Some Lessons from Capital Market History

Arrange investments in ascending order from lowest historical risk premium at the top to highest historical risk premium at the bottom

1. US treasury bills 2. Long-term corporate bonds 3. Large-company stocks 4. Small-company stocks

Efficient capital market

A market in which security prices reflect available information. Current market prices fully reflect available information. Based on available information, there's no reason to believe that the current price is too low or too high.

Standard deviation is a measure of which one of the following? a. average rate of return b. volatility c. probability d. risk premium e. real returns

B

The Sharpe Ratio

Calculated as the risk premium of the asset divided by the standard deviation. Measure of return relative to level of risk taken (as measured by standard deviation). Measures reward to risk.

Assume all stock prices fairly reflect all of the available information on those stocks. Which of the following terms best defines the stock market under these conditions? a. riskless market b. evenly distributed market c. zero volatility market d. Blume's market e. Efficient capital market

E

Generally speaking, which of the following best correspond to a wide frequency distribution? a. High standard deviation, low rate of return b. low rate of return, large risk premium c. small risk premium, high rate of return d. small risk premium, low standard deviation e. high standard deviation, large risk premium

E

Efficient markets hypothesis

Hypothesis that actual capital markets, such as NYSE, are efficient.

Return on investment

If you buy an asset of any sort, your gain (or loss) from that investment.

Income component of return

May receive some cash directly while you own investment

Delayed reaction

Price partially adjusts to the new information; eight days elapse before price completely reflects new information

Geometric average return

The average compound return earned per year over a multiyear period.

Variance

The average squared difference between the actual return and average return

Risk premium

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

Standard deviation

The positive square root of the variance.

Efficient market reaction

The price instantaneously adjusts to and fully reflects new information; there's no tendency for subsequent increases and decreases to occur.

Overreaction

The price overadjusts to the new information; it overshoots the new price and subsequently corrects.

Arithmetic Average Return

The return earned in an average year over a multiyear period.

Large-company stocks

This common stock portfolio is based on Standard & Poor's (S&P) 500 index, which contains 500 of the largest companies (in 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 NY Stock Exchange, again as measured by market value of outstanding stock.

US Treasury bills

This is based on Treasury bills (T-bills for short) with one-month maturity.

Long-term US government bonds

This is based on US government bonds with 20 years to maturity.

Long-term corporate bonds

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

What's the amount of the risk premium on a US treasury bill if the risk-free rate is 3.1%, the inflation rate is 2.6%, and the market rate of return is 7.4%? a. 0% b. 2.8% c. 0.5% d. 1.7% e. 4.3%

a.

The return earned in an average year over a multiyear period is called the ______ average return

arithmetic

Efficient financial markets fluctuate continuously because: a. The markets are continually reacting to old information as that information is absorbed b. the markets are continually reacting to new information c. arbitrage trading is limited d. current trading systems require human intervention e. investments produce varying levels of net present values

b

The excess return is computed as the: a. return on a security minus the inflation rate b. return on a risky security minus the risk-free rate c. risk premium on a risky security minus the risk-free rate d. risk-free rate plus inflation rate e. risk-free rate minus inflation rate

b

Which one of the following statements is a correct reflection of the US financial markets for the period 1926-2016? a. US Treasury bill returns never exceeded a return of 9% in any one year b. US Treasury bills had an annual return in excess of 10% in three or more years c. Inflation equaled or exceeded the return on US treasury bills every year during the period. d. long-term government bonds outperformed US treasury bills every year during the period e. national deflation occurred in at least one year during the period

b

Which one of the following categories of securities had the highest average annual return for the period 1926-2016? a. US Treasury bills b. Large-company stocks c. Small-company stocks Long-term corporate bonds d. Long-term government bonds

c

Inside information has the least value when financial markets are: a. weak from efficient b. semiweak form efficient c. semistrong form efficient d. strong form efficient e. inefficient

d

Capital gain or capital loss

value of asset you purchase will often change

Normal distribution

A symmetric, bell-shaped frequency distribution that's complete defined by its mean and standard deviation. Useful for describing the probability of ending up in a given range.

The rate of return on which type of security is normally used as the risk-free rate of return? a. long-term treasury bonds b. long-term corporate bonds c. treasury bills d. intermediate-term treasury bonds e. intermediate-term corporate bonds

C

The historical record for the period 1926-2016 supports which of the following statements? a. When large-company stocks have a negative return, they will have a negative return for at least two consecutive years. b. The return on US Treasury bills exceeds the inflation rate by at least 0.5% each year c. There was only one year during the period when double-digit inflation occurred d. Small-company stocks have lost as much as 50% and gained as much as 100% in a single year e. The inflation rate was positive each year throughout the period

D

The primary purpose of Blume's formula is to: a. compute an accurate historical rate of return b. determine a stock's true current value c. consider compounding when estimating a rate of return. d. determine actual real rate of return e. project future rates of return

E

You're aware that your neighbor trades stocks based on confidential information he overhears at his workplace. This information isn't available to the general public. This neighbor continually brags to you about the profits he earns on trades. Given this, you would tend to argue that the financial markets are at best _____ form efficient. a. weak b. semiweak c. semistrong d. strong e. perfect

c