Chapter 10
If your total dollar return was %7 and your dividend was $2, then the price change on your stock must have been ____.
$5
Historically, the real return on Treasury bills has been:
quite low
What is the first lesson from capital market history?
Risky assets, on average, earn a risk premium. Put another way: There is a reward for bearing risk.
Studying market history can reward us by demonstrating that:
The greater the potential reward is, the greater the risk there is a reward for bearing risk
What is the second lesson from capital market history?
The greater the potential reward, the greater is the risk.
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 (in terms of total market value of outstanding stock) in the United States.
Proceeds from stock sale+Dividends = ___________
Total cash if stock is sold
US Treasury Bills
Treasury bills (T-bills for short) with a one-month maturity.
Normal distribution
a symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation
strong form efficient
all information of every kind is reflected in stock prices. In such a market, there is no such thing as inside information.
In an efficient market ____ investments have a ____ NPV
all; zero
A positive capital gain on a stock results from ____.
an increase in price
two ways of calculating average returns are ___ and ___.
arithmetic avg and geometric avg.
Keurig Green Mountain (GMCR) EXAMPLE
began 2014 at $75.54 per share. Keurig Green Mountain paid dividends of $1.00 during 2014, and the stock price at the end of the year was $132.40. What was the return on GMCR for the year? For practice, see if you agree that the answer is 76.60 percent TRUE
The second lesson from studying capital market history states that the ____ the potential reward, the ___ the risk
greater; greater lower; lower
long term corporate bonds
high quality bonds with 20 years to maturity
An efficient market is one in which any change in available information will be reflected in the company's stock price ____.
immediately
GameStop EXAMPLE
in 2014, GameStop's stock price at the beginning of the year was $49.26 per share, and dividends of $1.32 were paid. The stock ended the year at $33.80 per share. Verify that the loss was 28.70 percent for the year. TRUE
if you use an arithmetic average to project long-run wealth levels, your results will most likely be ____
optimistic
Capital gains and dividend yield together EXAMPLE
per dollar invested, we get 5 cents in dividends and 9 cents in capital gains; so, we get a total of 14 cents. Our percentage return is 14 cents on the dollar, or 14 percent
Capital Gain/Loss EXAMPLE
At the beginning of the year, the stock is selling for $37 per share. If you buy 100 shares, you have a total outlay of $3,700. Suppose, over the year, the stock pays a dividend of $1.85 per share. By the end of the year, then, you will have received income of: Dividend=$1.85×100=$185 Also, the value of the stock rises to $40.33 per share by the end of the year. Your 100 shares are worth $4,033, so you have a capital gain of: Capital gain=($40.33−37)×100=$333 On the other hand, if the price had dropped to, say, $34.78, you would have had a capital loss of: Capital loss=($34.78−37)×100=−$222
which of the following are true based on the year-to-year returns from 1926-2014?
Common stocks frequently experience negative returns T-Bills sometimes outperform common stocks
Total Dollar Return
Dividend income+Capital gain (or loss)
What are the two parts of total return?
Dividend yield and capital gains yield
AVERAGE ANNUAL RETURNS: 1926-2014
Large stocks 12.1% Small stocks 16.7 Long-term corporate bonds 6.4 Long-term government bonds 6.1 U.S. Treasury bills 3.5 Inflation 3.0
Why are unrealized capital gains or losses included in the calculation of returns?
The total dollar return on your investment is the sum of the dividend and the capital gain. If you sold the stock at the end of the year, the total amount of cash you would have would be your initial investment plus the total return
the two potential ways to make money as a stockholder are through ___ and capital appreciation.
dividends
Variance & SD measures:
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 is, the more spread out the returns will be.
Dividend Yield
the dividend per share divided by the stock price
risk premium
the excess return required from an investment in a risky asset over that required from a risk-free investment
Efficient Market Hypothesis
the hypothesis that actual capital markets, such as the NYSE, are efficient If a market is efficient, then there is a very important implication for market participants: All investments in an efficient market are zero NPV investments. The reason is not complicated. If prices are neither too low nor too high, then the difference between the market value of an investment and its cost is zero; hence, the NPV is zero.
How do we measure volatility?
variance and its square root, the standard deviation
total cash if stock is sold
initial investment + total return
What is the arithmetic average return for a stock that had annual returns of 8%, 2%, and 11% the past 3 years?
(.08+.02+.11)/3 = .07 7%
One year ago, Ernie purchased shares of RTF common stock for $100 a share. Today the stock paid a dividend of $1 per share. If the stock currently sells for $114 per share, what is Ernie's total return?
(1/100) + (14/100) = .15 15%
the price os XYZ stock rises from $10-$15. If you own 100 shares, your capital gain is _____.
(15-10) *100 $500
Investments arranged from highest to lowest risk (standard deviation) based on our study of capital market history from 1926-2014
1) small-company common stock 2) large-company common stock 3) long-term corporate bonds 4) long-term government bonds 5) US treasury bills
A share of common stock currently sells for $100 and will pay a dividend of $2 at the end of the year. If the price is expected to increase to $113 at the end of one year, what is the stock's current dividend yield?
2/100 = .02 2%
If a stock's returns for years 1-4 were 3%, 5%, 8%, and -2%, what is the standard deviation of these returns?
