Ch 12. Capital Market History. 1) Return Measures In this chapter, we want to understand the relationship between returns and risks. 1) How to measure.

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Presentation transcript:

Ch 12. Capital Market History

1) Return Measures In this chapter, we want to understand the relationship between returns and risks. 1) How to measure returns? (1) Total dollar return = dividend income + capital gain (or loss) (2) Percentage return (R i ) = D t+1 /P t + (P t+1 – P t )/P t = dividend yield + capital gains

Ex) The stock price at the beginning of the year was $35 per share. At the end of the year, price was $ The dividend paid during the year on each share was $1.85. Total dollar return = ( ) Percentage return = 1.85/35+ ( )/35

2. Historical record Average returns during 1926 and 2010 Large-company stocks: 11.9% (8.2%) Small-company stocks: 16.7% (13.0%) Long-term corporate bonds: 6.2% (2.5%) Long-term government bonds: 5.9% (2.2%) US Treasury bills: 3.7% (0.0%) Inflation: 3.1% Here risk premium is in parentheses. Risk premium = average return – risk free rate return (US Treasury Bill).

3. Risk: Variability of Return Variance: measurement of variability of returns.

Ex)

4. Historical Record Average returns during 1926 and 2010 Large-company stocks: 11.9% (20.4%) Small-company stocks: 16.7% (32.6%) Long-term corporate bonds: 6.2% (8.3%) Long-term government bonds: 5.9% (9.5%) Intermediate-term government bonds: 5.5% (5.7%) US Treasury bills: 3.7% (3.1%) Inflation: 3.1% (4.2%) Here standard deviations are in parentheses. What you can learn from the record? Return and risk.

Risk premium: average US risk premium is 7.4% and standard deviation is 2% during 1900 to 2005.

5. Probability distribution Returns usually have a normal – bell shape – (frequency) distribution. Under normal distribution, the probability that the return in a given year is in the range of an average return +/- one (two, three) times standard deviation is 68% (95%, 99%).

6. Arithmetic and geometric Arithmetic: return in an average year. Earnings in a typical year Geometric: average compound return per year. Average compound earnings

Ex) annual returns of 10%, 12%, 3% and – 9%. Geometric return? Rg = [(1+0.1)×(1+0.12)× (1+0.03)× ( )]^(1/4)-1 = 3.66% Geometric average is smaller than arithmetic average. For forecasting wealth or growth level, long run estimates with arithmetic average may be too optimistic. Short run estimates with geometric average are too pessimistic.

Blume’s formula for return forecasting; R(T) = (T-1)/(N-1)*Geometric average + (N-T)/(N- 1)*Arithmetic average. Here T is the year of average return. N is the number of years. e.g) 25 years of return data. An arithmetic return is 12%. A geometric return is 9%. 1 year average return forecast = (1- 1)/24*9%+(25-1)/24*12% = 12%. 5 year average return forecast = 11.5% 10 year average return forecast = %

7. Market Efficiency 1)Price behavior in an efficient market (Figure 12.14) -Efficient market reaction -Delayed market reaction -Overreaction and correction 2) Market efficiency hypothesis: it asserts that well organized markets are efficient. It can be achieved by investors’ competition to find mispriced stocks.

- Weak form: current stock price reflects the stock’s own past prices (e.g. patterns). - Semi-strong form: all public information (e.g. F/S information) is reflected in the stock price. - Strong form: no inside information exists.