Chapter 12 Some Lessons from Capital Market History 12-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • • • • • • 12-2 Returns The Historical Return Average Returns: The st Lesson The Variability of Returns: The More about Average Returns Capital Market Efficiency nd Lesson Chapter Outline • • • • • • 12-3 Returns The Historical Return Average Returns: The st Lesson The Variability of Returns: The More about Average Returns Capital Market Efficiency nd Lesson Risk, Return and Financial Markets Looking back through time we know… 1.There is a reward for bearing risk 2.The > the risk = the > the potential return! 12-4 This is called: The Risk/Return Trade-of 12-5 Dollar Returns Total dollar return = income from investment + capital gain (or loss) due to the change in price 12-6 What is my return? 12-7 • You bought a bond for $950 one year ago • You have received two coupons of $30 each • You can sell the bond for $975 today • What is your total dollar return? What is my return? • Income = 30 + 30 = 60 • Capital Gain = 975 - 950 = 25 • Total Dollar return = 60 + 25 = $85 12-8 Percentage Returns It is generally more intuitive to think in terms of percentage, (rather than dollar), returns 12-9 Percentage Returns Dividend Yield = income/beginning price Capital Gains Yield = (ending price – beginning price) / beginning price Total percentage return = dividend yield + capital gains yield 12-10 Strong Form Efficiency • Prices reflect all information, including public and private • 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 12-42 Semi-strong Form Efficiency • Prices reflect all publicly available information including trading information, annual reports, press releases, etc • If the market is semi-strong form efficient, then investors cannot earn abnormal returns by trading on public information • Implies that fundamental analysis will not lead to abnormal returns 12-43 Weak Form Efficiency • Prices reflect all past market information such as price and volume • If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information • Implies that technical analysis will not lead to abnormal returns • Empirical evidence indicates that markets are generally weak form efficient 12-44 Common Misconceptions about EMH • Efficient markets not mean that you can’t make money • They mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns • Market efficiency will not protect you from wrong choices if you not diversify – you still don’t want to “put all your eggs in one basket” 12-45 Ethics Issues 12-46  Program trading is defined as automated trading generated by computer algorithms designed to react rapidly to changes in market prices Is it ethical for investment banking houses to operate such systems when they may generate trade activity ahead of their brokerage customers, to which they owe a fiduciary duty?  Suppose that you are an employee of a printing firm that was hired to proofread proxies that contained unannounced tender offers (and unnamed targets) Should you trade on this information, and would it be considered illegal? 1-46 Comprehensive Problem Your stock investments return 8%, 12%, and -4% in consecutive years 1.What is the geometric return? What is the sample standard deviation of the above returns? Using the standard deviation and mean that you just calculated, and assuming a normal probability distribution, what is the probability of losing 3% or more? 12-47 Comprehensive Problem Your stock investments return 8%, 12%, and -4% in consecutive years What is the geometric return? (1.08 x 1.12 x 96)^ 333 -1 = 0511 12-48 Comprehensive Problem Your stock investments return 8%, 12%, and -4% in consecutive years What is the geometric return? What is the sample standard deviation of the above returns? Mean = (.08 + 12 + -.04) / = 0533 Variance = (.08 - 0533)^2 + (.12 - 0533)^2 + (-.04 - 0533)^2 / (3-1) = 00693 Standard deviation = 00693 ^ = 0833 12-49 Comprehensive Problem Your stock investments return 8%, 12%, and -4% in consecutive years Using the standard deviation and mean that you just calculated, and assuming a normal probability distribution, what is the probability of losing 3% or more? Probability: a 3% loss (return of -3%) lies one standard deviation below the mean There is 16% of the probability falling below that point (68% falls between -3% and 13.66%, so 16% lies below -3% and 16% lies above 13.66%) 12-50 Terminology • • • • • • • • 12-51 Dollar return Percentage return Dividend Yield Capital Gain Yield Risk Premium Variance and Std Deviation Arithmetic vs Geometric Mean Efficient Market Hypothesis Formulas Total Dollar return = income + capital gain (or loss) Percentage return = dividend yield + capital gain yield Variance = sum of the squared deviations from the mean / (number of observations – 1) 12-52 Formulas (continued) Arithmetic average = sum of the return earned over multiple years / number of years Geometric average = average compound return per period over multiple periods 12-53 Key Concepts and Skills • • Calculate the return on an investment Compare returns to the various levels of risk of an investment • Compute variance and standard deviation as a measure of financial risk • Compare the three forms of the Efficient Market Hypothesis 12-54 What are the most important topics of this chapter? Risk and Return are directly related (risk/return tradeoff) Variance and Standard Deviation are used to measure financial risk The three forms of the EMH suggest how stocks are valued by the market 12-55 Questions? 12-56 [...]... and standard deviation measure the volatility of asset returns The greater the volatility, the greater the uncertainty In finance, we use both variance and standard deviation to measure… 12-26 Risk! Variance and Standard Deviation Historical variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = square root of the variance Std Dev = 12-27 √Variance Example... Outline • • • • • • 12-18 Returns The Historical Return Average Returns: The 1 st Lesson The Variability of Returns: The 2 More about Average Returns Capital Market Efficiency nd Lesson A Comparison of Average Returns Investment 12-19 Average Return Large Stocks 12.3% Small Stocks 17.1% Long-term Corporate Bonds 6.2% Long-term Government Bonds 5.8% U.S Treasury Bills 3.8% Inflation 3.1% Now let’s add... available so that they can invest in productive assets 12-13 The Importance of Financial Markets Financial markets also provide us with information about the returns that are required for various levels of risk 12-14 Chapter Outline • • • • • • 12-15 Returns The Historical Return Average Returns: The 1 st Lesson The Variability of Returns: The 2 More about Average Returns Capital Market Efficiency nd... Investment 12-22 Average Return Risk Premium Large Stocks 12.3% 8.5% Small Stocks 17.1% 13.3% Long-term Corporate Bonds 6.2% 2.4% Long-term Government Bonds 5.8% 2.0% U.S Treasury Bills 3.8% 0.0% Chapter Outline • • • • • • 12-23 Returns The Historical Return Average Returns: The 1 st Lesson The Variability of Returns: The 2 More about Average Returns Capital Market Efficiency nd Lesson 12-24 Variance and... for $35 • You received dividends of $1.25 • The stock is now selling for $40 12-11 Percentage Returns 1 Dividend Yield = income/beginning price 1.25 / 35 = 3.57% 2 Capital Gains Yield = (ending price – beginning price) / beginning price (40 – 35) / 35 = 14.29% 3 Total percentage return = dividend yield + capital gains yield 3.57 + 14.29 = 17.86% 12-12 The Importance of Financial Markets Financial markets... Development fund (AEDCX) Enter the ticker, press go and then click “Risk Measures” 12-29 12-30 Chapter Outline • • • • • • 12-31 Returns The Historical Return Average Returns: The 1 st Lesson The Variability of Returns: The 2 More about Average Returns Capital Market Efficiency nd Lesson Arithmetic vs Geometric Mean So which is better?  The arithmetic average is overly optimistic for long horizons  The geometric ... Standard Deviation Historical variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = square root of the variance Std Dev = 12-27 √Variance Example... productive assets 12-13 The Importance of Financial Markets Financial markets also provide us with information about the returns that are required for various levels of risk 12-14 Chapter Outline •... Return Average Returns: The st Lesson The Variability of Returns: The More about Average Returns Capital Market Efficiency nd Lesson A Comparison of Average Returns Investment 12-19 Average Return