BUSINESS Financial
Management
RUTGERS SCHOOL
Lectures 14
Stock Market
Lecture Sources
Lectures are compiled using the slides provided
by McGraw-Hill for courses based on:
Ross, Westerfield, Jordan. Fundamentals of Corporate Finance
Chapters 12 and 8
Additional material, compilation, and
presentation layout is provided by the lecturer.
Gains from Holding a
Financial Security
Total dollar return =
income from investment +
capital gain (loss) due to change in price
Example:
You bought a stock for $950 one year ago. You
have received two dividend payments of $30
each. You can sell the stock for $975 today.
What is your total dollar return?
Income = 30 + 30 = 60
Capital gain = 975 950 = 25
Total dollar return = 60 + 25 = $85
Percentage Returns
It is generally more intuitive to think in terms
of percentage, rather than dollar, returns
Dividend
yield = income / beginning price
Capital
gains yield = (ending price
beginning price) / beginning price
Total
percentage return = dividend yield +
capital gains yield
The Importance of
Financial Markets
Savers have the ability to invest in financial
assets so that they can defer consumption and
earn a return to compensate them for doing so
Borrowers have better access to the capital that
is available so that they can invest in productive
assets
INFORMATION: Financial markets also
provide us with information about the
returns that are required for various levels of
risk
Lessons for Investing
There is a reward for bearing risk
(calculated risk, not recklessness!)
risk-return trade-off: The greater the
potential reward, the greater the risk
Risk Premiums
The extra return earned for taking on risk
Treasury bills are considered to be risk-free
The risk premium is the return over and above
the risk-free rate
Average Returns
Modeling Stock Returns
1
r1
T
Var
2
1
r1
T
2
...
r2
rT
rT
...
2
Types of Averages
Arithmetic
average return earned in an
average period over multiple periods
Geometric
average average
compound return per period over multiple
periods
Year 2
-3%
Year 1
5%
Year 3
12%
Arithmetic average = (5 + (3) + 12)/3 = 4.67%
Geometric average =
[(1+.05)*(1-.03)*(1+.12)]1/3 1 = .0449 = 4.49%
Efficient Capital Markets
Stock prices in equilibrium are FAIR:
you should not be able to consistently earn
abnormal or excess returns
that is,
only risk premium dictates the EXPECTED return
(consequently, average return)
Efficient markets DO NOT imply that investors cannot
earn a positive return in the stock market
Information and Stock Prices
Mechanics of EMH:
Information and Stock Prices
Many investors research stocks:
As new information comes to market, this
information is instantaneously and correctly
analyzed and immediately
trades are made based on this information
Therefore, prices should reflect all available
public information
If investors stop researching stocks, then the market
will not be efficient. COSTS of research positive
returns needed to provide adequate compensation
Mechanics
Weak Form Efficiency
Prices reflect all past market information such
as price and volume
If the market is weak form efficient, then
investors cannot earn abnormal returns by
trading on market information
Implies that technical analysis will not lead to
abnormal returns
Empirical evidence indicates that markets are
generally weak form efficient (issue is still being
actively debated)
Semi-strong Form EMH
Prices reflect all publicly available information
including trading information, annual reports,
press releases, etc.
If the market is semi-strong form efficient, then
investors cannot earn abnormal returns by
trading on public information
Implies that fundamental analysis will not lead
to abnormal returns
Strong Form EMH
Prices reflect all information, including public
and private
If the market is strong form efficient, then
investors could not earn abnormal returns
regardless of the information they possessed
Empirical evidence indicates that markets are
NOT strong form efficient and that insiders
could (ILLEGALY!!!) earn abnormal returns
(surprised? )