Lec3 Portfolio Theory I

Lec3 Portfolio Theory I - Portfolio Theory I Jinghan Meng...

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Portfolio Theory I Jinghan Meng

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Roadmap for Today 1. Chapter 5.1-5.3: Interest Rates and Inflation 2. Chapter 5.4: Risk and Returns – Scenario Analysis 3. Chapter 5.5-5.8: Risk and Returns – Time Series Analysis 2
Interest Rates and Inflation

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Interest Rates Interest rates is one of the most important issue in firm’s investment decision – time value of money Forecasting of interest rates is very difficult Published interest rates figures are nominal Federal funds rate 30-day Treasury bill rate CD rates 4
Real and Nominal Rates of Interest Nominal interest rate ( R ): Growth rate of your money Real interest rate ( r ): Growth rate of your purchasing power Inflation ( 𝑖𝑖 ): a sustained increase in the general price level of goods and services in an economy over a period of time. When 𝑖𝑖 > 0 , purchasing power per unit of money reduces Usually measured by annualized change in CPI ( consumer price index ) Approximate relationship: 𝑟𝑟 ≈ 𝑅𝑅 − 𝑖𝑖 Exact relationship: 𝑟𝑟 = 𝑅𝑅−𝑖𝑖 1+𝑖𝑖 5

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Interest Rate Determinants Fundamental determinants of real rate of interest: Supply – households Demand – businesses Government (Central Bank)’s monetary policy : net supply of and/or demand for fund 4 th factor for nominal rate of interest: Expected inflation rate ( Current issue: US and European QE ) 6
Equilibrium Real Rate of Interest 7 Government borrowing demand

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Equilibrium Nominal Rate of Interest Fisher Equation : 𝑅𝑅 = 𝑟𝑟 + 𝐸𝐸 ( 𝑖𝑖 ) Fisher (1930) argued that nominal rate should increase one-for-one with increase of expected inflation rate. If real rates are stable, increases in nominal rates should predict higher inflation rates. But this is difficult to test empirically. Future inflation is risky, if nominal rate is announced to be fixed (e.g., CDs rate), real rate of interest is risky. 8
9 History of Bills and Inflation Average 𝑟𝑟 Real Average 𝑟𝑟 Nominal Average Inflation Because, 𝑟𝑟 Real = 𝑟𝑟 Nominal −Inflation 1+Inflation

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10 History of Bills and Inflation (1926-2009) Lesson : Moderate inflation can offset most of the nominal gains on low-risk investments. \$10.29 \$1.61
Risk and Returns: Scenario Analysis

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