1. Chapter 10 - Capital Markets!

2. 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!!! Impress your friends, family, and significant other with your knowledge!

3. Chapter Outline Returns!!! The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second Lesson More on Average Returns

4. Risk, Return, and Financial Markets We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets Lessons from capital market history Risk Risk/reward relationship

5. 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. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return? Income = ? Capital gain = ? Total dollar return = ?

6. Percentage Returns Percentages versus dollar returns Dividend yield formula Capital gains yield formula Total percentage return formula

7. Example – Calculating Returns You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40. What is your dollar return? Dollar return = ? What is your percentage return? Dividend yield = ? Capital gains yield = ? Total percentage return = ?

8. The Importance of Financial Markets Financial markets allow companies, governments, and individuals to increase their utility Savers - investment Borrowers - capital

9. The Importance of Financial Markets (continued) Information about required returns

10. Year-to-Year Total Returns Large-Company Stock Returns Long-Term Government Bond Returns U.S. Treasury Bill Returns

11. Average Returns InvestmentAverage Return Large stocks12.4% Small Stocks17.5% Long-term Corporate Bonds6.2% Long-term Government Bonds 5.8% U.S. Treasury Bills3.8% Inflation3.1%

12. Risk Premiums Defined Relationship to Treasury bills Nominal rate of return Real rate of return

13. 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%

14. Variance and Standard Deviation Variance and standard deviation – what do they measure? Relationship of volatility to uncertainty Historical variance Standard deviation

15. Example – Variance and Standard Deviation YearActual Return Average Return Deviation from the Mean Squared Deviation 1.15.105.045.002025 2.09.105-.015.000225 3.06.105-.045.002025 4.12.105.015.000225 Totals.42.00.0045 Variance =.0045 / (4-1) =.0015 Standard Deviation =.03873

16. Work the Web Example How volatile are mutual funds? Morningstar provides information on mutual funds, including volatility (standard deviation) Click on the web surfer to go to the Morningstar site Pick a fund, such as the Aim European Development fund (AEDCX) Enter the ticker in the “quotes” box, click on the right arrow, and then click on “risk measures”

17. Probability Distribution

18. Arithmetic vs. Geometric Mean Consider annual returns of 10%, 12%, 3% and -9% Arithmetic mean formula Defined Geometric mean = (1.1 x 1.12 x 1.03 x.91) 1/4 – 1=.0366 = 3.66% Defined

19. Example S & P 500 ReturnsProduct 11.14 37.13 43.31 -8.91 -25.26 1.1114 X 1.3713 X 1.4331 X.9109 X.7474 1.4870 The geometric average return is calculated as 1.4870 1/5 -1 =.0826 = 8.26%

20. End of Chapter 10! Chapter 11 is next! The Analyst Competition!