Lecture11_student

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    The Equity Risk Premium Correlations between stocks Was the US stock market on an 82- year winning streak? Introducing risk of a stock portfolio
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Random walks If you have studied a lot of probability  theory, you probably know what a  random walk is If you are not familiar with random  walks, I will give you a five-minute guide This is very simplified and not meant to be  a rigorous analysis of random walks
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Example: A simple random walk It’s 3 am on DP on Halloween night Someone has had too much to drink  and is trying to walk home without  passing out Due to the lack of sobriety, every step  taken is a step to the left or right This person never walks straight
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50/50 Each step has the same likelihood of  going each direction 50% probability of going right 50% probability of going left What is this kind of walk going to look  like? We assume that the previous step has no  impact on the next step
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8 examples of random walks Source: Wikipedia user Toobaz,  http://en.wikipedia.org/wiki/File:Random_Walk_example.svg
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How do random walks apply  to this lecture? Suppose that there is a company that  has not revealed any recent  information Also suppose that market conditions  have not recently changed for this  company The price of the stock throughout the  day may look like a random walk IBM stock price on May 6,  2011, from Google
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The random walk hypothesis Stocks fluctuate up and down like a random  walk Recall that the previous movements of a stock  have no impact on future movements if this  hypothesis is true If potential movements in the stock’s price are  symmetric in probabilities, we would have the  expected future value at any point in time to  be the same as the price now
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Some do not believe the  random walk hypothesis Some people believe that trends in the  stock market are predictable to a  degree Past fluctuations can help to predict future  stock prices If you can figure out how the past  affects the future, you can buy and sell  stocks in such a way as to profit
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What do you believe? Do you think that you are able to figure  out patterns? Make sure that patterns continue to repeat  in the same way Do you believe that a random walk is a  better explanation? Maybe you believe that it is just better to  have sound investment fundamentals
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More on random walks later in  the quarter In Chapter 14, I will introduce a richer  form of the random walk hypothesis The random walk hypothesis applies to  short-run changes to stock prices How do we expect prices to change in the  long run?
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