Finance Chapter 10
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Investment Selection. Given that Human Genome Sciences was up almost 1,342 percent for 2009, why didn't all investors hold Human Genome Sciences?
Must have been that the performance was not expected or all would have.
Investment Selection. Given that RHI Entertainment was down by 96% for 2009, why did some investors hold the stock? Why didn't they sell out before the price declined so sharply?
Must have been unexpected.
Risk and Return. We have seen that over long periods of time stock investments have tended to substantially outperform bond investments. However, it is not at all uncomon to observe investors with long horizons holding their investments entirely in bonds. Are such investors irrational?
No. Stocks are risker. Some investors are highly risk averse, and the extra possible return doesn't outweigh the extra risk.
Stocks vs. Gambling. Critically evaluate the following statement: Playing the stock market is like gambling. Such speculative investing has no social value, other than the pleasure people get from this form of gambling
Unlike gambling, the stock market is a positive sum game, everybody can win. Also speculators provide liquidity to markets and thus help to promote efficiency.
Effects of inflation. Look at tabel 10.1 and Figure 10.7 in the text. When were T-bill rates at their highest over the period from 1926-2009? Why do you think they were so high during this period? What relationship underlies your answer?
T-bill rates were highest in the early eighties. this was during a period of high inflation and consistent with the Fisher effect.
A rise in the rate of inflation causes the nominal rate to rise juste enough so that the real rate of interest is unaffected. In other words, the real rate is invariant to the rate of inflation.
Risk Premiums. Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be negative after the fact? Explain.
Before the fact, for most assets the risk premium will be positive, investors demand compensation over and above the risk free return to invest their money in the risky asset. After the fact, the observed risk premium can be negative if the aset's nominal return is unexpectedly low, the risk free return is unexpectedly high, or some combination.
Returns. Two years ago, General Materials' and Standard Fixtures' stock prices were the same. During the first year, GM's stock price increased by 10% while SF's price decreased 10%. During the second year, GM'stock decreased by 10% and SF's price increased by 10%. Do these two have the same price today?
- Yes. (-2, -1, 0)
- GM(P, 1.1*P, 1.1*0.9*P)
- SF (P, 0.9*P, 0.9*1.1*P)
Returns. Two years ago LM and STF stock prices were the same. The average return for both over the past two years was 10%. LM stock price increased 10% each year. STF price increased 25% in the first year and lost 5% the last year. To they have same price today.
- No. Time (-2, -1)
- LM (P*1.1, P*1.1*1.1=1.21*P)
- STF (P*1.25, P*1.25*0.95=1.19)
Arithmetic vs Geometric Returns. What is the difference between arithmetic and geometric returns? Suppose you have invested in a stock for the last 10 years. Which number is more important to you?
As an investor geometric returns are more important. To calculate the arithmetic return, you sum the returns and divide by the number of returns. As such the arethmetic returns do not account for the effects of compounding. Geometric returns do account for compounding.
Historic returns. The historical asset class returns presented in the chapter are not adjusted for inflation. What would happen to the estimates risk premium if we did account for inflation? The returns are also not adjusted for taxes. What would happen if accounted for taxes? What would happen to the volatility?
Risk premiums are about the same whether or not we account for inflation. The reason is that risk premiums are the difference between two returns, so inflation essentially nets out. Returns, risk premiums, and volatility would all be lower than we estimated because aftertax returns are smaller than pretax returns.
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