from thefrom the
Historical RecordHistorical Record
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5-2
Factors Influencing Rates
Supply
± Households
Demand
± Businesses
Government¶s Net Supply and/or Demand
± Federal Reserve Actions
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Real and Nominal Rates of Interest
Nominal interest rate
± Growth rate of your money
Real interest rate
± Growth rate of your purchasing power
If R is the nominal rate and r the real rate and
i is the inflation rate:
r R i!
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Equilibrium Real Rate of Interest
Determined by:
± Supply
± Demand
± Government actions
± Expected rate of inflation
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Figure 5.1 Determination of the
Equilibrium Real Rate of Interest
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Equilibrium Nominal Rate of Interest
As the inflation rate increases, investors will
demand higher nominal rates of return
If E (i ) denotes current expectations of
inflation, then we get the Fisher Equation:
( ) R r E i!
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5-7
Risk and Risk Premiums
P
D P P HPR
0
101 !
HP R = Holding Period Return
P 0 = Beginning price
P 1 = Ending price
D1 = Dividend during period one
Rates of Return: Single Period
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Ending Price = 48
Beginning Price = 40
Dividend = 2
HP R = (48 - 40 + 2 )/ (40) = 25%
Rates of Return: Single Period Example
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Expected returns
p(s) = probability of a state
r (s) = return if a state occurs
s = state
Expected Return and Standard Deviation
( ) ( ) ( ) s
E r p s r s!§
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State Prob. of State r in State
1 .1 -.05
2 .2 .05
3 .4 .154 .2 .25
5 .1 .35
E (r ) = (.1)(-.05) + (.2)(.05)« + (.1)(.35)
E (r ) = .15
Scenario Returns: Example
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Standard deviation = [variance]1/2
Variance:
Var =[(.1)(-.05-.15)
2
+(.2)(.05- .15)2
«+ .1(.35-.15)2
]Var= .01199
S.D.= [ .01199] 1/2 = .1095
Using Our Example:
Variance or Dispersion of Returns
? A22 ( ) ( ) ( )
s
p s r s E r W ! §
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Time Series Analysis of Past Rates of
Return
§§ !!!!
n
s
n
s sr
n sr s pr E
11)(
1)()()(
Expected Returns and
the Arithmetic Average
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Geometric Average Return
1 2(1 )(1 ) (1 )nn
r r r x xTV ! ! K
TV = Terminal Value of the
Investment
1/1
!TV g n
g=
geometric averagerate of return
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Quoting Conventions
APR = annual percentage rate
(periods in year) X (rate for period)
EAR = effective annual rate( 1+ rate for period)Periods per yr - 1
Example: monthly r etur n of 1%
APR = 1% X 12 = 12%EAR = (1.01)12 - 1 = 12.68%
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Figure 5.5A Normal and Skewed Distributions
(mean = 6% SD = 17%)
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Figure 5.5B Normal and Fat-Tailed
Distributions (mean = .1, SD =.2)
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Figure 5.6 Frequency Distributions of
Rates of Return for 1926-2005
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Table 5.4 History of Excess Returns of Asset
Classes for Generations, 1926- 2005
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Figure 5.10 Annually Compounded, 25-Year
HPRs from Bootstrapped History and
A Normal Distribution (50,000 Observation)
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Figure 5.11 Annually Compounded,
25-Year HPRs from Bootstrapped
History(50,000 Observation)
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Figure 5.12 Wealth Indexes of Selected
Outcomes of Large Stock Portfolios and
the Average T-bill Portfolio