FIN 323: chapter 10 : Some lessons from Capital Market History
FIN 323: chapter 10 : Some lessons from Capital Market History FIN 323
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This 6 page Class Notes was uploaded by Winn on Monday March 28, 2016. The Class Notes belongs to FIN 323 at Marshall University taught by in Spring 2016. Since its upload, it has received 14 views. For similar materials see Principles of Finance in Business at Marshall University.
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Date Created: 03/28/16
Chapter 10 : Some Lessons from Capital Market History Explaining Important More Important 1) Risk-return tradeoff : Is the principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns High levels of uncertainty (high-risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost 2) Percent returns : 3) Permanent Portfolio Performance from 1972 to 2011 in U.S Market : About stock , bonds , cash , golds. Average return is the simple mathematical average of a series of returns generated over a period of time. An average return is calculated the same way a simple average is calculated for any set of numbers; the numbers are added together into a single sum, and then the sum is divided by the count of the numbers in the set (from vanguard.com ) 4) Risk Premiums : a) Risk-free rate : the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Example : Treasury Bills b) Risk premium : the return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment. 5) Return Variability : The statistical tools for historical returns : 6) arithmetic and geometric averages : Arithmetic mean is the sum of a series of numbers divided by the count of that series of numbers. If you were asked to find the class (arithmetic) average of test scores, you would simply add up all the test scores of the students, and then divide that sum by the number of students. For example, if five students took an exam and their scores were 60%, 70%, 80%, 90% and 100%, the arithmetic class average would be 80%. This would be calculated as: (0.6 + 0.7 + 0.8 + 0.9 + 1.0) / 5 = 0.8. The reason you use an arithmetic average for test scores is that each test score is an independent event. If one student happens to perform poorly on the exam, the next student's chances of doing poor (or well) on the exam isn't affected. In other words, each student's score is independent of the all other students' scores. However, there are some instances, particularly in the world of finance, where an arithmetic mean is not an appropriate method for calculating an average Geometric mean : the average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio. Technically defined as "the 'n'th root product of 'n' numbers", the formula for calculating geometric mean is most easily written as: Where 'n' represents the number of returns in the series. The geometric mean must be used when working with percentages (which are derived from values), whereas the standard arithmetic mean will work with the values themselves 7) Efficient Capital Markets : 1. Weak-Form EMH The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid. 2. Semi-Strong EMH The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information. 3. Strong-Form EMH The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak- form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information