Lecture2.pdf

# Lecture2.pdf - FINM2003 Investments Lecture 2 Risk Return...

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FINM2003 - Investments Lecture 2 Risk, Return, and the Historical Record Kun Li RSFAS Australian National University FINM2003 - Investment 1

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Overview Determinants of the Level of Interest Rates. Comparing Rates of Return for Different Holding Periods. Risk and Risk Premiums. Time Series Analysis of Past Rates of Return. FINM2003 - Investment 2
Determinants of the Level of Interest Rates Determinants of real interest rates include Supply side. The supply of funds from savers, or those who have more than they wish to consume today. Demand side. The demand for funds from those who have less than they wish to consume or invest today. Government's net demand. The government's net supply of funds or demand for them, both of which are affected by the actions of the federal reserve(in Australia, the RBA). FINM2003 - Investment 3

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The Equilibrium Real Rate of Interest Why is the supply (demand) curve of real interest rate upward (downward) slopping? FINM2003 - Investment 4
Real and Nominal Rates of Interest Nominal interest rate. The growth rate of money. Real interest rate. The growth rate of purchasing power. Suppose r n the nominal rate, r r the real rate, and i the inflation rate. The approximation formula is r r r n i The exact relationship 1 + r r Growth of purchasing power = Growth of money 1 + r n 1 + i Growth of prices FINM2003 - Investment 5

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The Theory of Interest r n = r r + ( i ) To work out the approximation, we know 1 + r n = (1 + r r )(1 + i ) = 1 + r r + i + r r i Since r r i is very small comparing to r r and i , we have 1 + r n 1 + r r + i therefore r n r r + i r r r n i FINM2003 - Investment 6
Example 5.1 Approximating the Real Rate If the nominal interest rate on a 1-year CD (certificate of deposit) is 8 %, and you expect inflation to be 5 % over the coming year. Using the approximation formula, you expect the real rate of interest to be r r = 8 % 5 % = 3 % . Using the exact formula, the real rate is r r = 0 . 08 0 . 05 1 + 0 . 05 = 2 . 86 % . The approximation rule overstates the expected real rate by 0 . 14 %. FINM2003 - Investment 7

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Real and Nominal Rates of Interest Investors are concerned with their real rate of interest given it measures the increase in their purchasing power. Given this, Investors will demand higher nominal rates of return on their investments as expected inflation increases. Fisher (1930) argued that, with stable real interest rate, nominal interest rates should increase one for one with expected inflation. This is hard to test (as real rates aren't constant over time) but nominal interest rates and inflation move closely together. FINM2003 - Investment 8
Interest Rates FINM2003 - Investment 9

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Interest Rates Concept check 1 a. Suppose the real interest rate is 3% per year and the expected inflation rate is 8%. What is the nominal interest rate? b. Suppose the expected inflation rate rises to 10%, but the real rate is unchanged. What happens to the nominal interest rate?
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