T12.1 Chapter Outline

1
Chapter 12 Lessons from Capital Market History

• Homework 1, 7 14

2
Lecture Organization

• Percentage Return
• Historical Return and Risk Premium
• Measure of Risk
• The Efficient Market Hypothesis

3
Risk, Return, and Financial Markets

• . . . Wall Street shapes Main Street.
  Financial markets transform factories, department
  stores, banking assets, film companies,
  machinery, soft-drink bottlers, and power lines
  from parts of the production process . . . into
  something easily convertible into money.
  Financial markets . . . not only make a hard
  asset liquid, they price that asset so as to
  promote it most productive use.
• Peter Bernstein, in his book, Capital Ideas

4
Percentage Returns
Total
42.18
Inflows
Dividends
1.85
Endingmarket value
40.33
Time
t
t 1
Outflows
37
5
Percentage Returns
Rates of Return
Percentage Return

Percentage Return
6
A 1 Investment in Different Types of Portfolios
1948-1999
7
A 1 Investment in Different Types of
Portfolios 1926-1998 (US Comparison)
8
Year-to-Year Total Returns on TSE300 1948-1999
9
Year-to-Year Total Returns on Small Company
Common Stocks 1970-1999
10
Year-to-Year Total Returns on Bonds 1926-1998
11
Year-to-Year Total Returns on Treasury Bills
1948-1999
12
Using Capital Market History

• Now lets use our knowledge of capital market
  history to make some financial decisions.
  Consider these questions
• Suppose the current T-bill rate is 5. An
  investment has average risk relative to a
  typical share of stock. It offers a 10 return.
  Is this a good investment?
• Suppose an investment is similar in risk to
  buying small Canadian company equities. If the
  T-bill rate is 5, what return would you demand?

13
Using Capital Market History (continued)

• Risk premiums The risk premium is the
  difference between a risky investments return
  and that of a riskless asset. Based on historical
  data
• Investment Average Standard Risk return deviat
  ion premium
• Common stocks 13.2 16.6 ____
• Small stocks 14.8 23.7 ____
• LT Bonds 7.6 10.6 ____
• U.S. Common 15.6 16.9 ____ (SP 500 in C)
• Treasury bills 3.8 3.2 ____

14
TSE 300 Frequency of returns (1948-1999) Figure
12.5
15
Historical Returns and Standard Deviations

• Investment Average Standard Frequency return d
  eviation
• Small stocks 14.8 23.7
• Common stocks 13.2 16.6
• LT Bonds 7.6 10.6
• Treasury bills 3.8 3.2

16
The Normal Distribution
Probability
68
95
Return onlarge companystocks
gt 99
3 62.47
3 -36.22
2 -19.77
1 -3.32
013.13
1 29.58
2 46.03
17
Asset mean returns versus variability 1948-1999
Standard Mean Deviation Inflation
4.25 3.51 T-bills 6.04 4.04 Bonds
7.64 10.57 TSE300 13.20 16.62 Small
Stocks 14.79 23.68
18
Asset mean returns versus variability 1948-1999
19
Expected Returns and Risk

• Returns are important, but they cant be the sole
  driver of investment decisions
• Risk-free Rate
• The rate of return that can be earned with
  certainty
• Risk Premium
• Difference between return and risk-free asset
  return
• Volatility
• The standard deviation of asset returns
• Risk Aversion
• The degree to which an investor is willing to
  accept risk

20
Do We Like Risk?

• Coin-Flipping game
• Wonderland and Kings Island
• Las Vegas

21
Example

• Using the following returns, calculate the
  average returns, the variances, and the standard
  deviations for stocks X and Y.
• 
  Returns
• Year X Y
• 1 18 26
• 2 6 -7
• 3 -9 -20
• 4 13 31
• 5 7 16

22
Solution to Example

• Mean return on X
• Mean return on Y

Variance of X Variance of Y
Standard deviation of X Standard deviation of
Y
23
Two Views on Market Efficiency

• . . . in price movements . . . the sum of
  every scrap of knowledge available to Wall Street
  is reflected as far as the clearest vision in
  Wall Street can see.
• Charles Dow, founder of Dow-Jones, Inc. and
  first editor of The Wall Street Journal (1903)
• In an efficient market, prices fully reflect
  available information.
• Professor Eugene Fama, financial economist (1976)

24
Reaction of Stock Market to New Information
25
Efficient Market

• Efficient Market Hypothesis (EMH) states that
  asset prices fully reflect all available
  information
• Active strategies do not work systematically due
  to competitive market environment
• EMH recommends a passive portfolio investment of
  investment in a well-diversified portfolio
  without attempting to find mispriced
  securities.

26
Market Efficiency

• Information is the key. Market prices
  incorporate information quickly.
• What information is included in prices?
• Weak form
• Semi-strong form
• Strong form

All insider info
All public info
Past prices
27
Implications

• Suppose markets are weak form efficient
• Implies information from past trading history of
  security, or technical analysis, cannot help
  investors identify systematic mispricing. Why?
• Suppose markets are semi-strong form efficient
• Suppose markets are strong form efficient

28
Implications
Semi-strong
Strong
Weak
29
Implications

• EMH implies stock prices are a Random Walk
• Stock price changes should be random and
  unpredictable (Why? Is this bad?)

30
Empirical Evidence on Market Efficiency
The Empirical Evidence tells us three main
things