3/28/2018

Unit 4: Risk and Return Interest Rate

Lecture 1: Investment Returns

Portfolio Risk and Return Portfolio Risk and Return

Interest Rate Interest Rate
Nominal interest rate:
Definition
Growth rate of your money allowing for inflation

An interest rate is a promised rate of return denominated in some unit of account Real interest rate:
(rand, dollars, euros, or even purchasing power units) over some time period (a Growth rate of your of your money over and above inflation, i.e.,

month, a year, 20 years, or longer) nominal interest rate less inflation

Let R = nominal rate, r = real rate and i = inflation rate

R i☎
r ✂ R i
✁
OR r ✆

1 i✄

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Portfolio Risk and Return Portfolio Risk and Return

Interest Rate Interest Rate
Example: Nominal and Real Interest Rates
Equilibrium Real Rate of Interest is determined by:
Over the past year you earned a nominal rate of interest of 10%p.a. on your
Supply & Demand
money. The inflation rate was 5%p.a. over the same period. The exact actual
Government actions
growth rate of your purchasing power was:
Expected rate of inflation
R i✞ ☛✠✡☞☛✠☛✌
r ✟ = = 4.8%
1 i
✝
✡✍☛✠☛✌

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 3/28/2018

Portfolio Risk and Return

Investment Returns

Effective Annual Rate (EAR):

Allows us to compare assets with
✛
✙ different investment horizons.
✓✔✕ ✖ ✗ ✘ ✜ ✗
✚ EAR is the percentage increase in

funds invested over a 1-year horizon.

Investment Returns ✁✂✄ ☎✆ ✝✞✟ ✠✡✂☛✟☞ ✌✍ ✎✌✂✏✌✡✠✑☎✠✒

periods per year

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Portfolio Risk and Return Portfolio Risk and Return

Investment Returns Investment Returns

Holding Period Return Expected Return: Single Asset

P0 = Beginning price
✣✦ ✧ ✣★ ✩ ✪✦ p(s) = probability of a state
✢✣✤ ✥
✣★
P1 = Ending price E (r ) ✫
✬
p (s)r (s) r(s) = return if a state occurs
s = state
D1 = Dividend during period s

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Portfolio Risk and Return

Investment Returns

Example: Expected Returns: Single Asset

State Prob. of State r in State

Excellent .25 0.31 End of lecture 1: Investment Returns
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200

E(r) = (.25)(.31) + (.45)(.14) + (.25)(-.0675) + (0.05)(-0.52)

E(r) = .0976 or 9.76%
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