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1、Some Lessons from Capital Market HistoryChapter 1010.1Key Concepts and SkillsnKnow how to calculate the return on an investmentnUnderstand the historical returns on various types of investmentsnUnderstand the historical risks on various types of investments10.2Chapter OutlinenReturnsnThe Historical
2、RecordnAverage Returns:The First LessonnThe Variability of Returns:The Second LessonnCapital Market Efficiency10.3Risk,Return and Financial MarketsnWe can examine returns in the financial markets to help us determine the appropriate returns on non-financial assetsnLesson from capital market historyn
3、There is a reward for bearing risknThe greater the potential reward,the greater the risknThis is called the risk-return trade-off10.4Dollar ReturnsnTotal dollar return=income from investment+capital gain(loss)due to change in pricenExample:nYou bought a bond for$950 1 year ago.You have received two
4、coupons of$30 each.You can sell the bond for$975 today.What is your total dollar return?nIncome=30+30=60nCapital gain=975 950=25nTotal dollar return=60+25=$8510.5Percentage ReturnsnIt is generally more intuitive to think in terms of percentages than dollar returnsnDividend yield=income/beginning pri
5、cenCapital gains yield=(ending price beginning price)/beginning pricenTotal percentage return=dividend yield+capital gains yield10.6Example Calculating ReturnsnYou bought a stock for$35 and you received dividends of$1.25.The stock is now selling for$40.nWhat is your dollar return?nDollar return=1.25
6、+(40 35)=$6.25nWhat is your percentage return?nDividend yield=1.25/35=3.57%nCapital gains yield=(40 35)/35=14.29%nTotal percentage return=3.57+14.29=17.86%10.7The Importance of Financial MarketsnFinancial markets allow companies,governments and individuals to increase their utilitynSavers have the a
7、bility to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing sonBorrowers have better access to the capital that is available so that they can invest in productive assetsnFinancial markets also provide us with information about the returns th
8、at are required for various levels of risk10.8Figure 10.410.9Year-to-Year Total ReturnsLarge-Company Stock ReturnsLong-Term GovernmentBond ReturnsU.S.Treasury Bill Returns10.10Average ReturnsInvestmentAverage ReturnLarge stocks12.7%Small Stocks17.3%Long-term Corporate Bonds6.1%Long-term Government B
9、onds 5.7%U.S.Treasury Bills3.9%Inflation3.1%10.11Risk PremiumsnThe“extra”return earned for taking on risknTreasury bills are considered to be risk-freenThe risk premium is the return over and above the risk-free rate10.12Historical Risk PremiumsnLarge stocks:12.7 3.9=8.8%nSmall stocks:17.3 3.9=13.4%
10、nLong-term corporate bonds:5.7 3.9=1.8%nLong-term government bonds:5.7 3.9=1.8%10.13Figure 10.910.14Variance and Standard DeviationnVariance and standard deviation measure the volatility of asset returnsnThe greater the volatility the greater the uncertaintynHistorical variance=sum of squared deviat
11、ions from the mean/(number of observations 1)nStandard deviation=square root of the variance10.15Example Variance and Standard DeviationYearActual ReturnAverage ReturnDeviation from the MeanSquared Deviation1.15.105.045.0020252.09.105-.015.0002253.06.105-.045.0020254.12.105.015.000225Totals.42.00.00
12、45Variance=.0045/(4-1)=.0015 Standard Deviation=.0387310.16Work the Web ExamplenHow volatile are mutual funds?nMorningstar provides information on mutual funds,including volatilitynClick on the web surfer to go to the Morningstar sitenPick a fund,such as the Aim European Development fund(AEDCX)nEnte
13、r the ticker,press go and then scroll down to volatility10.17Figure 10.1010.18Figure 10.1110.19Efficient Capital MarketsnStock prices are in equilibrium or are“fairly”pricednIf this is true,then you should not be able to earn“abnormal”or“excess”returnsnEfficient markets DO NOT imply that investors c
14、annot earn a positive return in the stock market10.20Figure 10.1210.21What Makes Markets Efficient?nThere are many investors out there doing researchnAs new information comes to market,this information is analyzed and trades are made based on this informationnTherefore,prices should reflect all avai
15、lable public informationnIf investors stop researching stocks,then the market will not be efficient10.22Common Misconceptions about EMHnEfficient markets do not mean that you cant make moneynThey do mean that,on average,you will earn a return that is appropriate for the risk undertaken and there is
16、not a bias in prices that can be exploited to earn excess returnsnMarket efficiency will not protect you from wrong choices if you do not diversify you still dont want to put all your eggs in one basket10.23Strong Form EfficiencynPrices reflect all information,including public and privatenIf the market is strong form efficient,then investors could not earn abnormal returns regardless of the information they possessednEmpirical evidence indicates that markets are NOT strong form efficient and tha
