Chapter 5 - Risk, Return, and the Historical Record

Question 1

What does an economy’s equilibrium level of real interest rates depend on?

Answer 1

The willingness of households to save, as reflected by the supply curve of funds and on the expected profitability of business investment in plant, equipment, and inventories as reflected in the demand curve for funds. Also depends on gov monetary and fiscal policy.

Question 2

What is the nominal interest rate?

Answer 2

The equilibrium real rate plus the expected rate of inflation. In general we can directly observe only nominal interest rates; from them we must infer expected real rates using inflation forecasts

Question 3

What is the equilibrium expected rate of return on any security

Answer 3

The sum of the equilibrium real rate of interest, the expected rate of inflation, and a security specific risk premium.

Question 4

Investors face a trade off between risk and expected return.

Answer 4

Historical data confirms our intuition that assets with low degrees of risk provide lower returns on average than do those of higher risk.

Question 5

Why are assets with guaranteed nominal interest rates risky?

Answer 5

Because the future inflation rate is uncertain.

Question 6

What do historical rates of return over 20th century developed capital markets suggest about US history of stock returns?

Answer 6

That is is not an outlier compared to other countries

Question 7

Do investments become safer in the long run?

Answer 7

No, the longer a risky investment is held, the greater the risk. The basis of the argument that stocks are safe in the long run is the fact that the probability of a shortfall becomes smaller . However, probability of shortfall is a poor measure of the safety of an instrument, it ignores the possible magnitude of losses.

Question 8

What are the most widely used measures of tail risks? (2)

Answer 8

Value at Risk (VaR) and expected shortfall