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Sources of Return on the Purchase of Stock
- Cash (dividends)
- Capital Gains
Sources of Return on the Purchase of Bonds
- Cash (Coupons)
- Capital Gains
Lessons from History
- 1. Stocks have the highest return over the long run
- The most profitable have been small cap stocks2. Stocks have the highest riskThe riskiest have been small cap stocks again
- The least risky investment:Treasury bills are considered risk free investments because they have backing of govt.
- 2nd Lesson
- 3. Higher returns come with higher risk
- risk premium is the extra return a risky investment offers over the risk-free rate
(Proxy for risk) How comfortable will you be if you invest in something in which the price chances every day - sometimes not the way you want it to change
Axioms of Finance
- Investor prefer more to less
- Financial markets are competitive
Efficience Markets Hypothesis
- Also called "Price is Right"
- A market in which stock prices fully reflect all available info
- EMH argues that info is immediatly incorporated into prices. Once info becomes available analyze it
- Misconception: doesnt mean that it doesnt make a difference how you invest, since the risk/return trade-off still applies, but rather that you can't expect to consistently "beat the market" on a risk-adjusted basis using costless trading strategies
- Price fluctuations are evidence that the market is efficient since new info is constantly arriving-prices that dont change are evidence of inefficiency
collection of assets(combination of stocks, bonds, cash, etc.)
Total Risk in a Stock
- Firm Specific + Market
- 1. Firm-Specific risk (unsystematic): also called diversifiable riskThese are company specific
- 2. Market risk (systematic): also called non diversifiable risk
- Affects all securities in the market. changes in interest rates and unemployment, terrist attack, hurricane, etc.
- A measurement of systematic risk
- Beta is a number that measures the systematic (market) risk in a stock. It is related to how the stock's return in correlated with the return on the market
- Beta of the market is assumed to be 1
- B>1 indicates the company is riskier
- B=1 indicates equal risk
- B<1 indicates less risky
- Reward-to-Risk ratio that us a measure of how much return is obtained by bearing one unit of risk (variability)
- E(R)-Risk free rate/Beta
Capital Asset Pricing Model
- In equilibrium, we can formulate a relation between systematic risk and expected returns
- Risk-free rate- the pure time value of money
- Market risk premium- the reward for bearing systematic risk
- The beta coefficient- a measure of the amount of systematic risk present in a particular asset
Security Market Line
Cost of capital
- Finance deals withhow corporations raise funds (capital structure) andhow they use these funds to make profits and maximize shareholders' worth (capital budgeting)
- The following all mean the same thing
- Required return
- Appropriate discout rate
- Cost of capital
Percentage Returns for Stocks
- Dividend Yield= D(t+1)/PtCapital Gains Yield= (Pt+1Pt)/Pt
Forms of Market Efficiency
- Weak form efficiency: A form of the theory that suggests you can't beat the market by knowing past prices.
- Semi-strong form efficiency: Perhaps the most controversial form of the theory, it suggests you can't consistently beat the market using publicly available information. That is, you can't win knowing what everyone else knows.
- Strong form efficiency: The form of the theory that states no information of any kind can be used to beat the market. Evidence shows this form does not hold.
Capital market history and the EMH
- Casual evidence and empirical observation suggest the following statements are true.
- Prices respond very rapidly to new information.
- Future prices are difficult to predict.
- Mispriced stocks (those whose future price level can be predicted accurately) are difficult to identify and exploit on a consistent basis. (Note: the key here is consistency: anyone can "get lucky" at stock-picking, just as anyone can get lucky at the craps table. The important question is: can they do it time and time again?)
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