Sol_Ch09 - CHAPTER 9 SOME LESSONS FROM CAPITAL MARKET...

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CHAPTER 9 SOME LESSONS FROM CAPITAL MARKET HISTORY Answers to Concepts Review and Critical Thinking Questions 1. They all wish they had! Since they didn’t, it must have been the case that the stellar performance was not foreseeable, at least not by most. 2. As in the previous question, it’s easy to see after the fact that the investment was terrible, but it probably wasn’t so easy ahead of time. 3. No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn’t attract them relative to the extra risk. 4. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency. 5. T-bill rates were highest in the early eighties. This was during a period of high inflation and is consistent with the Fisher effect. 6. Before the fact, for most assets, the risk premium will be positive; investors demand compensation over and above the risk-free return to invest their money in the risky asset. After the fact, the observed risk premium can be negative if the asset’s nominal return is unexpectedly low, the risk- free return is unexpectedly high, or if some combination of these two events occurs. 7. Yes, the stock prices are currently the same. Below is a diagram that depicts the stocks’ price movements. Two years ago, each stock had the same price, P 0 . Over the first year, General Materials’ stock price increased by 10 percent, or (1.1) P 0 . Standard Fixtures’ stock price declined by 10 percent, or (0.9) P 0 . Over the second year, General Materials’ stock price decreased by 10 percent, or (0.9)(1.1) P 0 , while Standard Fixtures’ stock price increased by 10 percent, or (1.1)(0.9) P 0 . Today, each of the stocks is worth 99 percent of its original value. 2 years ago 1 year ago Today General Materials P 0 (1.1)P 0 (1.1)(0.9)P 0 = (0.99)P 0 Standard Fixtures P 0 (0.9)P 0 (0.9)(1.1)P 0 = (0.99)P 0 8. The stock prices are not the same. The return quoted for each stock is the arithmetic return, not the geometric return. The geometric return tells you the wealth increase from the beginning of the period to the end of the period, assuming the asset had the same return each year. As such, it is a better measure of ending wealth. To see this, assuming each stock had a beginning price of $100 per share, the ending price for each stock would be: Lake Minerals ending price = $100(1.10)(1.10) = $121.00 Small Town Furniture ending price = $100(1.25)(.95) = $118.75
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SOLUTIONS B-234 Whenever there is any variance in returns, the asset with the larger variance will always have the greater difference between the arithmetic and geometric return. 9. To calculate an arithmetic return, you simply sum the returns and divide by the number of returns. As such, arithmetic returns do not account for the effects of compounding. Geometric returns do account for the effects of compounding. As an investor, the more important return of an asset is the geometric return.
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