FIN3000 Chapter 12: Capital Market History

importance of financial markets

-allow companies, governments, and individuals to increase their utility -provide information about the returns that are required for various levels of risk

risk premiums

-the "extra" return earned for taking on risk -treasury bills are considered to be risk-free -the return over and above the risk-free rate

Historical rates of return on five important types of financial information:

1. Large-company stocks 2. Small-company stocks 3. Long-term corporate bonds 4. Long-term U.S. government bonds 5. U.S. Treasury bills

Studying market history can reward us by demonstrating that:

1. on average, investors will earn a reward for bearing risk 2. the greater the potential reward is, the greater the risk

3 forms of market efficiency

1. strong form efficiency (public and private info) 2. semistrong form efficiency (all available info) 3. weak form efficiency (all past market info)

What was the worst year for stock market investors in history?

2008

efficient capital market

a market in which security prices reflect available information

normal distribution

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

geometric average

average compound return per period over multiple periods -tells you what you actually earned per year on average, compounded annually

U.S. Treasury bills

based on Treasury bills (T-bills) with a one-month maturity, risk-free

long-term government bonds

based on U.S. government bonds with 20 years to maturity

long-term corporate bonds

based on high quality bonds with 20 years to maturity (low risk, investment rate BBB)

Fisher Effect

defines the relationship between real rates, nominal rates, and inflation

When attempting to forecast for extremely long intervals, such as 50 years, it is best to use:

expected return averages

As long as the inflation rate is positive, the real rate of return on a security will be ____________ the nominal rate of return.

less than

Unless all the returns are equal, geometric average will be _______________the arithmetic average.

less than

Short-run projected wealth levels calculated using geometric averages are probably__________

pessimistic

arithmetic average

return earned in an average period over multiple periods -tells you what you earned in a typical year

market capitalization (total market value of outstanding stock)

share price x # shares outstanding

What best defines the variance of an investment's annual returns over a number of years?

the average squared difference between the actual returns and the arithmetic average return

risk-return trade-off

the greater the potential reward, the greater the risk

The greater the volatility...

the greater the uncertainty.

Efficient Markets Hypothesis (EMH)

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

large-company stocks

this portfolio is based on the S&P's 500 Index, which contains 500 of the largest companies (in terms of total market value of outstanding stock) in the U.S.

small-company stocks

this portfolio is composed of the stock corresponding to the smallest 20% of the companies listed on the NYSE (in terms of total market value of outstanding stock)- higher returns higher risk, performed the best overall in the years 1925-2013, highest risk premium of five investments

Variance and standard deviation measure the ______________ of asset returns.

volatility