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Some Lessons from Capital Market History

Chapter 12. Some Lessons from Capital Market History. Chapter Overview. Return of an investment: arithmetic and geometric The variability of returns Efficiency of capital m arkets. Return from a Security (1). Dollar return vs. percentage return Two sources of return dividend income

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Some Lessons from Capital Market History

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  1. Chapter 12 Some Lessons from Capital Market History

  2. Chapter Overview • Return of an investment: arithmetic and geometric • The variability of returns • Efficiency of capital markets

  3. Return from a Security (1) • Dollar return vs. percentage return • Two sources of return • dividend income • capital gain (loss) • realized or unrealized Capital Gain Dividend Payout

  4. Mean • Assume the distribution is normal • Mean return - the most likely return • A measure of centrality • Best estimator of future expected returns

  5. The First Lesson • The difference between T-bills and other investment classes can be interpreted as a measure of the excess return on the risky asset See Excel spreadsheet in “Discussions” folder Risk premium = the excess return required from an investment in a risky asset over a risk-free investment

  6. Arithmetic vs. Geometric Averages (1) • Geometric return = the average compound return earned per year over multiyear period • Arithmetic average return = the return earned in an average (typical) year over a multiyear period Geometric average return =

  7. Arithmetic vs. Geometric Averages (2) • The geometric average tells what an investor has earned per year on average, compounded annually. • The geometric average is smaller than the arithmetic (exception: 0 variability in returns) • Geom. average ≈ arithmetic average – Var/2

  8. Which Average to Use? • Geometric mean is appropriate for making investment statements about pastperformance and for estimating returns over more than 1 period • Arithmetic mean is appropriate for making investment statements in a forward-looking context and for estimating average return over 1 period horizon

  9. The Variability of Returns • Variance = the average squared deviation between the actual return and the average return • Standard deviation = the positive square root of the variance

  10. Standard Deviation • Measure of dispersion of the returns’ distribution • Used as a measure of risk • Can be more easily interpreted than the variance because the standard deviation is expressed in the same units as observations

  11. The Normal Distribution (1) • A symmetric, bell-shaped frequency distribution • Can be completely described by the meanand standard deviation

  12. The Normal Distribution (2)

  13. Z-score • For any normal random variable: • Z – z-score (see “Supplements” folder) • X – normal random variable • - mean

  14. Yet Another Measure of Risk • How much can a bank lose during one year? • Usually reported at 5% or 1% level VaR = statistical measure of maximum loss used by banks and other financial institutions to manage risk exposures

  15. The Second Lesson • The greater the potential reward the greater the risk • Which types of securities have higher potential reward? See Excel spreadsheet in “Discussions” folder

  16. Capital Market Efficiency • Efficient capital market -market in which security prices reflect available information • Efficient market hypothesis -the hypothesis that actual capital markets are efficient

  17. What assumptions imply efficient capital market? • Large number of profit-maximizing participants analyze and value securities • New information about the securities come in random fashion • Profit-maximizing investors adjust security price rapidly to reflect the effect of new information

  18. Forms of Market Efficiency • Weak form – the current price of a stock reflects its own past prices • Semistrong form – all public information is reflected in stock price • Strong form – all information (private and public) is reflected in stock prices

  19. Weak Form Efficiency • Current stock price reflects all security market information • You should gain little from the use of any trading rule that decides whether to buy/sell security based on the passed security market data • Major markets (TSX, NYSE, NASDAQ) are at least weak form efficient • January effect

  20. Semistrong Form Efficiency • Mutual fund managers have no special ability to beat the market • Event studies (IPO, stock splits) support the semistronghypothesis • Quarterly earnings surprise – test results indicate abnormal returns during 13-26 weeks following the announcement of large unanticipated earnings change (earnings surprise) in a company

  21. Strong Form Efficiency • No group of investors has access to private information that will allow them to consistently experience above average profits • Evidence shows that corporate insiders and stock exchange specialists are able to derive above-average profits

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