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Some Lessons from Capital Market History


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Title: Some Lessons from Capital Market History

Chapter 12
  • Some Lessons from Capital Market History

Key Concepts and Skills
  • Know how to calculate the return on an investment
  • Understand the historical returns on various
    types of investments
  • Understand the historical risks on various types
    of investments

Chapter Outline
  • Returns
  • The Historical Record
  • Average Returns
  • The Variability of Returns
  • Capital Market Efficiency

Risk, Return and Financial Markets
  • Examine returns in financial markets to help
    determine the appropriate returns on
    non-financial assets
  • Risk-return trade-off
  • There is reward for bearing risk
  • The greater the reward, the greater the risk

Measuring Returns
  • Total dollar return TDR
  • End price Beg. Price Dividends
  • Total percentage return TDR
  • Beg. Price
  • Dividend yield
  • Dividends/beginning price
  • Capital gains yield
  • (End price - Beg. Price)/Beg. price

Total Percentage Return
  • You bought a stock for 35 and you received
    dividends of 1.25. The stock is now selling for
  • What is your dollar return?
  • Dollar return income change in price
  • What is your percentage return?
  • Dividend yield
  • Capital gains yield
  • Total percentage return

The Importance of Financial Markets
  • Financial markets allow companies, governments
    and individuals to increase their utility
  • Savers defer consumption by investing and earn a
    return that compensates them for doing so
  • Borrowers have better access to capital to invest
    in assets
  • Financial markets also tell us about the returns
    required for various levels of risk

Average Returns
(No Transcript)
Risk Premiums
  • The extra return earned for taking on risk
  • T-Bills are considered to be risk-free
  • The risk premium is the return over and above the
    risk-free rate

Historical Risk Premiums
  • Investment Avg Return Risk Prem
  • Large stocks 12.4 8.6
  • Small Stocks 17.5 13.7
  • Long-term Corporate Bonds 6.2 2.4
  • Long-term Government Bonds 5.8 2.0
  • U.S. Treasury Bills 3.8 0.0

Finding the Mean
  • Arithmetic average return earned in an average
    period over multiple periods
  • Geometric average average compound return per
    period over multiple periods
  • Which is better?
  • The answer depends on the planning period under
  • 15 20 years or less use arithmetic
  • 20 40 years or so split the difference between
  • 40 years use the geometric

Arithmetic vs. Geometric Means
  • What is the arithmetic and geometric average for
    the following returns?
  • Year 1 5
  • Year 2 -3
  • Year 3 12
  • Arithmetic average (5-312)/3 4.67
  • Geometric average 4.69... How?

Variance and Standard Deviation
  • Variance and standard deviation measure the
    volatility of asset returns
  • The greater the volatility the greater the
  • Historical variance sum of squared deviations
    from the mean/( of observations -1)
  • s2 S (Xn - X)2 / n-1
  • i1
  • Standard deviation s square root of the

Variance and Standard Deviation
Assume a stock had annual returns of 15, 9, 6
and 12 over the last four years. Solve for the
standard deviation.
Figure 12.11Probability and Return on
Large-Company Stocks
Efficient Capital Markets
  • Stock prices are in equilibrium or are fairly
  • If this is true, then you should not be able to
    earn abnormal or excess returns
  • Efficient markets DO NOT imply that investors
    cannot earn a positive return in the stock market

What Makes Markets Efficient?
  • There are many investors out there doing research
  • As new information hits the market, it is
    analyzed and trades are made based on this
  • Therefore, prices should reflect all available
    public information
  • If investors stop researching stocks, then the
    market will not be efficient

Figure 12.12
Overreaction and correction
Efficient market reaction
Delayed reaction
Days relative to announcement day
-8 -6 -4 -2 0 2 4 6 8
Common Misconceptions about EMH
  • EMH does not mean that you cant make money
  • It does mean that on average you will earn a
    return appropriate for the amount risk you have
    assumed and you can not make excess returns
  • Market efficiency will not protect you from wrong
    choices if you do not diversify

Weak Form Efficiency
  • Prices reflect all past market information such
    as price and volume
  • Investors can not earn abnormal returns by
    trading on market information
  • Implies that technical analysis will not lead to
    abnormal returns
  • Empirical evidence suggests that markets are
    generally weak form efficient

Semistrong Form Efficiency
  • Prices reflect all publicly available information
    including trading information, annual reports,
    press releases, etc.
  • If the market is semistrong form efficient, then
    investors cannot earn abnormal returns by trading
    on public information
  • Implies that fundamental analysis will not lead
    to abnormal returns

Strong Form Efficiency
  • Prices reflect all information, public and
  • If the market is strong form efficient, then
    investors could not earn abnormal returns
    regardless of the information they possessed
  • Empirical evidence indicates that markets are NOT
    strong form efficient and that insiders could
    earn abnormal returns

Quick Quiz
  • Which of the investments discussed have had the
    highest average return and risk premium?
  • What is capital market efficiency?
  • What are the three forms of market efficiency?