Finance 300 Chp 12

Arithmetic vs. Geometric Mean

Arithmetic average - return earned in an average period over multiple periods. This is the mean of a distribution. Geometric average - average compound return per period over multiple periods. This is the return from Chapter 5. The geometric average will be less than the arithmetic average unless all the returns are equal What to make of the difference? The arithmetic average is overly optimistic for long horizons

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 abnormal 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

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

Risk, Return and Financial Markets

Lessons from capital market history 1. There is a reward for bearing risk. 2. The greater the potential reward, the greater the risk This is called the risk-return trade-off

Reaction of Stock Price to New Information

Over Reaction and Correction Delayed Reaction Efficient market Reaction Think graphical image

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 regardless of the information they possessed Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

Weak Form Efficiency

Prices reflect all past market information such as price and volume If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information Implies that technical analysis will not lead to abnormal returns Empirical evidence indicates that markets are generally weak form efficient

Semistrong Form Efficiency

Prices reflect all publicly available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns

Percentage Total Return

Return= Dividend Yield + Capital Gains yield =(D(t+1)/Pc + (P2-P1)/P1

Efficient Capital Markets

Stock prices are in equilibrium or are "fairly" priced If this is true, then you should not be able to earn "abnormal" Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

Risk Premia

The "extra" return earned for taking on risk Treasury bills are considered to be risk-free The risk premium is the return over and above the risk-free rate Ri(Prem)=Ri-Rf

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

Variance and Standard Deviation

Variance and standard deviation measure the volatility of asset returns Greater volatility => Greater uncertainty Historical variance: Variance=(1/T)(r1-r(ave))^2 +.....(1/T)(r1-r(ave))^2 Standard deviation = square root of the variance

Risk, Return and Financial Markets

We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets Returns, Risk, Goods, and Bads