Interest Rates and Risk Premium

Financial Economics
Note 1

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INTRODUCTION
• Financial economics is one of the many branches of economics that deals with various
financial markets, taking into consideration how resources are being used. Its particular
attention to the elements of time, risk, opportunity cost and other variables related to
financial decisions.
• A financial market is a broad term describing marketplace where trading of securities
including equities, bonds, currencies, and derivatives occur.
• Financial economics is important, especially in making investment decisions, identifying
risks, and valuing securities and assets.
• Its concern is thus the interrelation of financial variables, such as prices, interest rates and
return, etc.
• Individuals must be concerned with both the expected return and the risk of the assets that
might be included in their portfolios.

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Determinants of the level of interest rates

• Interest rates and forecasts of their future values are among the most important inputs into
an investment decision.
• Whether to keep your money in a savings account or to move your money into a longer -
term investment depends on your outlook for interest rates.
- If you think rates will fall , you will invest in a relatively long -term investment.
- If you expect rates to rise you will postpone committing any funds on long term
investments.
• Forecasting interest rates is difficult , we are aware of the fundamental factors that
determine the level of interest rates.
• ie. the supply of funds from savers, the demand for funds from businesses , the
government’s net supply / demand for funds and the expected rate of inflation
 Nominal and Real Interest Rates
• Interest rate =a promised rate of return denominated in some unit of account over some time
period .
• Part of your interest earnings will be offset by the reduction in the purchasing power at the end of
the year.
• Thus, we need to distinguish between a nominal interest rate ( the growth rate of money ) and a
real interest rate ( the growth rate of your purchasing power)
• R= nominal rate , r= real rate , i=inflation rate
r ~ R-i
• In words, the real rate of interest is the nominal rate reduced by the loss of purchasing power
resulting from inflation
According to Fisher, the exact relationship between the real and the nominal interest rate is
given by

•If the nominal interest rate on a CD is 8% expected inflation 5% in the coming year , we can
approximate the real rate by , r= 8%- 5% =3%
•If we use the exact formula , we get 8%-5%/1+.05= .0286 , which is different from the
approximation by only 14 basis points. Thus, the approximation works for small inflation
rates
•The future real rate is unknown, and investors have to rely on expectations
 Equilibrium Real Rate of Interest

• Three basic factors supply , demand and government action determines the real interest rate
• The nominal rate is the real rate + the inflation
• Demand curve is downward sloping indicating more businesses would want to borrow at lower real
interest rates and vice versa.
• Supply curve is upward sloping indicating that at higher levels of real interest suppliers would
supply more and vice versa
• Equilibrium is at the point where the demand and supply intersects
• The government and the central bank can shift these curves either to the right or to the left through
fiscal and monetary policies.
• Example :increase of budget deficit resulting in government borrowing demand will shift the
demand curve to the right resulting in a rise in the equilibrium rate.
• That is a forecast that indicates higher than previously expected government borrowing increases
future expected interest rates. The CB can offset such a rise by expansionary monetary policy ,
which will shift the supply curve to the right
Nominal rate of interest is approximately equal to the real rate plus inflation
• As investors are concerned with the real returns ,as expected inflation increases investors
will demand higher nominal rates.
• Irvin Fisher (1930) argued that the nominal rate ought to increase one to one with increases
in the expected inflation rate
• Fisher Equation
R=r + E(i)
• This implies that if real rates are reasonably stable , increases in nominal rates ought to
predict higher inflation rates.
• This is highly debated and empirically investigated. Results are mixed.
• One reason it is difficult to prove the Fisher hypothesis that changes in nominal rates predict
changes in future inflation rates is that the real rates also changes unpredictably over time.
• Nominal interest rate can be viewed as the sum of the required real rate on nominally risk-
free assets, plus a noisy forecast of inflation
Comparing rates of return for
different holding periods

EAR and APR

Rates of return for 1 year for a discounted bill

• R(T)= (100/P(T) )-1

• T=1 , rate of return for an investment horizon of 1 year
Effective Annual Rate(ear)
Time Price (PT) 100/P(T)-1 Total Return for the given
horizon
Half year 97.36 100/97.36-1=0.0271 rf(.5)=2.71%
One year 95.52 100/95.52-1=0.0469 rf(1)=4.69%
25 years 23.30 100/23.30-1=3.2918 rf(25)=329.18%

Longer time horizons provide greater total returns

How should we compare returns of investments with differing horizons ?
We must express each return as a rate of return for a common period

