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Chapter 7
An Introduction to
Risk and Return—
History of Financial
Market Returns
Copyright ©
Copyright © 2021
2021 Pearson
Pearson Education
Education Ltd.
Ltd.
Learning Objectives
1. Calculate realized and expected rates of return
and risk.
2. Describe the historical pattern of financial market
returns.
3. Compute geometric (or compound) and
arithmetic average rates of return.
4. Explain the efficient market hypothesis and why
it is important to stock prices.
Legend:
We formalize the return calculations found in columns D and
E using Equations (7–1) and (7–2):
Column D (Cash or Dollar Return)
Cash Ending Cash Distribution Beginning
= + = PEnd + Dividend PBeginning 7 1
Return Price (Dividend) Price
The probabilities assigned to the three possible economic conditions have to be determined subjectively, which requires
a
management to have a thorough understanding of both the investment cash flows and the general economy.
Treasury Bill 5% 0%
= 2
2
r1 E r Pb1 + r2 E r Pb2 + + rn E r Pbn
2
= √([−.20−.115]2.2) + ([0−.115]2.2) + ([.15−.115]2.3)
+ ([.30−.115]2.2) + ([.50−.115]2.1)
= .2110 or 21.10%
0 Blank $25
1 40% $35
2 −50% $17.50
What annual rate of return can we expect for The arithmetic average rate of return
next year? calculated using annual rates of return.
What annual rate of return can we expect over a The geometric average rate of return
multiyear horizon? calculated over the same time period.
0 Blank $10,000.00
1 −15.0% $8,500.00
2 15.0% $9,775.00
3 25.0% $12,218.75
4 30.0% $15,884.38
5 −10.0% $14,295.94
1/ n
Geometric Rate of Return Rate of Return Rate of Return
= 1+ × 1+ × × 1+ 1
Average Return for Year 1, ryear 1 for Year 2, ryear 2 for Year n, r year n