393_lecture5

393_lecture5 - Capital Market History and Ecient Market...

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Capital Market History and Efficient Market Hypothesis Lecture 5 Myung Joo Song ECON 393 Fall 2011 Myung Joo Song (ECON 393) Fall 2011 1 / 30
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Chapter Outline Returns The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second Lesson More about Average Returns Capital Market Efficiency Myung Joo Song (ECON 393) Fall 2011 2 / 30
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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 period Invest in (buy) financial assets Earn a return to compensate for doing so Financial Assets are different from Consumption Goods. (Stocks, Bonds, etc.) You want to make a big gain or high return from the investment in the asset. Is 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? Each asset is characterized by a pair, Return and Risk. Myung Joo Song (ECON 393) Fall 2011 3 / 30
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Risk, Return and Financial Markets Our Approach: Look at historical data and see what data suggest. Input for discussion: Return and Risk 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. Our Goal: To check empirically this hypothesis. Later in the course, we will look at theory which explains this. But first, we need to understand what Return and Risk really mean. Myung Joo Song (ECON 393) Fall 2011 4 / 30
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Dollar Returns on Investment Financial asset is bought and sold in the market at changing price. generates income to the owner of the asset. (i.e. interest, dividends, etc.) Total dollar return = the difference (gain or loss) that you make from investment in term of dollars: difference in buying price and selling price = Capital Gain (Loss) income generated by the asset = Income Dollar Return(DR) = Capital Gain(Loss) + Income Myung Joo Song (ECON 393) Fall 2011 5 / 30
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Example: Dollar Returns on Investment Last year, you invested in a bond for $950 After 1 year, you receive 2 interest payments of $30 and the prevailing market price of the bond is $975. What is DR? Income = 30 + 30 = $60 Capital gain = 975 - 950 = $25 Total dollar return = 60 + 25 = $85 Myung Joo Song (ECON 393) Fall 2011 6 / 30
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Percentage Returns The dollar returns just focus on the dollar you earn, not relative to the cost of your investment. A more convenient measure of return which takes into account this; Percentage Returns (PR) = Dollar return / beginning price = (Capital gain + Income) / beginning price = (Capital gain / beginning price) + (Income / beginning price) PR gives you how much you get from $1 of investment.
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393_lecture5 - Capital Market History and Ecient Market...

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