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Topic:InvestmentRisk,ReturnsandtheHistoryofCapitalMarkets
Lecture7:Objectives
Knowhowtocalculatethereturnonan
investment
Knowhowtocomputeandinterpretinvestment
risk
Understandthehistoricalreturnsonvarious
typesofinvestments
Understandthehistoricalriskofvarioustypesof
investments
Understandtheimplicationsofmarketefficiency
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Motivation:
Whyshouldacorporatemanagercareaboutfinancialmarkets?
Amanagercanexaminereturnsfromfinancial
securities inordertohelpdeterminetheappropriate
returnonreal investments.
Similarly,amanagercanexaminereturnsin financial
markets tohelpdeterminehowmuchreturnhe
mustearnfortheshareholdersofthecompany.
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Weknowhistoricallythat:
Thereisarewardforbearingrisk.
Thegreaterthepotentialreward,thegreaterthe
risk.
Inotherwords,thereisatradeoff(riskreturn
tradeoff)
Implicationsforthecorporatemanager:
Thegreatertheriskinaproject,thegreatermust
betheexpectationforrewards.
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Motivation:
Onefactaboutfinancialmarketsand
implicationsforthecorporatemanager
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ComputingDollarreturns andPercentagereturnsfrominvestments
Totaldollarreturn=thereturnonaninvestment
measuredindollars.
$return=Dividends+Capitalgains
Capitalgains=Pricereceivedwhensold Pricepaid
whenbought
Example:Youboughtabondfor$950oneyearago.
Youhavereceivedtwocouponsof$30each.Youcan
sellthebondfor$975today.Whatisyourtotaldollar
return?
Income=30+30=$60
Capitalgain=975 950=$25
Totaldollarreturn=60+25=$85
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Itisgenerallymoreintuitivetothinkintermsof
percentagesthandollarreturns.
Totalpercentagereturn=thereturnonaninvestment
measuredasapercentageoftheoriginalinvestment.
%return=$return/$invested
ExampleContd:Total%return=
$60+$25
$950
= 8.9S%
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ComputingDollarreturns andPercentagereturnsfrominvestments
ComputingPercentagereturnsfrominvestments(contd)
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i:iJcnJiclJ = =

t+1
P
t
Copitol 0oins iclJ =C0 =
P
t+1
- P
t
P
t
% Return = + C0
% Return =

t+1
+P
t+1
-P
t
P
t
CalculatingreturnsExample10.1:Youinvestinastockwithasharepriceof
$25.Afteroneyear,thestockpricepershareis$35.Eachsharepaida$2
dividend.Whatwasyourtotalreturn?
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Thehistorical
record
Figure10.4
$1investedin
threemajor
domesticclassesof
investmentsas
fromthebeginning
of1900
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Quarterbyquarterreturns
All Ordinaries IndexFigure 10.5
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10yeargovernmentbondsFigure10.6
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Quarterbyquarterreturns(cont.)
CashFigure10.7
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Inflation Figure10.8
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Thefirstlesson:Historicalaveragereturns
Historicalaveragereturn=simple(arithmetic)average
Eistoricol A:crogc Rcturn =
ycorly rcturn
1
=1
I
Averagereturns intheperiod19852009
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RiskfreerateandtheRiskpremium
Riskfreerate
Rateofreturnonarisklessinvestment
Treasurybillsareconsideredriskfree
Riskfreeinvestmentshavezeroriskpremium
Riskpremium
Returnonariskyassetinexcessoftheriskfreerate
Investorsrewardfortakingoninvestmentrisk
HistoricalRiskPremiums
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Investment
ReturnRisk
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Investmentreturn
riskisusually
measuredbythe
volatilityofreturns.
Figure10.9
Frequency
distributionof
returnsontheAll
OrdinariesIndex,
19852009
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Returnvariabilityreview
Variance=VAR(R)or
2
Commonmeasureofreturndispersion
Alsocalledvariability of returns
Notthesameunitsastheaverage
Standarddeviation=SD(R)or
Squarerootofthevariance
Sometimescalledreturnvolatility
Sameunitsastheaverage
Returnvariance:(T=numberofreturnobservations)
IAR(R) = o
2
=
_ r

