Introduction to Finance

Lecture 9
Mike Zwecher

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 Chapter 12 – Capital Market Basics
▪ What are ‘Capital Markets’
▪ Total Return
– Ibbotson – Sinquefield
• Large Cap
• Small Cap
• LT Corporate
• LT Guvvy
• T-Bills
▪ Return isn’t everything (unless your risk doesn’t
matter i.e., you’re risk neutral)

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 Chapter 12 – Capital Market Basics
▪ Return on an Asset:
– Price return + dividend return
𝑃𝑡+1 − 𝑃𝑡 𝐷𝑡+1
𝑅𝑡,𝑡+1 = +
𝑃𝑡 𝑃𝑡
▪ Sometimes you’ll see this as
𝑃𝑡+1 𝐷𝑡+1
𝑅𝑡,𝑡+1 ≡ 𝑅𝑡 = + −1
𝑃𝑡 𝑃𝑡
If you start working with derivatives get used to
seeing returns written in log price form:
𝑟𝑡,𝑡+1 ≡ 𝑟𝑡 = 𝐿𝑛 𝑃𝑡+1 − 𝐿𝑛 𝑃𝑡 + 𝑑𝑡 ≡ 𝑝𝑡+1 − 𝑝𝑡 + 𝑑𝑡

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 Chapter 12 – Capital Market Basics
▪ Sample Mean Return
𝑛
1
𝑅ത = ෍ 𝑅𝑡+𝑖
𝑛
𝑖=1
▪ Sample Variance of Return
𝑛 ത 2
σ (𝑅
𝑖=0 𝑡+𝑖 − 𝑅)
𝑆2 =
𝑛−1

When you see means and other statistics regarding

returns, be aware of context. The symbols are the
same whether the context is performance across
time, or performance across a collection of assets
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 Chapter 12 – Capital Market Basics
▪ Geometric returns
We’ve seen the impact of compounding. When returns are
variable across time, the geometric average return
provides a natural view of the compounding impact

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Geometric return: ς𝑛𝑖=1(1 + 𝑅𝑡+𝑖 ) 𝑛

This may look daunting, but let’s look at it another way

𝑃𝑇
= (1 + 𝑅𝐺𝑒𝑜 )𝑇
𝑃0
𝑃𝑇 1
→ ( )𝑇 −1 = 𝑅𝐺𝑒𝑜
𝑃0

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 Chapter 12 – Capital Market Basics

Let’s play with some data

https://finance.yahoo.com/quote/%5EGSPC/history?period1=-630961200&period2=1567483200&interval=1mo&filter=history&frequency=1mo

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Chapter 12 – Capital Market Basics

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Chapter 12 – Capital Market Basics

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 Chapter 12 – Capital Market Basics
▪ Contrast the normal distribution with Chebyshev’s
inequality
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𝑃 𝑋 − 𝜇 ≥ 𝑘𝜎 ≤ 2
𝑘
– In words: The probability of an observation being more
than k standard deviations from the mean is less than 1
over k squared

– Chebyshev says that if the distribution is unknown, then

the odds of being multiple standard deviations away
from the mean may be much higher than a normal
distribution would indicate

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 Chapter 12 – Efficient Markets
▪ Read the first page (or so) of the following
https://notendur.hi.is/ajonsson/kennsla2013/market_efficiency.pdf
▪ Then Watch
▪ https://johnhcochrane.blogspot.com/2014/02/a-brief-history-of-efficient-markets.html

▪ Three forms of the EMH

• Weak Form
• Semi Strong Form
• Strong Form
▪ Misconceptions about the EMH
▪ Implications of the EMH

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 Chapter 13 – Risk and Return
▪ Diversification – A collection of imperfectly
correlated assets will have a variance less than
the sum of their individual variances

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 Chapter 13 – Risk and Return
▪ The amount of risk that can be eliminated by
combining assets into a portfolio.

▪ Individual assets have, idiosyncratic or specific

risk, and a risk common to all similar assets

▪ As we add assets we are able to reduce the

impact of idiosyncratic risks

▪ Only non-diversifiable risk is rewarded

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 Chapter 13 – Risk and Return
Capital Market
Expected Line (CML)
Return

Market
portfolio Efficient
rm Frontier
v
Risk Free rf v Individual
Rate Assets

Risk

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 Chapter 13 – Risk and Return
Security Market
Expected Line (SML)
Return

E[rm]

Risk Free rf
Rate

𝜎𝑖
𝛽𝑖 = 𝜌𝑖,𝑚
𝜎𝑚

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Low Higher Beta
sensitivity sensitivity
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 Chapter 13 – Risk and Return
▪ The Security Market Line shows the expected return
on an asset

𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝐸 𝑟𝑚 − 𝑟𝑓

▪ The risk / reward ratio is given by the slope of the

Security Market Line
– The SML is a representation of equilibrium.
– The slope of the SML is E[Rm] – rf
– The quantity E[Rm] – rf is also known as the Market Risk
Premium MRP

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 Chapter 13 – Risk and Return
▪ Let’s get some data and estimate a beta

▪ https://finance.yahoo.com/quote/AMZN/history?pe
riod1=1414555200&period2=1572321600&interva
l=1mo&filter=history&frequency=1mo

▪ https://finance.yahoo.com/quote/%5EGSPC/histor
y?period1=1414555200&period2=1572321600&in
terval=1mo&filter=history&frequency=1mo

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