CHAPTER 5: INTRODUCTION TO RISK, RETURN, AND THE
The Fisher equation predicts that the nominal rate will equal the equilibrium real rate plus the expected inflation rate. Hence, if the inflation rate increases from 3% to 5% while there is no change in the real rate, then the nominal rate will increase by 2%. On the other hand, it is possible that an increase in the expected inflation rate would be accompanied by a change in the real rate of interest. While it is conceivable that the nominal interest rate could remain constant as the inflation rate increased, implying that the real rate decreased as inflation increased, this is not a likely scenario.
If we assume that the distribution of returns remains reasonably stable over the entire history, then a longer sample period (i.e., a larger sample) increases the precision of the estimate of the expected rate of return; this is a consequence of the fact that the standard error decreases as the sample size increases. However, if we assume that the mean of the distribution of returns is changing over time but we are not in a position to determine the nature of this change, then the expected return must be estimated from a more recent part of the historical period. In this scenario, we must determine how far back, historically, to go in selecting the relevant sample. Here, it is likely to be disadvantageous to use the entire dataset back to 1880.
The true statements are (c) and (e). The explanations follow. Statement (c): Let = the annual standard deviation of the risky investments and 1 = the standard deviation of the first investment alternative over the two-year period. Then:
Therefore, the annualized standard deviation for the first investment alternative is equal to:
Statement (e): The first investment alternative is more attractive to investors with lower degrees of risk aversion. The first alternative (entailing a sequence of two identically distributed and uncorrelated risky investments) is riskier than the second alternative (the risky investment followed by a riskfree investment). Therefore, the first alternative is more attractive to investors with lower degrees of risk aversion. Notice, however, that if you mistakenly believed that ‘time diversification’ can reduce the total risk of a sequence of risky investments, you would have been tempted to conclude that the first alternative is less risky and therefore more attractive to more riskaverse investors. This is clearly not the case; the two-year standard deviation of the first alternative is greater than the two-year standard deviation of the second alternative.
For the money market fund, your holding period return for the next year depends on the level of 30-day interest rates each month when the fund rolls over maturing securities. The one-year savings deposit offers a 7.5% holding period return for the year. If you forecast that the rate on money market instruments will increase significantly above the current 6% yield, then the money market fund might result in a higher HPR than the savings deposit. The 20-year Treasury bond offers a yield to maturity of 9% per year, which is 150 basis points higher than the rate on the one-year savings deposit; however, you could earn a one-year HPR much less than 7.5% on the bond if long-term interest rates increase during the year. If Treasury bond yields rise above 9%, then the price of the bond will fall, and the resulting capital loss will wipe out some or all of the 9% return you would have earned if bond yields had remained unchanged over the course of the year.
If businesses reduce their capital spending, then they are likely to decrease their demand for funds. This will shift the demand curve in Figure 5.1 to the left and reduce the equilibrium real rate of interest.
Increased household saving will shift the supply of funds...
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