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Chapter12

# Chapter12 - Outline L12-1 Chapter 12 Some Lessons From...

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L12-1 Outline Chapter 12. Some Lessons From Capital Market History n Returns n The Historical Returns n Average Returns and The Variability of Returns n Normal Distribution n Capital Market Efficiency n Statistics Review

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L12-2 Returns and Risk n What determines the required return on investment? One of the most important concept in finance is that the required return should depend on the risk of the investment . The greater the risk, the greater is the required return . But, how do you measure the amount of risk present in the investment? What does it mean to say that one investment is riskier than another? In order to get the feel of risk and return, we first examine the history of actual returns of several securities from 1926 to 2005. And, we will show the relationship between the return and risk in the Chapter 13. We should be able to come up with at least two findings from the history of returns: First, there is a reward for bearing risk . Second, the greater the potential reward is, the greater is the risk .
L12-3 Returns and Risk n If you buy an asset of any sort, your gain (or loss) from that investment is called the return on your investment . This return will usually have two components. First, you may receive some cash directly while you own the investment. This is called the income component of your return . Second, the value of the asset you purchase will often change. In this case, you have a capital gain or capital loss on your investment . Example: Suppose you have bought 100 shares of Video Concept Company. You paid \$37 per share at the beginning of the year. Over the year, the stock paid a dividend of \$1.85 per share, and the value of the stock has risen to \$40.33 per share by the end of the year. What is your return on this investment? Return comes from dividend and capital gain: Dividend = \$1.85 x 100 = \$185 Capital gain = (\$40.33 - 37) x 100 = \$333 Hence, the Total dollar return = Dividend income + Capital gain = \$518, and Percentage return = (Dividend income + Capital gain) / Initial investment = (\$185 + \$333) / \$3,700 = \$518 / \$3,700 = 14%

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L12-4 Percentage returns (continued) n If we let P t be the price at the beginning of period, P t+1 be the price at the end of the peri- od, and D t+1 be the dividend paid at the end of period, we get % return = [(Dt +1 + (P t+1 - P t )] / Pt = (Dividend + Capital gains) / Initial price = D t +1 / P t + (P t+1 – P t ) / P t = Dividend yield + Capital gains yield 1 + % return = (D t +1 + P t+1) / P t = (Dividend + Final price) / Initial price Note : It is more convenient to express the return in % term rather than in \$ term, be- cause, by this way, the return does not depend on how much the dollar investment is. In other words, we are concerned with how much we get for each one dollar invested.
L12-5 Percentage returns (continued) Example 12.1: Calculating Returns Suppose you bought some stock at the beginning of the year for \$25 per share.

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