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Dr. Samuel Xin Liang Dr. Samuel Xin Liang Fina 110 Spring 2009
Dr. Samuel Xin Liang Dr. Samuel Xin Liang Fina 110 Spring 2009
Obama also is prepared to let Chrysler LLC go bankrupt and be sold off
piecemeal if the third-largest U.S. automaker can’t form an alliance with Fiat
SpA, said members of Congress who were briefed on the GM and Chrysler
situation before the president said two days ago that the automakers’ viability
plans were insufficient.
What are GM and Chrysler one day return after the new information?
When did investors expect GM’s bankruptcy?
Why is not GM’s common share trading zero now?
Note: We will study risks and returns together with market efficiency in coming
lectures!
Dr. Samuel Xin Liang
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Risk, Return, and Financial Markets
We learn from the history that there are risks associated with expected returns and
realized returns in the financial markets.
Our understanding and study on financial assets will help us determine the
appropriate returns on non-financial assets.
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The connectivity of materials taught
2) Stock Example: We assume that Dr. Liang bought shares of Bank of America
at price of $4.88 in February 2009. The implied market required return for Bank
of America is 40% since it was very risky to invest in banking stocks at that time.
Dr. Liang received $0.04 after he bought the stock. Bank of American is trading
at $7.22 on March 25 in the market. He decides to sell the bond to realize its
capital gain on his investment.
What are the dollar and percentage returns on Dr. Liang’s investments?
What types of sources were the contributors of these returns?
Bond Example:
Income = $6 + $6 = $12
Capital Gain = $120-$102 = $18
Total dollar return = $12 + $18 = $30
What if Dr. Liang decided to hold the bond until maturity?
Stock Example:
Income = $0.04
Capital gain = $7.22 – $4.88 = $2.34
Total dollar return = $0.04 + $2.34 = $2.38
What if Dr. Liang decided to hold the stock until today (trading at $6.38)?
Which investment is better? Bond or Stock?
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Percentage Returns
It is generally more intuitive to think in terms of percentages than dollar returns
Bond Returns
Current yield = coupon/beginning price
Capital gains yield = (ending price – beginning price) / beginning price
Total percentage return = current yield + capital gains yield
Stock Returns
Dividend yield = income / beginning price
Capital gains yield = (ending price – beginning price) / beginning price
Total percentage return = dividend yield + capital gains yield
Holding Period: The length between buying and selling the securities
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Comparable Returns without Risks
Bond Example:
Current Yield = $12/$102 =
Capital Gain Yield = $18 / $102 =
Total percentage return = $30/$102 = 29.4% for holding 1.25 years!
The annualized returns = 29.4 % / 1.25 = 23.5%
Stock Example:
Dividend Yield = $0.04/$4.88
Capital gain yield= $2.34/$4.88 =
Total percentage return = $2.38/$4.88 = 48.78% for holding 1 month!
The annualized returns = 48.78*12 = 585.4%
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Bank of America Returns
Dividends: $0.04
Dividend Yield =
Total Return: $2.38
48.78%
Capital Gain: $2.34
Capital Gain Yield =
Time
$7.22 Ending market price
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Mode “Before you buy” “If you buy” “After you buy”
Financial markets also provide us with information about the returns that are
required for various levels of risk.
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Average Returns
Inflation 3.1%
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Year-to-Year Total Returns
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Risk Premiums
Stocks are risky and have higher returns than government bonds
The risk premium is the return over and above the risk-free rate (treasury bill).
risk premium = R − R f
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Historical Risk Premiums
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What is the risk premium in our previous
examples?
1) Bond Example:
The expected risk premium = 5.5% - 0.4% = 5.1%
The realized risk premium = 23.5% - 0.4% = 23.1%
2) Stock Example:
The expected risk premium = 40% - 0.4% = 39.6%
The realized risk premium = 585.4% - 0.25% = 585.15%
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What is traditional risk measure?
We use variance and standard deviation to measure the volatility of asset
returns
Historical variance
= sum of squared deviations from the mean / (number of observations – 1)
We sometime call the standard deviation the total risk for stocks, but not all
risks eg. Bankcruptcy
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Variance and Standard Deviation
The history of capital market returns can be summarized by the mean and standard
deviation.
( R1 + L + R T ) 1 T
Average return : R =
T
=
T
∑
t =1
Rt
Return Variability :
( R1 − R ) 2 + ( R 2 − R ) 2 + L ( R T − R ) 2
SD = Variance =
T −1
1
1 T
=[ ∑
T − 1 t =1
( Rt − R ) ]
2 2
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Volatility of financial assets
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Return Distribution: Normal
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Arithmetic vs. Geometric Mean
Arithmetic average – return earned in an average period over multiple periods
Geometric average – average compound return per period over multiple periods
The geometric average will be less than the arithmetic average unless all the
returns are equal
Which is better?
The arithmetic average is overly optimistic for long horizons
The geometric average is overly pessimistic for short horizons
So the answer depends on the planning period under consideration
15 – 20 years or less: use arithmetic
20 – 40 years or so: split the difference between them
40 + years: use the geometric
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Computing Returns
What are the arithmetic and geometric averages for the following returns?
Year 1 5%
Year 2 -3%
Year 3 12%
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When did investors expect GM’s
bankruptcy? Getting funding from Bloomberg (April 1): Obama
Said to Find Bankruptcy
US government
Likely for GM, Chrysler
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Efficient Capital Markets
Stock prices are in equilibrium - they are “fairly” priced
If this is true, then you should not be able to earn “abnormal” or “excess” returns
Efficient markets DO NOT imply that investors cannot earn a positive return in the
stock market
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Market Reaction
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What Makes Markets Efficient?
If investors stop researching stocks, then the market will not be efficient
It is the perfect assumption and condition for many theories in model finance.
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Common 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 excess
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
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When did market react to GM’s new
information? Was it overpriced?
Should the price move below $1.27?
Underpriced!
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Strong Form Efficiency
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 can earn abnormal returns (may be illegal)
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Semistrong Form Efficiency
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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
There are strong debate on whether capital markets are in either strong or weak
form efficient.
Discussion:
Does the global financial crisis suggests market efficiency? A research debate!
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