We normally express it for a one -year horizon EAR

EAR APR
16.4 15.77
4.69 4.69
26.1 13.4
Annual Percentage
Rate
• Annualized rates on short term investments are reported using simple
interest rates.
• These are called “ Annual Percentage Rates”
• APR corresponding to a monthly rate is expressed as 12 times the monthly
rate
• Conversely you can find the monthly( per period ) rate by =APR/n
Continuous Compounding

• As can be seen from the example the difference between APR and EAR grows with
the frequency of compounding
• How far these two rates diverge as the compounding frequency continues to grow?
• What is the limit of , as T gets ever smaller ?
As T approaches zero, we approach continuous compounding (CC)
And the relation of EAR to the APR is given as,

Where e is approximately 2.71828

EXERCI
SE
• A bank offers two alternative interest schedules for a saving account of Rs.
100,000 locked in for 3 years.
a) a monthly rate of 1%
b)annually continuously compounded rate of 12%

Which alternative should you choose ?

• (1.01) ^12-1=12.68
• 2.71278^12-1=12.72
Risk and Risk Premiums
 Holding Period Return (HPR)

HPR is the total return the investor received during the period he held the security.

HPR = Dividend yield + Capital Gain

Div P 1 − P0
HPR = +
P0 P0
Div + ( P1 − P0 )
HPR =
P0

/ Initial price/ Previous price

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Holding Period
Return
• The definition of HPR assumes the dividend is paid at the end of the
holding period. If dividends are received earlier HPR ignores
reinvestment income between the receipt of the payment and the
end of the holding period.
• There is considerable uncertainty about the price of a share a year
from now, thus we cannot be sure about the eventual HPR.
• However, we can try to quantify our beliefs about the state of the
economy and the stock market in terms of 3 possible scenarios, with
probabilities. we can estimate the expected( mean) return E(r)
Example : Scenario

STATE OF THE PROBABILITY ENDING PRICE HPR

ECONOMY
Boom .25 140 44%
Normal Growth .50 110 14%
Recession .25 80 -16%

The expected rate of return is the probability-weighted average of

the rates of return in each scenario.
CONT…

E(r)=(.25*44)+(.5*14) +(.25*-16)=14%
 Expected Return and Standard Deviation

• The standard deviation(σ) of the rate of return is a measure of risk. It is

defined as the square root of the variance, which in turn is the expected
value of the squared deviations from the expected return.
• The higher the volatility in outcomes higher the average value of these
squared deviations. Thus, variance and the standard deviation measure the
uncertainty of outcomes.

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Variance = .25(44-14)^2 + .5(14-14)^2 + .25 (-16-14)^2=450
SD=sqrt 450=21.21%

• Probably what would trouble potential investors? is the downside risk of a -16% rate of
return, not the upside
• The potential of a 44% rate of return. The standard deviation of the rate of return does
not distinguish between
• These two: it treat both simply as deviations from the mean.
• As long as the probability distribution is more or less symmetric about the mean
standard deviation is an adequate
• Measure of risk.
• In the special case where we can assume that the probability distribution is normal , E(r)
and the SD are perfectly adequate to characterize the distribution
Excess Returns and Risk Premiums

Should you invest in the example fund, first you must ask how much of an expected reward is offered for the
risk involved investing in money
The Reward = difference between the expected HPR on the investment and the risk-free
rate. ( risk premium )
Excess Return =difference between the actual rate of return (on a risky asset )and the
risk-free rate

The risk premium is the expected value of the excess return.

the standard deviation of the excess return is the measure of its risk

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Risk Aversion

• The degree to which investors are willing to commit funds to stocks depends on risk
aversion
• Financial analysts generally assume that investors are risk averse , in a sense that , if the risk
premium were zero , people would not be willing to invest any money in stocks.
• In theory then, there must always be a positive risk premium on stocks in order to induce
risk averse investors to hold the existing supply of stocks instead of placing all their money
in risk free assets .
• To get a more realistic view of the E(r) and risk for common stocks and other types of
securities we can look at the historical returns
You invest 27000/-in a corporate bond selling for 900 /-per 1000/- par value .Over the
coming year , the bond will pay interest of 75/- per 1000/- of par value. The price of the
bond at the end of the year will depend on the level of interest rates prevailing at the
time. You construct the following scenario analysis.

Interest Probability Yr end bond price Your alternative investment is a T bill that
rates
yields a sure rate of return of 5%.
higher .2 850
Calculate the HPR for each scenario, the
unchanged .5 915 expected rate of return, and the risk
premium on your investment .
lower .3 985
What is the end of year dollar value of
your investment
 Time Series Analysis of Past Rates of Return

When we use historical data , we use each observation as an equally

likely scenario, and substitute equal probabilities of 1/n for each p(s)

= the arithmetic average of rates of return

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 The Geometric (Time Weighted) Average

In GA each past return receives an equal weight in the process of averaging.

