Chapter 12 Lessons from Capital Market History Homework: 1, 7 & 14.
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Transcript of Chapter 12 Lessons from Capital Market History Homework: 1, 7 & 14.
Chapter 12 Lessons from Capital
Market History
•Homework: 1, 7 & 14
Lecture Organization
Percentage Return
Historical Return and Risk Premium
Measure of Risk
The Efficient Market Hypothesis
Risk, Return, and Financial Markets
“. . . Wall Street shapes Main Street. Financial markets
transform factories, department stores, banking assets,
film companies, machinery, soft-drink bottlers, and power
lines from parts of the production process . . . into
something easily convertible into money. Financial
markets . . . not only make a hard asset liquid, they price
that asset so as to promote it most productive use.”
Peter Bernstein, in his book, Capital Ideas
Percentage Returns
Inflows
Outflows
$42.18
$1.85
$40.33
Total
Dividends
Endingmarket value
t = 1t
– $37
Time
Percentage Returns
Rates of Return
Dt+1 + (Pt+1 - Pt)
PtPercentage Return =
Dt+1
(Pt+1 - P t)
Pt Pt+Percentage Return =
A $1 Investment in Different Types of Portfolios: 1948-1999
0.1
1
10
100
1000
1945 1955 1965 1975 1985 1995
Year
Ind
ex
TSE 300 Stocks
Long Bonds
Treasury bills
Small Stocks
A $1 Investment in Different Types of Portfolios: 1926-1998 (US Comparison)
Year-to-Year Total Returns on TSE300: 1948-1999
TSE300
-30
-20
-10
0
10
20
30
40
50
60
Year 1950 1965 1980 1995
Year-to-Year Total Returns on Small Company Common Stocks: 1970-1999
Small Company Stocks
-40
-30
-20
-10
0
10
20
30
40
50
60
1975 1985 1995
Year-to-Year Total Returns on Bonds: 1926-1998
Bonds
-20
-10
0
10
20
30
40
50
Year 1950 1965 1980 1995
Year-to-Year Total Returns on Treasury Bills: 1948-1999
Treasury Bills
0
5
10
15
20
25
Year 1950 1965 1980 1995
Using Capital Market History
Now let’s use our knowledge of capital market history to make some financial decisions. Consider these questions:
Suppose the current T-bill rate is 5%. An investment has “average” risk relative to a typical share of stock. It offers a 10% return. Is this a good investment?
Suppose an investment is similar in risk to buying small Canadian company equities. If the T-bill rate is 5%, what return would you demand?
Risk premiums: The risk premium is the difference between a risky investment’s return and that of a riskless asset. Based on historical data:
InvestmentAverage Standard Riskreturn deviation premium
Common stocks 13.2% 16.6% ____%
Small stocks 14.8% 23.7% ____%
LT Bonds7.6% 10.6% ____%
U.S. Common 15.6% 16.9% ____%(S&P 500 in C$)
Treasury bills 3.8% 3.2% ____%
Using Capital Market History (continued)
TSE 300: Frequency of returns (1948-1999): Figure 12.5
0
1
2
3
4
5
6
7
8
9
-25
-15 -5 5 15 25 35 45 55
Fre
qu
en
cy
Historical Returns and Standard Deviations:
InvestmentAverage Standard Frequencyreturn deviation
Small stocks 14.8% 23.7%
Common stocks 13.2% 16.6%
LT Bonds7.6% 10.6%
Treasury bills 3.8% 3.2%
The Normal Distribution
Probability
Return onlarge companystocks
68%
95%
> 99%
– 3 – -36.22%
– 2 – -19.77%
– 1 – -3.32%
013.13%
+ 1 29.58%
+ 2 46.03%
+ 3 62.47%
Asset mean returns versus variability: 1948-1999
StandardStandard Mean Mean DeviationDeviation
InflationInflation 4.25 3.51T-billsT-bills 6.04 4.04BondsBonds 7.64 10.57TSE300TSE300 13.20 16.62Small StocksSmall Stocks 14.79 23.68
Asset mean returns versus variability: 1948-1999
Average returns versus variability
0
2
4
6
8
10
12
14
16
4 9 14 19 24
Variability (std dev)
Ave
rag
e R
etu
rn (
%)
T-bills
Bonds
TSE300
Small Stocks
Expected Returns and Risk
Returns are important, but they can’t be the sole driver of investment decisions
Risk-free Rate The rate of return that can be earned with certainty
Risk Premium Difference between return and risk-free asset return
Volatility The standard deviation of asset returns
Risk Aversion The degree to which an investor is willing to accept risk
Do We Like Risk?
Coin-Flipping game
Wonderland and King’s Island
Las Vegas
Example
Using the following returns, calculate the average returns, the variances, and the standard deviations for stocks X and Y.
Returns
Year X Y
1 18% 26%
2 6 -7
3 -9 -20
4 13 31
5 7 16
Solution to Example
Mean return on X =
Mean return on Y =
Variance of X =
Variance of Y =
Standard deviation of X =
Standard deviation of Y =
Two Views on Market Efficiency
“ . . . in price movements . . . the sum of every scrap of
knowledge available to Wall Street is reflected as far as the
clearest vision in Wall Street can see.”
Charles Dow, founder of Dow-Jones, Inc. and first editor of The Wall Street Journal (1903)
“In an efficient market, prices ‘fully reflect’ available
information.”
Professor Eugene Fama, financial economist (1976)
Reaction of Stock Market to New Information
-8 -6 -4 -2 0 2 4 6 80
50
100
150
200
250
Efficient Reaction
Delayed Reaction
Overreaction
Efficient Market
Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information Active strategies do not work systematically due to competitive
market environment
EMH recommends a passive portfolio investment of investment in a well-diversified portfolio without attempting to find ‘mispriced’ securities.
Market Efficiency
Information is the key. Market prices incorporate information quickly.
What information is included in prices? Weak form Semi-strong form Strong form
Past prices
All public info
All insider info
Implications
Suppose markets are weak form efficient Implies information from past trading history of security, or technical
analysis, cannot help investors identify systematic mispricing. Why?
Suppose markets are semi-strong form efficient
Suppose markets are strong form efficient
Implications
Strong Semi-strong
Weak
Implications
EMH implies stock prices are a Random Walk Stock price changes should be random and unpredictable
(Why? Is this bad?)
Empirical Evidence on Market Efficiency
The Empirical Evidence tells us three main things: