Chapter 12 - FIN320

Given that NII Holding 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?

(Following is the reason for certain investors to hold to stock): - Stock market is a place where bonds and stocks are bought an sold. The market fluctuates on day to day basis. This fluctuation is analyzed by the experts in the market. However, they cannot project the changes exactly as they would occur. - Here, NI Holdings declined about 63% still some investors hold the stock. The reason might be that they would have considered the stock prices will increase in the future. - In the expectation of the price rise in future they would have decided to hold the stock. (Reasons for investors NOT selling out the stock before price decline): -Market performances are estimated based of the past data. However, the market may not always perform as expected because of the political and economic and various other factors. - Here, the investors would have expected the stock to rise but the stock declined sharply. Based on this, the investors would have failed to sell these stocks before the sharp price decline.

Suppose a stock had an initial price of $79 per share, paid a dividend of $1.45 per share during the year, and had an ending share price of $88. Compute the percentage total return.

- 1st : Calculate the change in market value over period = Ending share price - Initial share price =$88-$79 =$9 - 2nd : Calculate the percentage total return = ((Change in market value over period) + (Dividends paid at the end of the period))/ (Beginning market value) =(0.1323 x 100) or 13.23%

Explain why a characteristic of an efficient market is that investment in that market have zero NPV's

- Efficient market is a market in which all the information are made available to the participants and the prices in these markets responds to the available information. - The reason why investment in efficient market yield zero NPV is that the price in these market is just fair and thus investors in these markets get what they pay by investing in a security in these markets and the firm get the exact worth of their bonds and stock on selling. - The price of securities in efficient markets are neither lower nor higher and thus the return on the securities in these markets are the same as expected.

What are forms of market efficiency?

- If the market is strong form efficient, then all information of every kind is reflected in stock prices. in such a market, there is no such thing as inside information. - The second form of efficiency, semi strong form efficiency, is the most controversial. if a market is semi strong from efficient, then all public information is reflects in the stock price. -The 3rd, weak form of efficiency, suggests that at a minimum the current price of a stock reflects the stocks own past prices. in other words studying past prices in an attempt to identify mispriced securities if the market is weak from efficient

Assume that you invest 5 % of your salary an receive the full 5 % match from S&S air. What EAR do you earn from this match? What conclusion do you draw about matching plans?

- In this case, 5% of salary is invested an 5 % full amount match is received from S&S. The EAR will be 100% as the amount invested is received back in full

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

- Stock market is a place bonds and stocks are bought and sold. The market fluctuates on day to day basis. This is analyzed by market experts. However, they cannot project the changes exactly as it would occur. Here, it is given that FM'S stocks were up by 1,333% in 2013 and all investors were not holding the stock until then. This has occurred because of wrong prediction of market performances.

Risk Premium?

- The extra return earned for taking on a risk -Treasury bills are considered to be risk-free -The risk premium is the return over and above the risk free rate

Define Variability of return?

- The return from the investment may vary from time to time. This fluctuation makes it not possible to determine return from investment accurately. The investment return can be exactly predicted only from historical date and market conditions.

Why are unrealized capital gains or losses included in the calculation of returns?

- Unrealized capital gains or losses included in the calculation of returns because indirectly. unrealized portion is also a gain to the company on a particular investment, so to get accurate returns we will include both unrealized capital gains or losses.

The importance of financial markets?

-Financial markets allow companies, governments and individuals to increase their utility -Savers have the ability to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing so -Borrowers have better access to the capital that is available so that they can invest in productive assets -Financial markets also provide us with information about the returns that are required for various levels of risk

Efficient Capital Markets?

-Stock prices are in equilibrium or are "fairly" priced - If true, then "abnormal" or "excess" returns are not attainable -Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

One of the most significant observation of the stock market data?

-The long run excess of stock return over the risk free return

What makes markets efficient?

-There are many investors out there doing research. -As new information comes to market, this information is analyzed and trades are made based on this information -Therefore, prices should reflect all available public information -If investors stop researching stocks, then the market will not be efficient

Lessons from capital market history?

-There is a reward for bearing risk -The greater the potential reward, the greater the risk -This is called the risk return trade off

The measures of risk are?

-Variance -Standard deviation

What are two parts of total return?

1. Dividend yield expressed as a percentage of the beginning stock price. 2. Capital gains yield is calculated as the change in the prince during this year.

What is an efficient market?

A efficient capital market is one in which, current market prices fully reflect available information. Which simply means, there is NO reason to believe, based on the provided information, that the current prices are too high or too low.

Define dividend yield?

A financial ratio indicates how much a firm pays out in dividends each year relative to its share price is termed as dividend yield. in absence of any capital gains, the dividend yield is return on investment for a stock.

Define nominal return?

A nominal rate of return refers to the sum of money yielded by an investment before adjusting the expenses such as taxes, fees, and inflations. The investors should not consider only the nominal return before going for making an investment

Define real return?

A real rate of return to the sum of money yielding by an investment after adjusting the expenses such as taxes, fees, and inflation. the amount the investor will get his hands is a real return.

What is the difference between a dollar return and a percentage return? Why are percentage returns more convenient?

Dollar returns - if you buy an asset, your gain on that investment is called dollar return. Percentage return - The return on a investment when expressed in percentage terms is called percentage returns. * Percentage returns are more convenient because it doesn't depend on how much is actually invested.

Common misconceptions about EMH

Efficient markets do not mean that you can't make money They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns Market efficiency will not protect you from wrong choices if you do not diversify - you still don't want to "put all your eggs in one basket"

What do we mean by excess return an risk premium?

Excess return is defined as a return that an investor receives over an above a risk-free investment. For example, excess return is the difference of return between the risk free rate and return on common stock. The risk premium is the difference between the average return earned and risk free rate. - Risk premium = Average return - Risk free rate

Define inflation?

Inflation is an increase in price of "goods" and "services" in a territory. in this case, the price level increases with each unit of currency which lead to reduction in the purchasing power of currency

Define EAR (Effective annual rate)

It is the rate which helps to compare different interest plans. if we are comparing the two interest plans, the interest plan which has higher effective annual rate will be considered as better plan.

Define capital gain yield?

It refers to profits or losses an investor receives on financial instrument that depreciates or appreciates in price time investor possesses.

semi-strong form efficiency

Prices reflect all publicly available information

What is the first lesson from capital market history?

The first lesson of the capital market history is that every risky asset, will earn a risk premium. There is a reward for taking risk, reward is the risk premium.

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 the weak efficient. This is because the stock prices do not reflect the stock's past prices. Also if the market is weak from efficient it is futile to find the mispriced securities.

What was the nominal risk premium on corporate bonds? The real risk premium?

The nominal risk premium is the difference between real risk premium on corporate bond and the historical nominal rate. The real risk premium is the expected inflation rate on the corporate bonds over the life of the bond.

What was the real (as opposed to nominal) risk premium on the common stock portfolio?

The real risk premium is the expected rate on the common stock portfolio over the life of the portfolio.

If you wanted to forecast what the stock market is going to do over the next century, should you use an arithmetic or geometric average?

To forecast the stock market performance over the next century we would use geometric average return because geometric average tells you what you actually earned per year on average, compounded annually. Also, the geometric average return is probably too low for shorter periods and might give returns that are more pessimistic.

If you wanted to forecast what the stock market is going to do over the next year, should you use an arithmetic average?

To forecast the stock market performance over the next year we use arithmetic average because the arithmetic average tells you what you earned in a typical year. Also, the arithmetic average return is probably too high for longer period which might give returns that are optimistic.

Define treasury bill?

Treasury bill is a government guaranteed "debt instrument" issued to public for raising money. it is a short term debt.

strong form efficiency

prices reflect all information, including public and private If the market is strong form efficient, then investors could NOT earn abnormal returns Empirical evidence indicates that markets are NOT strong form efficient Empirical evidence indicates that insiders could earn abnormal returns

weak form of efficiency

prices reflect all past market information such as price and volume