The larger the swings in rates of return , the greater the discrepancy between the
geometric and arithmetic mean.

If returns come from a normal distribution , the difference exactly equals half the
variance of the distribution.

Express returns as decimals not as percentages

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EXERCIS
E
You invest 1 million at the beginning of 2020,in a S&P500 stock
index fund . If the rate of return in 2020,is -40%.
What rate of return in 2021 will be necessary for you to recover its
original value ?
Variance and Standard Deviation
Adapting the equation for historical data ,

Using equal probabilities for each observation:

as we have taken the arithmetic average instead of the expected we adjust for that again by multiplying
the equation by (n/n-1)

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• We should stress that the variability of HPR in the past can be an unreliable
guide to risk.at least in the case of a risk-free asset.
• For example, one year TB is a riskless investment, at least in terms of the
nominal return, which is known with certainty. However, SD from historical
data is not zero. This reflects the variation in time over expected returns,
rather than the fluctuation of actual returns around prior expectations.
• The risk of cash flows of real assets reflects both business risk and financial
risk. An all-stock portfolio represents claims on leveraged corporations.
Most corporations carry some debt, the service of which is a fixed cost.
greater fixed costs make profits riskier thus, leverage increases equity risk
Real versus Nominal Risk
• The distinction between the real and the nominal rate of return is crucial in
making investment choices. when investors are interested in the future
purchasing power of their wealth.
• When the nominal rate of interest is equal to inflation , the price of goods
increases just as fast as the money accumulated from the investment , and
there is no growth in purchasing power.
 Mean and Standard Deviation Estimates

• Do more frequent observations lead to more accurate estimates?

• Observation frequency has no impact on the accuracy of estimates of
expected return.
• It’s the duration of the sample time series that improves accuracy.
• In contrast to the mean accuracy of estimates of the standard deviation
can be made more precise by increasing the number of observations.
• More frequent observations give us more information about the
distribution of deviations from the average. Thus, we can improve the
accuracy of the estimates of SD can be increased by using more frequent
observations.
• Estimates of SD begin with the variance. When monthly returns are uncorrelated
from one month to another monthly variances simply add up.
• Thus, when the variance is the same every month variance of annual returns is 12
times the variance of monthly returns. In general T month variance is T times 1
month variance , consequently standard deviation grows at the rate of √T
• While mean and variance grows in direct proportion to time , SD grows at the
rate of square root of time.
Reward to Volatility Ratio

Investors are interested in the expected excess return they can earn by replacing
T bills with a risky portfolio, as well as the risk they would thereby incur.
Investors price risky assets to include risk premium to its price. And hence its
best to measure risk by the standard deviation of excess not total return.

The importance of the trade off between reward and risk

suggest that we measure the attraction of an Investment
portfolio by the ratio of its risk premium to the SD of its excess
returns. Widely used to measure the performance of investment managers
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Returns Distribution
• The valuation of a stock is based on its discounted expected future cash
flows ,and the equilibrium price is set so as to yield a fair expected return , in
line with risk. Deviations of the actual returns from its expectation results
from forecasting errors concerning the various economic factors that effect
future cash flows.
• Its natural to expect that the net effect of these many potential forecasting
errors, and hence rates return on stocks , will be at least approximately
normally distributed
• The normal distribution has two attractive properties.
• First its symmetric and completely described by two parameters
its mean and SD. This property implies that the risk of a normally
distributed investment return is fully described by its SD.
• Second the weighted average of variables that are normally
distributed also will be normally distributed.
• When individual stock returns are normally distributed, the return
on any portfolio combining any set of stocks will also be normally
distributed and its SD will fully convey the risk .
• It is useful to know whether the assumption of normality is
warranted.
• Let’s take a brief look at the distribution, focusing particularly on its left tail representing
investment losses.
• If we want to measure extreme negative values are too large and frequent to be
adequately characterized by the normal distribution
• One approach is to compute the standard deviation separately for the negative
deviations . This statistic is called lower partial standard deviation (LPSD)
• If LPSD is large relative to the overall SD it should replace the standard deviation as a
measure of risk, since investors presumably think of risk as the possibility of large
negative outcomes.
• Another way to describe the negative extreme values is to quantify the asymmetry by
averaging the cubed deviations from the mean. This preserves the sign which allows us
to distinguish good from bad outcomes.
• When the cubed deviations are divided by the cubed SD we call it skewness, which is a
measure of asymmetry
• Professional investors use a risk measure that highlights the potential loss from extreme
negative returns called Value at risk (VAR)