Slide4 - Lectur e 4 Lessons fr om Capital M ar ket H istor...

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Unformatted text preview: Lectur e 4 Lessons fr om Capital M ar ket H istor y and Efficient M ar ket H ypothesis By Diep Duong Some Motivations We consume and save in a way to maximize our lifetime utility. Financial markets help increase our utility. How? Savers can Defer consumption to the next per iod I nvest in (buy) financial assets Ear n a retur n to compensate for doing so Financial Assets are different from Consumption Goods: Stocks, Bonds . You want to make a big gain or high retur n from the investment in the asset. I s that easy ? We buy an asset now and sell it in the future. Can we know 100% sure what we will get in the future ? There are a huge number of assets. What makes them different 12-2 Risk, Retur n and Financial Markets Our Approach: Look at histor ical data and see what data suggest I nput for discussion: Retur n and Risk Lessons from capital market histor y There is a reward for bear ing r isk The greater the potential reward, the greater the r isk This is called the r isk-retur n trade-off Our Goal: To check empir ically this hypothesis. Later in the course, we will look at theor y which explains this. But first, we need to understand what Retur n and Risk really mean. 12-3 Dollar Retur ns on I nvestment Financial asset is bought and sold in the market at changing pr ice generates income to the owner of the asset (i.e., interest, dividends) Total dollar retur n = the difference (gain or loss) that you make from investment in ter m of dollars: difference in buying pr ice and selling pr ice Capital Gain income generated by the asset - I ncome DR=(Capital Gain + I ncome) Example: Last year, you invested in a bond for $950 After 1 year, you receive 2 interest payments of $30 and the prevailing market pr ice of the bond is $975. Whats DR? I ncome = 30 + 30 = 60 12-4 Percentage Retur ns The DR retur ns just focus on the dollar you ear n, not relative to the cost of your invesment A more convenient measure of retur n which takes into account this PR = Dollar retur n/beginning pr ice = (capital gain + income)/beginning pr ice = capital gain/beginning pr ice + income/beginning pr ice PR gives you how much you get from $1 of investment I n the case of common stock, income is dividend payment Dividend yield = dividend / beginning pr ice Capital gains yield = capital gain/beginning pr ice Total percentage retur n = dividend yield + capital gains yield 12-5 Example Calculating Retur ns You bought a stock for $35, and you received dividends of $1.25. The stock is now selling for $40....
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This note was uploaded on 02/08/2011 for the course ECON 393 taught by Professor D during the Spring '10 term at Rutgers.

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Slide4 - Lectur e 4 Lessons fr om Capital M ar ket H istor...

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