Intermediate Finance

Session 16
Turn on the recording
Risk & Return
 Returns
• What are the two purposes for which people
invest in stock markets?
 Returns
• When you invest in stocks what kind of
returns do you expect?
Returns
 Returns
• How can you convert this into percentage
form?
Returns
 Returns
• Why are we using Dividend in t+1 and Price at
t
 Returns
• Capital Gains
 Returns
• Total Return
Why is it important to study market history?
US Capital Market History
1. Large-company common stocks: how do
you define large?
2. Small-company common stocks: how do
you define small?
US Capital Market History
1. Large-company common stocks: This common stock
portfolio is based on the Standard & Poor’s (S&P)
Composite Index. At present the S&P Composite
includes 500 of the largest (in terms of market value)
stocks in the United States.
2. Small-company common stocks: This is a portfolio
corresponding to the bottom fifth of stocks traded on
the New York Stock Exchange in which stocks are
ranked by market value (that is, the price of the stock
multiplied by the number of shares outstanding).
US Capital Market History
3. Long-term corporate bonds: This is a
portfolio of high-quality corporate bonds
with 20-year maturities. (why high quality?)
4. Long-term U.S. government bonds: This is
based on U.S. government bonds with
maturities of 20 years. (why not municipal ?)
5. U.S. Treasury bills: This is based on
Treasury bills with a one-month maturity.
 Key Lessons
• The risk premium is the added return (over and above the
risk-free rate) resulting from bearing risk.
• One of the most significant observations of stock market data
is the long-run excess of stock return over the risk-free return.
• The average excess return from large company common stocks
for the period 1926 through 2007 was:
8.5% = 12.3% – 3.8%
• The average excess return from small company common stocks
for the period 1926 through 2007 was:
13.3% = 17.1% – 3.8%
• The average excess return from long-term corporate bonds for
the period 1926 through 2007 was:
2.4% = 6.2% – 3.8%
 Explanation
• It shows the growth of a dollar investment in
the stock market from 1926 through 2011.
• In other words, it shows what the value of the
investment would have been if the dollar had
been left in the stock market and if each year
the dividends from the previous year had been
reinvested in more stock
Holding Period Return
Does it Make Sense?
Does it Make Sense?
Does it Make Sense?
 Equity Risk Premium
• The average excess return from large-company
common stocks relative to T-bills for the entire
period was 8.2 percent (11.8 percent – 3.6
percent).
• The average excess return on common stocks
is called the historical equity risk premium but
what does it tell us?
 Equity Risk Premium
• The average excess return from large-company
common stocks relative to T-bills for the entire
period was 8.2 percent (11.8 percent – 3.6
percent).
• The average excess return on common stocks
is called the historical equity risk premium
because it is the additional return from
bearing risk.
 Sharp Ratio
• The Sharpe ratio is the average equity risk
premium over a period of time divided by
the standard deviation.
• From 1926 to 2011 the average risk premium
(relative to Treasury bills) for large-company
stocks was 8.2 percent while the standard
deviation was 20.3 percent
• Find the sharp ratio.
 Sharp Ratio
• The Sharpe ratio is the average equity risk
premium over a period of time divided by
the standard deviation.
• From 1926 to 2011 the average risk premium
(relative to Treasury bills) for large-company
stocks was 8.2 percent while the standard
deviation was 20.3 percent
Normal Distribution
What does this graph tell you?
What is a six sigma event?
What is a six sigma event?
• Any event that is extremely rare, beyond the
sixth standard deviation in a normal
distribution, is known as a six sigma event.
• Can you think of any example?
What is a six sigma event?
• Any event that is extremely rare, beyond the
sixth standard deviation in a normal
distribution, is known as a six sigma event.
• An example of six sigma event can be 2008
financial crisis.
 Scenario
• Suppose you buy a particular stock for $100.
• Unfortunately, the first year you own it, it falls
to $50. The second year you own it, it rises
back to $100, leaving you where you started
(no dividends were paid)
• What is your return in this scenario?
 Arithmetic Average
• If we calculate the returns year-by-year, we see
that you lost 50 percent the first year (you lost
half of your money). The second year, you
made 100 percent (you doubled your money)

• “What was your return in an average year over

a particular period?”
 Geometric Average
• Common sense seems to say that your average
return must be exactly zero because you
started with $100 and ended with $100.
• “What was your average compound return per
year over a particular period?”
 Common Mistake !
• “What was your return in an average year over
a particular period?” (Arithmetic average)
• “What was your average compound return per
year over a particular period?” (Geometric
average)
 International Markets
• Where are major stock markets located?
International Markets
Where is China?
How ‘Bad’ is ‘Bad’?
How ‘Bad’ is ‘Bad’?
Global Financial Crisis
Any winners ?
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance
Rise of Islamic Finance