4.203
2008 was a bad year for markets worldwide. One of the worst hit was the Icelandic Exchange where shares priced dropped ___ in one day.
76%
Percentage returns are more convenient than dollar returns because they:
Apply to any amount invested Allow comparison against other investments
Deviation
Actual return - average return
overreaction and correction
price over-adjusts to the new information; it overshoots the new price and subsequently corrects
What do we mean by excess return and risk premium?
Differences between treasury bills and common stock on the average risky asset.
Dividend yield EXAMPLE
Dividend per share: $1.85 Price of stock: $37 Dividend yield: 1.85/37 = .05 interpret: for each dollar we invest, we get five cents in dividends
What is the difference between a dollar return and a percentage return? Why are percentage returns more convenient?
For each dollar invested you get an amount back in dividends. One is the percentage of a payment. It is easier to summarize information about returns in percentage terms because that way your return doesn't depend on how much you actually invest
Capital gains yield EXAMPLE
Initial stock price: 37 New stock price: 40.33 capital gains yield: (40.33-37)/37 = .09 interpret: per dollar invested, we get nine cents in capital gains.
small company stocks
Smallest twenty percent of the firms listed on the NYSE.
which of the following are needed to describe the distribution of stock returns?
The mean return the standard deviation of returns
The Ibbotson-Sinquefield data shows that:
US T-bills had the lowest risk or variability Long-term corporate bonds has less risk or variability than stocks
long term US government bonds
US government bonds with 20 years to maturity
The normal distribution is completely described by the ____ and ____
Variance or standard deviation and mean
The dividend yield for one-year period is equal to the annual dividend amount divided by the ___
beginning stock price
The total dollar return is the sum of dividends and _____.
capital gains or losses
When a company declares a dividend, shareholders generally receive _____.
cash
capital gains yield
change in the price during the year (the capital gain) divided by the beginning price
Capital Gain/Loss
changes in the value of your investment
Roger Ibbotson and Rex Sinquefield
conducted a famous set of studies dealing with rates of return in U.S. financial markets They presented year-to-year historical rates of return on five important types of financial investments
frequency distribution
count up the number of times the annual return on the large stock portfolio falls within each 10 percent range
efficient capital market
current market prices fully reflect available information. By this we simply mean that, based on available information, there is no reason to believe that the current price is too low or too high.
Total Percentage Return
dividend yield + capital gains yield
in 2008, the prices on long-term US Treasury bonds ______.
gained 40%
GEOMETRIC VERSUS ARITHMETIC AVERAGE RETURNS
geometric will always be smaller than arithmetic average returns as long as the returns are not all identical
How often did the T-bill portfolio have a negative return?
never
income component
receiving cash payments from the asset (dividends)
The excess return is the difference between the rate of return on a risky asset and the ____ rate.
risk-free
geometric averages are usually ____ arithmetic averages.
smaller than
The standard deviation is the ____ of the variance
square root
weak form efficiency
suggests that, at a minimum, the current price of a stock reflects its own past prices. In other words, studying past prices in an attempt to identify mispriced securities is futile if the market is weak form efficient. While this form of efficiency might seem rather mild, it implies that searching for patterns in historical prices that are useful in identifying mispriced stocks will not work (this practice, known as "technical" analysis, is quite common).
Variance
sum of squared deviation / number of returns -1
Arithmetic average return example:
suppose a particular investment had annual returns of 10 percent, 12 percent, 3 percent, and −9 percent over the last four years: (.10 + .12 + .03 − .09)/4 = 4.0%
Geometric average return example:
suppose a particular investment had annual returns of 10 percent, 12 percent, 3 percent, and −9 percent over the last four years: (1.10 × 1.12 × 1.03 × .91)^1/4 − 1 = 3.66%
Why doesn't everyone just buy small stocks as investments?
the T-bill portfolio and the bond portfolio grew slower than the stock portfolio, but they also grew more steadily. Small stocks end up on top, but grew erratically at times
geometric average return
the average compound return earned per year over a multiyear period answers the question "What was your average compound return per year over a particular period?" tells you what you actually earned per year on average, compounded annually. if for some reason you are doing very long forecasts covering many decades, use the geometric average
What was the real (as opposed to nominal) risk premium on the common stock portfolio?
the expected inflation rate on the common stock portfolio over the life of the portfolio
semistrong efficiency
the most controversial. all public information is reflected in the stock price. The reason this form is controversial is that it implies that security analysts who try to identify mispriced stocks using, for example, financial statement information are wasting their time because that information is already reflected in the current price.
return on investment
the percentage of the total cost of purchasing an investment and the profit made from selling that investment
Efficient market reaction
the price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases to occur
Delayed reaction
the price partially adjusts to the new information; eight days elapse before the price completely reflects the new information
arithmetic average return
the return earned in an average year over a multiyear period answers the question "What was your return in an average year over a particular period?" tells you what you earned in a typical year. if you are using averages calculated over a long period of time (such as the 89 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 (such as you might do for retirement planning), then you should just split the difference between the arithmetic and geometric average returns
Standard deviation
the square root of the variance
A capital gain on a stock is counted as part of the total return whether or not the gain is realized from selling the stock
true
geometric average return CALCULATOR
you can put $1 (investment) in as the present value, $1.4870 (returns +1 and multiplied together) as the future value, and 5 as the number of periods. Then, solve for the unknown rate
