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Unformatted text preview: Chapter 12 Chapter Some Lessons from Capital Some Market History Market Risk, Return and Financial Markets Markets We can examine returns in the financial We markets to help us determine the appropriate returns on non-financial assets returns Lessons from capital market history There is a reward for bearing risk The greater the potential reward, the greater the risk This is called the risk-return trade-off Dollar Returns Dollar Total dollar return = income from investment + Total capital gain (loss) due to change in price capital Example: You bought a bond for $950 one year ago. You You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return? dollar
• • • Income = 30 + 30 = 60 Capital gain = 975 – 950 = 25 Total dollar return = 60 + 25 = $85 Percentage Returns Percentage It is generally more intuitive to think in terms of It percentages than in dollar returns percentages Dividend yield = income / beginning price Capital gains yield = (ending price – beginning Capital price) / beginning price price) Total percentage return = dividend yield + Total capital gains yield capital Example – Calculating Returns Example You bought a stock for $35 and you You received dividends of $1.25. The stock is now selling for $40. now What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25 What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57% • Capital gains yield = (40 – 35) / 35 = 14.29% • Total percentage return = 3.57 + 14.29 = 17.86% The Importance of Financial Markets Markets Financial markets allow companies, governments and Financial individuals to increase their utility individuals Savers have the ability to invest in financial assets so that they Savers can defer consumption and earn a return to compensate them for doing so for Borrowers have better access to the capital that is available so Borrowers that they can invest in productive assets that Financial markets also provide us with information Financial about the returns that are required for various levels of risk risk Year-to-Year Total Returns Year-to-Year Year-to-Year Total Returns Year-to-Year
Large-Company Stock Returns
Large Companies Long-Term Government Bond Returns
LongTerm Government Bonds U.S. Treasury Bill Returns U.S. Treasury Bills Average Returns Average
Investment Large stocks Small Stocks Long-term Corporate Bonds Long-term Government Bonds U.S. Treasury Bills Inflation Average Return 12.3% 17.4% 6.2% 5.8% 3.8% 3.1% Risk Premiums Risk The “extra” return earned for taking on risk Treasury bills are considered to be risk- free The risk premium is the return over and The above the risk-free rate above Table 12.3 Average Annual Returns and Risk Premiums Returns
Investment Large stocks Small Stocks Long-term Corporate Bonds Long-term Government Bonds U.S. Treasury Bills Average Return 12.3% 17.4% 6.2% 5.8% 3.8% Risk Premium 8.5% 13.6% 2.4% 2.0% 0.0% Figure 12.9 Figure Variance and Standard Deviation Deviation Variance and standard deviation measure the Variance volatility of asset returns volatility The greater the volatility, the greater the The uncertainty uncertainty Historical variance = sum of squared deviations Historical from the mean / (number of observations – 1) from Standard deviation = square root of the variance Example – Variance and Standard Deviation Standard
Year Actual Return .15 .09 .06 .12 .42 Average Return .105 .105 .105 .105 Deviation from the Mean .045 -.015 -.045 .015 .00 Squared Deviation .002025 .000225 .002025 .000225 .0045 1 2 3 4 Totals Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873 Figure 12.11 Figure Arithmetic vs. Geometric Mean Arithmetic Arithmetic average – return earned in an average (typical) Arithmetic period over multiple periods period Geometric average – average compound return per period Geometric over multiple periods (what you earned per period on average, compounded annually) average, Example: What is the arithmetic and geometric average for Example: the following returns? the Year 1 5% Year 2 -3% Year 3 12% Arithmetic average = (5 + (–3) + 12)/3 = 4.67% Geometric average = Geometric [(1+.05)*(1-.03)*(1+.12)]1/3 – 1 = .0449 = 4.49% [(1+.05)*(1-.03)*(1+.12)] Geometric vs Arithmetic Mean Geometric vs The geometric average will be less than the arithmetic The average unless all the returns are equal average Which is better to use when forcasting future wealth Which levels? levels? If we have true arithmetic average, this is what you shoud use in If true your forecast, however we usually have only estimates of the arithmetic and geometric returns arithmetic The arithmetic average is overly optimistic for long horizons The geometric average is overly pessimistic for short horizons So the answer depends on the planning period under So consideration consideration Blume’s formula R(T)=Geometric avg* (T-1)/(N-1)+Arithmetic avg*(N-T)/(N-1) Efficient Capital Markets Efficient Capital market history suggest that the market value of Capital securities can fluctuate widely securities Why does this occur? Partly because new information arrives A market is said to be efficient if prices adjust quickly and market correctly when new information arrives correctly In an efficient market, market prices fully reflect available In information; hence there is no reason to believe that the current price is too low or too high price
• prices are in equilibrium or are “fairly” priced If this is true, then you should not be able to earn If “abnormal” or “excess” returns “abnormal” Efficient markets DO NOT imply that investors cannot earn Efficient DO a positive return in the stock market positive Figure 12.12 Figure What Makes Markets Efficient? What There are many investors out there doing There research research As new information comes to market, this As information is analyzed and trades are made based on this information based Therefore, prices should reflect all available Therefore, public information public If investors stop researching stocks, then If the market will not be efficient the Common Misconceptions about EMH EMH Efficient markets do not mean that you can’t make Efficient money money They do mean that, on average, you will earn a return They that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns excess Market efficiency will not protect you from wrong Market choices if you do not diversify – you still don’t want to put all your eggs in one basket put Strong Form Efficiency Strong Prices reflect all information, including public and Prices private private If the market is strong form efficient, then If investors could not earn abnormal returns regardless of the information they possessed regardless Empirical evidence indicates that markets are Empirical NOT strong form efficient and that insiders could earn abnormal returns earn Semistrong Form Efficiency Semistrong Prices reflect all publicly available information Prices including trading information, annual reports, press releases, etc. press If the market is semistrong form efficient, then If investors cannot earn abnormal returns by trading on public information trading Weak Form Efficiency Weak Prices reflect all past market information such Prices as price and volume as If the market is weak form efficient, then If investors cannot earn abnormal returns by trading on market information trading Empirical evidence indicates that markets are Empirical generally weak form efficient generally ...
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This note was uploaded on 04/13/2010 for the course BUSINESS engl 102 taught by Professor Seyhanözmenek during the Spring '10 term at Middle East Technical University.
- Spring '10
- Financial Markets