You are on page 1of 9

# 4/09/2013

1
Topic:InvestmentRisk,ReturnsandtheHistoryofCapitalMarkets
Lecture7:Objectives
Knowhowtocalculatethereturnonan
investment
Knowhowtocomputeandinterpretinvestment
risk
Understandthehistoricalreturnsonvarious
typesofinvestments
Understandthehistoricalriskofvarioustypesof
investments
Understandtheimplicationsofmarketefficiency
FINS1613S2Yr2013 1
Motivation:
Amanagercanexaminereturnsfromfinancial
securities inordertohelpdeterminetheappropriate
returnonreal investments.
Similarly,amanagercanexaminereturnsin financial
markets tohelpdeterminehowmuchreturnhe
mustearnfortheshareholdersofthecompany.
FINS1613S2Yr2013 2
Weknowhistoricallythat:
Thereisarewardforbearingrisk.
Thegreaterthepotentialreward,thegreaterthe
risk.
Implicationsforthecorporatemanager:
Thegreatertheriskinaproject,thegreatermust
betheexpectationforrewards.
FINS1613S2Yr2013 3
Motivation:
implicationsforthecorporatemanager
4/09/2013
2
ComputingDollarreturns andPercentagereturnsfrominvestments
Totaldollarreturn=thereturnonaninvestment
measuredindollars.
\$return=Dividends+Capitalgains
whenbought
Example:Youboughtabondfor\$950oneyearago.
sellthebondfor\$975today.Whatisyourtotaldollar
return?
Income=30+30=\$60
Capitalgain=975 950=\$25
Totaldollarreturn=60+25=\$85
FINS1613S2Yr2013 4
Itisgenerallymoreintuitivetothinkintermsof
percentagesthandollarreturns.
Totalpercentagereturn=thereturnonaninvestment
measuredasapercentageoftheoriginalinvestment.
%return=\$return/\$invested
ExampleContd:Total%return=
\$60+\$25
\$950
= 8.9S%
FINS1613S2Yr2013 5
ComputingDollarreturns andPercentagereturnsfrominvestments
ComputingPercentagereturnsfrominvestments(contd)
FINS1613S2Yr2013
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?
6
4/09/2013
3
Thehistorical
record
Figure10.4
\$1investedin
threemajor
domesticclassesof
investmentsas
fromthebeginning
of1900
FINS1613S2Yr2013 7
Quarterbyquarterreturns
All Ordinaries IndexFigure 10.5
FINS1613S2Yr2013
10yeargovernmentbondsFigure10.6
8
Quarterbyquarterreturns(cont.)
CashFigure10.7
FINS1613S2Yr2013
Inflation Figure10.8
9
4/09/2013
4
Thefirstlesson:Historicalaveragereturns
Historicalaveragereturn=simple(arithmetic)average
Eistoricol A:crogc Rcturn =
ycorly rcturn
1
=1
I
Averagereturns intheperiod19852009
FINS1613S2Yr2013 10
Riskfreerate
Rateofreturnonarisklessinvestment
Treasurybillsareconsideredriskfree
Returnonariskyassetinexcessoftheriskfreerate
Investorsrewardfortakingoninvestmentrisk
FINS1613S2Yr2013 11
Investment
ReturnRisk
FINS1613S2Yr2013
Investmentreturn
riskisusually
measuredbythe
volatilityofreturns.
Figure10.9
Frequency
distributionof
returnsontheAll
OrdinariesIndex,
19852009
12
4/09/2013
5
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)
FINS1613S2Yr2013 13
Example:Calculatinghistorical variance
andstandarddeviation
FINS1613S2Yr2013
(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:
14
Historicalaveragereturnsandstandarddeviation
Figure10.10
FINS1613S2Yr2013
Historicallyin
capitalmarkets,
average
investment
returnshave
beenpositively
relatedwith
investmentrisk.
Inotherwords,
higher
investmentrisks
=higheraverage
returns
15
4/09/2013
6
Returnvariabilityreviewandconcepts
Normaldistribution
symmetricfrequencydistribution
Hasabellshapedcurve
Completelydescribedbythevariablesmeanandvariance
Areinvestmentreturnsnormallydistributed?
Thenormaldistribution Figure10.11
FINS1613S2Yr2013 16
GeometricandArithmeticaveragereturn:Formula
FINS1613S2Yr2013
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
17
Arithmeticand geometricaveragereturn
Arithmeticaverage
Returnearnedinanaverageperiodovermultipleperiods
year overaparticularperiod?
Geometricaverage
Averagecompoundreturnperperiodovermultipleperiods
return per year overaparticularperiod?
Geometricaverage<arithmeticaverage,unlessallthe
returnsareequal.
FINS1613S2Yr2013 18
4/09/2013
7
Calculatingageometricaverage return
FINS1613S2Yr2013
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:
19
Efficientcapitalmarkets
Theefficientmarkethypothesis(EMH)
Stockpricesareinperfectequilibrium(supplyanddemand)
Stocksarefairlypriced
Stockmarketsareinformationally efficiency
infinancialmarkets.
EMHdoes meanthat:
onaverage,youwillearnareturnappropriatefortheriskundertaken
therearenobiasesinpricesthatcanbeexploitedtoearnabnormal
profits
marketefficiencywillnotprotectinvestorsfrompoorchoices,i.e.lack
diversification
FINS1613S2Yr2013 20
Stockpricereactiontonewinformationinefficientandinefficient
markets Figure10.12
FINS1613S2Yr2013 21
4/09/2013
8
Whatmakesmarketsefficient?
Therearemanyinvestorsouttheredoingresearch.
Asnewinformationcomestomarket,thisinformationis
andpricesmove.
Therefore,pricesalwaysreflectallavailablepublic
information.
marketwillnolongerbeefficient.
Butinvestorsalwayscontinuetoconductresearchbecause
thereisastrongmotivetomakeabnormalprofits.
FINS1613S2Yr2013 22
FINS1613S2Yr2013 23
FormsofMarketEfficiency
3FormsofMarketEfficiency:
Isthestockmarketefficient?
Strongformefficiency:
meansthatinvestorscannotearnabnormalprofitsregardlessofthe
informationtheypossess.
EmpiricalevidenceindicatesthatmarketsareNOTstrongformefficient
andthatcorporateinsiderscanearnabnormalreturns.
Semistrongformefficiency:
information.
Weakformefficiency:
priceinformation.
Empiricalevidenceindicatesthatmarketsaregenerallyweakform
efficient.
FINS1613S2Yr2013 24
4/09/2013
9
Conclusion