-r
2
1
=1
I -1
Standarddeviation: S(R) = o = IAR(R)
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Example:Calculatinghistorical variance
andstandarddeviation
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(1) (2) (3) (4) (5)
Average Difference: Squared:
Year Return Return: (2)(3) (4)x(4)
1 0.10 0.04 0.06 0.0036
2 0.12 0.04 0.08 0.0064
3 0.03 0.04 0.01 0.0001
4 0.09 0.04 0.13 0.0169
Sum: 0.16 Sum: 0.027
Average: 0.04 Vari ance: 0.009
0.09486833 Standard Devi ati on:
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Historicalaveragereturnsandstandarddeviation
Figure10.10
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Historicallyin
capitalmarkets,
average
investment
returnshave
beenpositively
relatedwith
investmentrisk.
Inotherwords,
higher
investmentrisks
=higheraverage
returns
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Returnvariabilityreviewandconcepts
Normaldistribution
symmetricfrequencydistribution
Hasabellshapedcurve
Completelydescribedbythevariablesmeanandvariance
Areinvestmentreturnsnormallydistributed?
Thenormaldistribution Figure10.11
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GeometricandArithmeticaveragereturn:Formula
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Arithmetic(Simple)Average:
AAR =
1
I
r

1
=1
=
r
1
+r
2
+ +r
1
I
GeometricAverage:
0AR = _ 1 +r

1
=1
1 1
-1
= (1 +r
1
) (1 +r
2
) . . . (1 +r
1)
1 1
- 1
Where:
L = product (like X for sum)
r
I
= return in each period
I = number of periods
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Arithmeticand geometricaveragereturn
Arithmeticaverage
Returnearnedinanaverageperiodovermultipleperiods
Answersthequestion:Whatwasyourreturnin an average
year overaparticularperiod?
Geometricaverage
Averagecompoundreturnperperiodovermultipleperiods
Answersthequestion:Whatwasyouraveragecompound
return per year overaparticularperiod?
Geometricaverage<arithmeticaverage,unlessallthe
returnsareequal.
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Calculatingageometricaverage return
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Percent OnePlus Compounded
Year Return Return Return:
Mar93 8.42 1.0842 1.0842
Jun93 5.35 1.0535 1.1422
Sep93 13.72 1.1372 1.2989
Dec93 11.91 1.1191 1.4536
Mar94 4.84 0.9516 1.3833
Jun94 2.19 0.9781 1.3530
Sep94 2.72 1.0272 1.3898
Dec94 4.48 0.9552 1.3275
1.0360
3.60%
(1.3275)^(1/8):
GeometricAverageReturn:
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Efficientcapitalmarkets
Theefficientmarkethypothesis(EMH)
Stockpricesareinperfectequilibrium(supplyanddemand)
Stocksarefairlypriced
Stockmarketsareinformationally efficiency
Iftrue,investorsshouldnotexpecttoearnpositiveabnormalreturns.
EMHdoesnot meanthatyoucantmakemoney.Thereisariskpremium
infinancialmarkets.
EMHdoes meanthat:
onaverage,youwillearnareturnappropriatefortheriskundertaken
therearenobiasesinpricesthatcanbeexploitedtoearnabnormal
profits
marketefficiencywillnotprotectinvestorsfrompoorchoices,i.e.lack
diversification
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Stockpricereactiontonewinformationinefficientandinefficient
markets Figure10.12
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Whatmakesmarketsefficient?
Therearemanyinvestorsouttheredoingresearch.
Asnewinformationcomestomarket,thisinformationis
analyzedandtradesaremadebasedonthisinformation,
andpricesmove.
Therefore,pricesalwaysreflectallavailablepublic
information.
Ifinvestorsstopresearchinginformation,thenthestock
marketwillnolongerbeefficient.
Butinvestorsalwayscontinuetoconductresearchbecause
thereisastrongmotivetomakeabnormalprofits.
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FormsofMarketEfficiency
3FormsofMarketEfficiency:
Isthestockmarketefficient?
Strongformefficiency:
meansthatinvestorscannotearnabnormalprofitsregardlessofthe
informationtheypossess.
EmpiricalevidenceindicatesthatmarketsareNOTstrongformefficient
andthatcorporateinsiderscanearnabnormalreturns.
Semistrongformefficiency:
meansthatinvestorscannotearnabnormalprofitsbytradingonpublic
information.
Impliesthatfundamentalanalysiswillnotleadtoabnormalreturns.
Weakformefficiency:
meansthatinvestorscannotearnabnormalprofitsbytradingonpast
priceinformation.
Impliesthattechnicalanalysiswillnotleadtoabnormalreturns.
Empiricalevidenceindicatesthatmarketsaregenerallyweakform
efficient.
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Conclusion
Riskyassets,historically,hasofferedariskpremium.Therehasbeena
rewardforbearingrisk.
Thegreaterthepotentialrewardfromariskyinvestment,thegreaterthe
investmentrisk.
Marketefficiencymeansthatassetpricesshouldnotbetoohighortoo
low.
Thecorporatemanagermusthaveagoodknowledgeofcapitalmarkets.
Itsthemanagersjobtoearnafairreturnfortheshareholders.
Textbookproblems:
QuestionsandProblems:14,9,21,22,23,27,31.
CriticalThinkingandConceptsReview:110.
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