Chapter 12 - Capital Market Efficiency Yihui Wang Capital...

Capital Market Efficiency py
h t 12 --Chapter 12
Yihui Wang
Capital Market Efficiency

Main Issues
• Return, Risk and Financial Markets
he Efficient Market Hypothesis • The Efficient Market Hypothesis
Capital Market Efficiency
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Return
• Dollar return
t t
P P P P
) (
1 −
− +
t t t
P P D
• Percentage return
• ou bought a stock for $35 and you received dividends
1
1
1 1
1
−
−
− −
− + = =
t
t t
t
t
t
t t t
t
P P P
r
(DY+cap. Gains Yield)
You bought a stock for $35 and you received dividends
of $1.25. The stock is now selling for $40.
♦ Dollar return = 1.25+(40 – 35)= $6.25
♦ Percentage return = (1.25+40 – 35)/35 =17.86%
• Dividend yield = 1.25 / 35 = 3.57%
Capital Market Efficiency
• Capital gains yield = (40 – 35) / 35 = 14.29%
3

Capital Market Efficiency
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Capital Market Efficiency
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Capital Market Efficiency
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Risk-Return Trade-Off
• Risk-return trade-off
♦ There is a reward for bearing risk
♦ The greater the potential reward, the greater the risk
• Risk premium: the reward for bearing 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 above the risk-free
rate
Capital Market Efficiency
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Average Return and Risk Premium
Investment
Average Return Risk Premium
Large stocks
12.3% 8.5%
Small Stocks
17.4% 13.6%
Long-term Corporate Bonds
6.2% 2.4%
Long-term Government Bonds
5.8% 2.0%
U.S. Treasury Bills
.8% .0%
y
3.8% 0.0%
Capital Market Efficiency
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Return As Random Variable
Capital Market Efficiency
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How to Measure Risk
• Variance and standard deviation measure volatility of asset returns
• Sample variance where
• The greater the volatility, the greater the uncertainty/risk
∑
=
−
−
=
T
t
t
R R
T
1
2 2
) (
1
1
σ
∑
=
=
T
t
t
R
T
R
1
1
Year Actual
Return
Average
Return
Deviation from the
Mean
Squared Deviation
1 .15 .105 .045 .002025
2 .09 .105 -.015 .000225
3 .06 .105 -.045 .002025
ariance = 0045 / (4 ) = 0015 Standard Deviation = 03873
4. 1 2 .105 .015 .000225
Totals .42 .00 .0045
Capital Market Efficiency
Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873
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Capital Market Efficiency
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Importance of Financial Markets
nancial markets allow companies governments and • Financial markets allow companies, governments and
individuals to increase their utility
h th bilit t i t i fi i l t th t th ♦ Savers have the ability to invest in financial assets so that they
can defer consumption and earn a return to compensate
orrowers have better access to the capital that is available so ♦ Borrowers have better access to the capital that is available so
that they can invest in productive assets
nancial markets also provide us with information about