Finance 300 Ch 12

The return earned in an average year over a multi-year period

Arithmetic average return

What was a bright spot in 2008 for US investors?

As stocks sank, bonds soared, particularly US Treasury bonds.

Equation for dividend yield

Dividend yield = Dt+1 // Pt

A market in which security prices reflect available information. Basically saying that based on available information, there is no reason to believe that the current price is too high or too low

Efficient capital market

What are the implications of the efficient market hypothesis for investors who buy and sell stocks in an attempt to "beat the market"?

Ignoring trading costs, on average, such investors merely earn what the market offers; stock investments all have a zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

What is the Short position?

Information that asset is overpriced...Sell high, buy low; by borrowing shares; take shares of someone else's stock and then try to sell them; proceeds from short sale will be stock price. Net impact is too much selling and not enough buying; then replace someone else's shares by buying back shares for the lower price then you get the profit. NEVER DO THIS VERY RISKY because the price can increase and you may not have enough money to cover your obligation to replace the shares

What is the Long strategy?

Information that asset is underpriced.....buy low and sell high. You actually hold the asset for a long period of time and the price goes up

As time to maturity increases on a bond what happens to interest rate risk?

Interest rate risk increases

What does speculative investing provide to the market?

It provides liquidity to the market, thus increasing its efficiency

Equation for risk premium?

Risk premium = Return on Investment --- Riskless rate of return

In what level of market efficiency is when all public information reflected in the stock price. The reason this form is controversial is that it implies that a security analyst who tries to identify mispriced stocks using, for example, financial statement information, is wasting time because that information is already reflected in the current price

Semistrong form efficiency

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40% of firms die in the first 5 years

If a market is efficient, then what important implication must market participants make?

All investments in the market are ZERO NPV investments

Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be negative after the fact?

Before the fact, for most assets the risk premium will be positive; investors demand compensation over and above the risk-free return to invest their money in the risky asset. After the fact, the observed risk premium can be negative if the asset's nominal return is unexpectedly low, the riskfree return is unexpectedly high, or if some combination of these two events occurs.

The hypothesis that actual capital markets, such as the NYSE, are efficient.

Efficient market hypothesis

What is a short squeeze?

Everyone buys, take shares of someone else's then no stock to buy and replace theirs; then you have the broker demand the shares back.. and you make nothing. At any time, the broker can demand shares back

What is usually smaller the geometric average return or arithmetic average return?

Geometric

The average compound return earned PER YEAR over a multi-year period

Geometric average return

As the risk increases what happens to the required return?

Increases

This common stock portfolio is based on the S&P 500 index, which contains 500 of the largest companies (in terms of total market value of outstanding stock) in the US, and is one of Ibbotson and Sinquefield's famous set of studies

Large-company stocks

This is based on US government bonds with 20 years to maturity, and is one of Ibbotson and Sinquefield's famous set of studies

Long-term US government bonds

What is the equation for Blume's formula?

R(T) = [(T - 1) / (N-1)] * Geometric average + [(N - T) / (N - 1)] * Arithmetic average N = number of years of collected data T = Specific year forecast

The excess return required from an investment in a risky asset over that required from a risk-free investment

Risk premium

This is a portfolio comprised of the stock corresponding to the smallest 20% of the companies listed on the NYSE, again as measured by market value of outstanding stock, and is one of Ibbotson and Sinquefield's famous set of studies

Small-company stocks

The positive square root of the variance

Standard deviation

In what level of market efficiency is all information of every kind reflected in stock prices? In such a market, there is no insider information

Strong form efficient

The difference between the risk-free return on T-Bills and the very risky return on common stocks is called what?

The excess return on the average risky asset

If you don't sell your stock at the end of the year, should you still consider the capital gain as part of your return?

YES. The fact that you decided to keep the stock instead of sell it is irrelevant because you could have converted it to cash if you wanted to. After all, if you insisted on converting your gain to cash, you could always sell the stock at year-end and immediately buy it back, there is no difference

If a market is semistrong form efficient, is it also weak form efficient?

Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.

What 3 things does market capital history say about market efficiency?

1. Prices appear to respond rapidly to new information, and the response is at least not grossly different from what we would expect in an efficient market 2. The future of market prices, particularly in the short run, is difficult to predict based on publicly available information 3. If mispriced stocks exist, then there is no obvious means of identifying them.

What are the two returns from an investment?

1. You may receive some cash directly while you own the investment. This is called the income component of your return 2. The value of the asset you purchase will often change. In this case, you have a capital gain or capital loss on your investment

READS

As a practical matter, Blume's formula says that if you are using averages calculated over a long period (such as 88 years we use) to forecast up to a decade or so into the future, then you should use the arithmetic average. If you are forecasting a few decades into the future (as you might for retirement planning), then you should just split the difference between the arithmetic and geometric averages. Finally, if you are doing very long forecasts covering many decades, use the geometric average

What is the relationship between inflation and T-Bills?

As inflation goes up, the risk-free rate on T-Bills go up

What is the equation to calculate geometric average return?

Geometric average return = [(1 +R1) * (1+R2)*....(1 + Rt)] ^ (1/t) --- 1

The geometric average return is approximately equal to the arithmetic average return minus ___ the variance

Half

This portfolio is based on high-quality bonds with 20 years to maturity, and is one of Ibbotson and Sinquefield's famous set of studies

Long-term corporate bonds

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More than anything else, what efficiency implies is that the price a firm will obtain when it sells a share of its stock is a "fair" price in the sense that it reflects the value of that stock given the information available about the firm

A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation

Normal distribution

What is the second lesson of the variability of returns?

On average, bearing risk is handsomely rewarded; but in a given year, there is a significant chance of a dramatic change in value. Thus, our second lesson is this: THE GREATER THE POTENTIAL REWARD, THE GREATER THE RISK

Investors who don't care what an asset is; look at patterns and see what gives an abnormal return; not very successful right now; every study says they just perform terribly

Technical investors

What does the variance measure?

The average squared difference between the actual returns and the average return. The bigger this number is, the more the actual returns tend to differ from the average return. Also, the larger the variance or standard deviation, the more spread out the returns will be

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The more times you do something the arithmetic average return decreases until you reach 0

This portfolio is based on T-Bills with a one month maturity, and is one of Ibbotson and Sinquefield's famous set of studies

US Treasury Bills

The average squared difference between the actual return and the average return

Variance

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We usually have only estimates of the arithmetic and geometric returns, and estimates have errors. In this case, the arithmetic average return is probably too high for longer periods and the geometric average return is probably too low for shorter periods. So, you should regard long-run projected wealth levels calculated calculated using arithmetic averages as optimistic. Short-run projected wealth levels calculated using geometric averages are probably pessimistic

In what level of market efficiency is when at a minimum, the current price of a stock reflects the stock's own past prices. In other words, studying past prices in an attempt to identify mispriced securities is futile if the market is in this state

Weak form efficient