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# Lecture6 - where r n is return in each of n subperiods e.g...

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1 1 Lecture 6: Risk/Return in Financial Markets ECON435: Financial Markets and the Macroeconomy Anton Korinek Spring 2011 2 Interest Rates Interest Rate = promised rate of return R … nominal interest rate: in dollar terms r … real interest rate: in terms of purchasing power = adjusted for inflation rate i relationship: r R – i (Fisher equation) [ more precisely: 1+r = (1+R)/(1+i) ] measurement of inflation: increase in consumer price index (CPI) 3 Interest and Inflation Rates 4 Risk-free Interest Rates “Risk-free” interest rates: no default risk Caveats: no investment is truly risk-free guaranteed nominal return does not protect against fluctuations in purchasing power 5 Determinants of Real Interest Rates Demand Supply Fed Policy Inflation Expectations 6 Determinants of Real Interest Rates

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2 7 Comparing Rates of Return Effective Annual Rate (EAR): incorporates compounding effect FV = (1 + EAR) n PV Annual Percentage Rate (APR): for subannual periods ignores compounding effect: APR = nr n
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Unformatted text preview: where r n is return in each of n subperiods e.g. credit card that charge 3% monthly: APR = 12*3% = 36% EAR = (1 + 3%) 12 – 1 = 42.6% 8 Comparing Rates of Return For risky investments: Holding-period return (HPR) = Price increase + dividends Initial price Expected return = E[HPR] Standard deviation = Risk premium = E[HPR] – Risk-free rate = 9 Sharpe Ratio Sharpe ratio = Risk premium Std. dev. first proposed by William Sharpe measures the “risk-weighted” excess return = 10 Value at Risk (VaR) Value-at-Risk = quantile of the return distribution = measure of loss under extreme market conditions typically 5% quantile (or 5 th percentile) is used Interpretation: the loss on an investment will be larger than the 5% VaR with 5% probability important in risk management systems to limit the maximum loss Example: VaR at Goldman Sachs for daily trading losses was \$250m in 2010 (up from \$125m in 2007)...
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