Chapter 12

Fisher equation

(1+R)=(1+r)(1+h) R=total % return r=real rate of return h=inflation rate

capital market history 3 takes aways about market efficiency

1. prices appear to respond rapidly to new info 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 short run is difficult to predict based on publicly available info 3. if misplaced stocks exist then there is no obvious means of identifying them

probability that you end up within one standard deviation

2/3 or 68%

probability that you end up within two standard deviations

95%

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 risk- free return is unexpectedly high, or if some combination of these two events occurs

total return

[increase in price + dividends(cash flows)]/initial price

efficient capital market

a market in which security prices reflect available info, price of a stock will reflect whats known about the corporations current operations and profitability, and it reflects market opinion about its potential future growth and profits

normal distribution

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

formula for average returns

add up yearly returns and divide by 88

strong form efficient

all info of every kind is reflected in stock prices

Given that NII Holdings was down by 63% for 2013, why did some investors hold the stock? Why didn't they sell out before the price declined so sharply?

as in the previous question, its easy to see after the fact that the investment was terrible, but it probably wasn't so easy ahead of time

income component of a return (dividend)

cash received directly from owning investment dividend yield = D1/P0

capital gains yield

change in price during the year capital gains yield = (P1-P0)/P0

Blumes formula

combines arithmetic and geometric when you only have estimates of both, arithmetic is too high and geometric is too low so must combine

dividend yield

dividend/initial price

return on investment

gain or loss from buying an asset

T Bills

how government borrows money, risk free return

what are the implications of the efficient markets 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 zero NPV. if trading costs exist, then these investors lose by the amount of the costs.

capital gains yield

increase in price/initial price

probability that you end up within three standard deviations

less than 1%

semi strong from of efficiency

most controversial, all public info is reflected in stock price

can dividend yield ever be negative

no that would mean you were paying the company for the privilege of owning the stock, it has happened on bonds

we have seen that over long periods of time stock investments have tended to substantially outperform bond investments. However, it is common to observe investors with long horizons holding entirely bonds. Are such investors irrational?

no, stocks are riskier. some investors are highly risk averse, and the extra possible return doesn't attract them relative to the extra risk

Explain why a characteristic of an efficient market is that investments in that market have zero NPVS

on average, the only return that tis earned is the required return, investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (negative NPV), driving the price lower and thus causing the return to rise to the required return (zero NPV)

geometric average return

smaller, tell you what you actually earned per year on average compounded annually [(1+R1) x (1+R2) x...x (1+RT)]^(1/T) - 1

weak form efficiency

suggests that at a minimum the current price of a stock reflects the stock's own past prices

several celebrated investors and stock pickers frequently mentioned in the financial press have recorded huge returns on their investments over the past 2 decades. is the success of these particular investors an invalidation of the EMH?

the EMH only says, within the bounds of increasingly strong assumptions about the info processing of investors, that assets are fairly priced. an implication of this is that on average the typical market participant cannot earn excessive profits fro, a particular trading strategy. however, that doesn't mean that a few particular investors can't outperform the market over a particular investment horizon. certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who don't do well over same period generally get less attention

variance

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

risk premium

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

the greater the potential reward..

the greater the risk

efficient markets hypothesis (EMH)

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

a stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. if this is true, what do you know about the market?

the market is not weak form efficient

standard deviation

the positive square root of the variance

efficient market reaction

the price instantaneously adjusts to and fully reflects new info, no tendency for subsequent increases and decreases to occur

overreaction

the price over adjusts to new info, it overshoots the new price and subsequently corrects

delayed reaction

the price partially adjusts to the new info, lapse of time before price completely reflects the new info

arithmetic average return

the return earned in an average year over a multiyear period, tells you what you earned in a typical year (sum of returns/# of returns)

Given that Fannie Mae was up by about 1,333% fro 2013, why didn't all investors hold this stock?

they all wish they had, since they didn't, it must have been the case that stellar performance was not foreseeable, at least not by most

large company stocks

this common stock portfolio is based on the Standard & Poor's (S&P) 500 index, which contains 500 of the largest companies (terms of total market value of outstanding stock) in the US

small company stocks

this is a portfolio composed of the stock corresponding to the smallest 20% of the companies listed on the NYSE, again as measured by market value of outstanding stock

long-term US government bonds

this is based on US government bonds 20 years to maturity

long term corporate bonds

this is based on high-quality bonds with 20 years to maturity

US treasury bills

this is based on treasury bills with a 1 month maturity

nominal rate of return

total % of return on bond, stated return

critically evaluate the following statement: playing the stock market is like gambling. such speculative investing has no social value other than the pleasure people get from this form of gambling

unlike gambling, the stock market is a positive sum game, everybody can win. also speculators provide liquidity to markets and this help promote efficiency

most common measures of volatility

variance and standard deviation

if a market is semi strong from efficient, is it also weak form efficient?

yes, historical info is also public info, weak from is a subset of semi strong