Chapter 10
Some Lessons from CapitalMarket History
Risk, Return, and FinancialMarkets
•We can examine returns in the financialmarkets to help us determine theappropriate returns on non-financial assets
•Lessons from capital market history
–There is a reward for bearing risk
–The greater the potential reward, the greaterthe risk
–This is called the risk-return trade-off
Dollar Returns
•Total dollar return = income from investment+ capital gain (loss) due to change in price
•Example:
–You bought a bond for $950 1 year ago. Youhave received two coupons of $30 each. Youcan sell the bond for $975 today. What is yourtotal dollar return?
•Income = 30 + 30 = 60
•Capital gain = 975 – 950 = 25
•Total dollar return = 60 + 25 = $85
Percentage Returns
•It is generally more intuitive to think interms of percentages than dollar returns
•Dividend yield = income / beginning price
•Capital gains yield = (ending price –beginning price) / beginning price
•Total percentage return = dividend yield +capital gains yield
The Importance of FinancialMarkets
•Financial markets allow companies, governments,and individuals to increase their utility
–Savers have the ability to invest in financial assets sothat they can defer consumption and earn a return tocompensate them for doing so
–Borrowers have better access to the capital that isavailable so that they can invest in productive assets
•Financial markets also provide us with informationabout the returns that are required for various levelsof risk
Figure 10.4
Average Returns
Investment
Average Return
Large stocks
12.4%
Small Stocks
17.5%
Long-term Corporate Bonds
6.2%
Long-term GovernmentBonds
5.8%
U.S. Treasury Bills
3.8%
Inflation
3.1%
Risk Premiums
•The “extra” return earned for taking on risk
•Treasury bills are considered to be risk-free
•The risk premium is the return over andabove the risk-free rate
Historical Risk Premiums
•Large stocks: 12.4 – 3.8 = 8.6%
•Small stocks: 17.5 – 3.8 = 13.7%
•Long-term corporate bonds: 6.2 – 3.8 =2.4%
•Long-term government bonds: 5.8 – 3.8 =2.0%
Figure 10.9
Variance and Standard Deviation
•Variance and standard deviation measurethe volatility of asset returns
•The greater the volatility, the greater theuncertainty
•Historical variance = sum of squareddeviations from the mean / (number ofobservations – 1)
•Standard deviation = square root of thevariance
Figure 10.10
Figure 10.11
Arithmetic vs. Geometric Mean
•Consider annual returns of 10%, 12%, 3%and -9%
•Arithmetic mean = (.1 + .12 + .03 - .09)/4 =.04 = 4%
–Rate earned in a typical year
•Geometric mean = (1.1 x 1.12 x 1.03 x.91)1/4 – 1= .0366 = 3.66%
–Rate earned per year, allowing for annualcompounding
Efficient Capital Markets
•Stock prices are in equilibrium or are“fairly” priced
•If this is true, then you should not be ableto earn “abnormal” or “excess” returns
•Efficient markets DO NOT imply thatinvestors cannot earn a positive return inthe stock market
Figure 10.12
What Makes Markets Efficient?
•There are many investors out there doingresearch
–As new information comes to market, thisinformation is analyzed and trades are madebased on this information
–Therefore, prices should reflect all availablepublic information
•If investors stop researching stocks, thenthe market will not be efficient
Common Misconceptions aboutEMH
•Efficient markets do not mean that you can’tmake money
•They do mean that, on average, you will earn areturn that is appropriate for the risk undertakenand there is not a bias in prices that can beexploited to earn excess returns
•Market efficiency will not protect you from wrongchoices if you do not diversify – you still don’twant to put all your eggs in one basket
Strong Form Efficiency
•Prices reflect all information, including publicand private
•If the market is strong form efficient, theninvestors could not earn abnormal returnsregardless of the information they possessed
•Empirical evidence indicates that markets areNOT strong form efficient and that insiderscould earn abnormal returns
Semistrong Form Efficiency
•Prices reflect all publicly availableinformation including trading information,annual reports, press releases, etc.
•If the market is semistrong form efficient,then investors cannot earn abnormalreturns by trading on public information
•Implies that fundamental analysis will notlead to abnormal returns
Weak Form Efficiency
•Prices reflect all past market informationsuch as price and volume
•If the market is weak form efficient, theninvestors cannot earn abnormal returns bytrading on market information
•Implies that technical analysis will not leadto abnormal returns
•Empirical evidence indicates that marketsare generally weak form efficient