Chapter 10

Returns

-2 ways to make a gain/loss on an investment 1) Receive Income (dividends/coupons) 2) Sell the investment for a higher (or lower) price (capital gain) -Dollar return on an investment is the sum of the income and the capital gains -We can also calculate returns on a percentage value by dividing the dollar return by the initial investment

Risk Premium

-Amount an investor demands to compensate for taking risks -Higher the risk = higher risk premium

In an efficient market ___ investments have a ___ NPV.

All ; Zero

If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?

An efficient market reaction

The dividend yield for a one-year period is equal to the annual dividend amount divided by the

Beginning stock price

___ were a bright spot for US investors during 2008.

Bonds

The percentage change in the price of a stock over a period of time is called its ___.

Capital Gain Yield

The total dollar return is the sum of dividends and ___.

Capital gains or losses

When a company declares a dividend, shareholders generally receive ___.

Cash

The geometric rate of return takes ___ into account.

Compounding

Efficient Market Hypothesis

Consider the Game of Darts -To win, you must have a better throw than your opponent -If prices already incorporate some type of information, it is like your opponent hit that type on the dartboard. You have to get a better hit (use better info) to win (earn an excess return) -Outer circle: Historic info -Inner circle: Public Info -Bulls eye: Private info

Historically, there is a ___ relationship between risk and expected return in the stock market.

Direct Relationship

The ___ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.

Excess

In an efficient market, firms should expect to receive ___ value for securities they sell.

Fair

Geometric averages are usually ___ arithmetic averages.

Smaller than

The standard deviation is the ___ of the variance.

Square root

Which of the following is commonly used to measure inflation?

The Consumer Price Index (CPI)

Which of the following are needed to describe the distribution of stock returns?

-The standard deviation of returns -The mean return

The Ibbotson-Sinquefield data shows that:

-U.S. T-bills had the lowest risk or variability -Long-term corporate bonds had less risk or variability than stocks (ALSO: bonds used in Ibbotson-Sinquefield's long-term US gov. bond portfolio had maturities of 20 years.)

Riskiness

-Small company stocks most risky -Treasury Bills would be least risky -Clear evidence between risk and return -Quantify this relationship more clearly = measure average returns and variance -Higher the risk = Higher return

Which of the following are ways to make money by investing in stocks?

-Dividends -Capital Gains

The second lesson from studying capital market history states that the ___ the potential reward, the ___ the rick.

-Less ; Less -Greater ; Greater

Two ways of calculating average returns are ___ and ___.

-Geometric Average -Arithmetic Average

Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices.

-All Information = Strong Form Efficiency -All Public Information = Semi-strong Form Efficiency -Historical stock prices = weak form efficiency

Percentage returns are more convenient than dollar returns because they:

-Apply to any amount invested -Allow comparison against other investments

Some important characteristics of the normal distribution are that it is:

-Bell-shaped -Symmetrical

Average Return

-Calculate average return of historical data, simply sum the returns and divide by the number of observations

Which of the following are true?

-T-Bills sometimes outperform common stocks -Common stocks frequently experience negative returns

Arrange the following investments from lowest historical risk premium to highest.

1) U.S. Treasury Bills (0%) 2) Long-Term Corporate bonds (2.8%) 3) Large-Company Stocks (8.6%) 4) Small-Company Stocks (13.4%)

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?

15% (114-100+1)/100=15%)

In 2008, the prices on long-term US Treasury bonds ___.

Gained 40%

The second lesson from studying capital market history is that risk is:

Handsomely rewarded

The risk-return relationship states that a riskier investment should demand a ___ return.

Higher

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

Immediately

Dividends are the ___ component of the total return from investing in a stock.

Income

An efficient market is one that fully reflects all available ___.

Information

Stock prices fluctuate from day to day because of:

Information flow

In the Ibbotson-Sinquefield studies, US Treasury bill data is based on T-bills with a maturity of ___ month(s).

One

If you use an arithmetic average to project long-run wealth levels, your results will most likely be ___.

Optimistic

If you use a geometric average to project short-run wealth levels, your results will most likely be ___.

Pessimistic

Historically, the real return on Treasury bills has been:

Quite Low

Average Return and Variance

There is too much going on with capital markets to make such sense of the raw data. So we will start with summary data, such as the average return and the variance (or standard deviation) of the return

(T/F) 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

Capital Market Efficiency

-Markets are considered to be efficient if prices instantaneously and fully reflect all of the economically relevant information ~Critically important if we use stock price to measure value creation -Investors should not be able to consistently earn abnormal returns (Abnormal=actual-expected) -Three forms of the Efficient Market Hypothesis ~Weak ~Semi-Strong ~Strong (Have to do with the type of information built into prices)

Semi-Strong Form Efficiency

-Markets are semi-strong form efficient if they reflect all historical and all publicly available info -Once info becomes public, prices react immediately. -Investors can't make abnormal returns on info that is already public if markets are semi-strong efficient -Cannot use public or historic info to make an abnormal profit, only private info

Strong Form Efficiency

-Markets are strong form efficient if prices fully reflect all info (historical, public & private) -If markets are strong form efficient then all securities are priced to provide exactly the required return for their level of risk -NO WAY to make abnormal profit -priced to make required return based on their risk

Weak Form Efficiency

-Markets are weak form efficient if prices reflect all historical information -Information about past economic conditions, past stock prices, etc -This is not the only type of info that prices may be based on or that investors may use to value securities -As soon as more historic information is available = prices should react to it -Cannot use historic info to make an abnormal profit if it is weak form -CAN use public or private info though to make an abnormal profit

Implications of Efficient Markets

-No benefit to timing unless you have more info than the rest of the market -Securities with the same level of risk are priced to provide the same level of return -We can be confident that the current stock price is an accurate measure of shareholder wealth given all publicly available info

Empirical Studies of Efficiency

-Studies of US markets support weak form. - Most studies support semi-strong form although there appear to be some anomalies ~January Effect ~Small firm Effect -Impossible to test strong form efficiency (researchers don't know private info either). However, profits made by illegal inside trades (i.e. Ivan Boesky or Dennis Levine) suggest that the markets are not strong form efficient

Variance

-To calculate the variance of historical data, we need to do several steps: 1) For each observation, calculate the deviation from the average return 2) Square each of these deviations 3) Sum the squares 4) Divide the number of observations minus 1 The standard deviation is the square root of the variance

Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2011.

1) Small-company common stock 2) Large-company common stock 3) Long-term corporate bonds 4) Long-term government bonds 5) U.S. Treasury Bills

In 2008, the S&P 500 plunged ___

37% (2008 was one of the worst years for stock market investors in US history)

The arithmetic average rate of return measures the ___.

Return in an average year over a given period