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Slide 4 CPM and EMH

Slide 4 CPM and EMH - Lecture 4 Lessons from Capital Market...

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Lecture 4 Lessons from Capital Market History and Efficient Market Hypothesis By Diep Duong
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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 period Invest in (buy) financial assets Earn a return to compensate for doing so Financial Assets are different from Consumption Goods: Stocks, Bonds … . 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 12-2
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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 12-3
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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…) 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 income generated by the asset - Income DR=(Capital Gain + Income) Example: 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’s DR? Income = 30 + 30 = 60 Capital gain = 975 – 950 = 25 12-4
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Percentage Returns The DR returns just focus on the dollar amount you earn, not relative to the cost of your investment A more convenient measure of return which takes into account this 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 In the case of common stock, income is dividend payment Dividend yield = dividend / beginning price Capital gains yield = capital gain/beginning price Total percentage return = dividend yield + capital 12-5
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Example – Calculating Returns You bought a stock for $35, and you received dividends of $1.25. The stock is now selling for $40.
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