Financial

Environment
By 

Laily Mumtahana (202210280211018)

Donna F Suwondo (202210280211020)

Capital Market History:
historical returns,
volatilities dan risk
premium
Risk, Return and
Financial Market
Lessons from capital market history :


● There is a reward for bearing risk


● The greater the risk, the greater the
potential reward

● This is called the risk-return trade-off




Dollar Return
Total Dollar Return = Income from investment +
Dividend = $1.85 x 100 = $185

capital gain (loss) due to change in price
 Capital Gain = ($40.33 - $37) x 100 = $333

Capital Loss = ($34.78 - $37) x 100 = -$222


 Total Dollar return = $185 - $333 = $518



Example :

Total Cash if stock is sold =Total investment +
You bought a bond for $3700 ($37 pershare x Total Return

Total Cash if stock is sold = 3700 + 518 = $4218

100 shares) one year. Dividend = $1.85 pershare.
Risen $40.33 pershare. Price drop $34.78. What
is your dollar return




Percentage return
It’s generally more intuitive to think in terms of
Example :

percentage than dollar return

You bought a stock for $37, devidend $1.85. The
Dividend yield = income /beginning price
 stock is now selling for $40.33.


Capital gain yield = (ending price - beginning Dollar return = 1.85 +(40.33-37) = $11.18

price)/ beginning price
 Percentage return :

Total Percentage return = dividend yield + Dividend yield =1.85/37 =0.05 =5%

capital gains yield

Capital gains yield = (40.33-37)/37 = 3.33/37 =9%

Total Percentage Return = 5% +9% =14%

The Historical Record
year-to-year historical rates of return on fi ve important types of fi nancial investments.


● Large-company stocks: This common stock portfolio is based on the Standard &
Poor’s (S&P) 500 index, which contains 500 of the largest companies (in terms of
total market value of outstanding stock) in the United States.

● Small-company stocks: This is a portfolio composed of the stock corresponding to
the smallest 20 percent of the companies listed on the New York Stock Exchange,
again as measured by market value of outstanding stock. 

● Long-term corporate bonds: This is based on high-quality bonds with 20 years to
maturity.

● Long-term U.S. government bonds: This is based on U.S. government bonds with
20 years to maturity. 5. U.S. Treasury bills: This is based on Treasury bills (T-bills for
short) with a one-month maturity.

The Importance of Financial Markets
Financial markets allow companies, governments,
and individuals to increase their utility

● Savers have the ability to invest in financial
assets

so they can defer consumption and earn a
return to compensate them for doing so 

● Borrowers have better access to the capital
that is available, allowing them to invest in
productive assets



Financial markets also provide us with information
about the returns that are required for various
levels of risk



 Roger Ibbotson on Capital Market
History
Financial market data are the foundation for the extensive empirical understanding
we now have of the financial markets. The following is a list of some of the principal
findings of such research: 


● Risky securities, such as stocks, have higher average returns than riskless
securities such as Treasury bills.

● Stocks of small companies have higher average returns than those of larger
companies.

● Long-term bonds have higher average yields and returns than short-term
bonds. 

● The cost of capital for a company, project, or division can be predicted using
data from the markets. 

Average Annual Returns: 1926–2007
Risk Premium
● The "extra" return earned for taking on risk

● Treasury bills are considered to be risk free 

● The risk premium is the return over and above the risk-free rate



Historical Risk Premium
 Frequency Distribution of Returns on
Large-Company Stocks: 1926–2007
Variance and Standard
Deviation
● We use variance and standard deviation to measure the volatility of asset returns

● The greater the volatility, the greater the uncertainty 


Historical variance = sum of squared deviations from the mean / (number of observations - 1) Standard
deviation = square root of the variance


illustrate calculate of historical variance

suppose a particular investment had returns of 10
percent, 12 percent, 3 percent, and 9 percent
over the last four years. The average return is
(.10 .12 .03 .09)4 4%. Notice that the return is
never actually equal to 4 percent.

illustrate calculate of
historical variance
suppose a particular investment had returns of 10
percent, 12 percent, 3 percent, and 9 percent
over the last four years. The average return is
(.10 .12 .03 .09)4 4%. Notice that the return is
never actually equal to 4 percent.

Historical Returns, Standard
Deviations, and Frequency
Distributions: 1926–2007 The Normal Distribution
Arithmetic vs. Geometric Mean
● Arithmetic average- return earned in an average period over multiple periods 



Arithmetic average return = (R1+R2+R3+....)/T



● 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



Example : Computing
returns

What are the arithmetic and geometric averages - Arithmetic average = (10%+ 12%+ 3+
for the following returns? 
 (-9%))/4=4.00%


-Year 1 >>10 % 
 - Geometric average =

[(1+0.10)*(1+0.12)*(1+0.03*(1-(0.09))]^[¼] – 1 =
-Year 2 >> 12 % 

.0449 = 3.66%

-Year 3 >> 3 % 



- Year 4 >> -9 %

Efficient Market Hypothesis :
Permasalahan dan
kesalahpahaman tentang
EMH
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




What Makes Markets Common Misconceptions
Efficient? about E MH
There are many investors out there doing ● Efficient markets do not mean that you
research 
 can't make money 

● They do mean that, on average, you
- As new information comes to market, will earn a return that is appropriate for
this information is analyzed and trades the risk undertaken, and there is not a
are made based on this information
 bias in prices that can be exploited to
- Therefore, prices should reflect all earn excess returns 

available
 ● Market efficiency will not protect you
public information If investors stop from wrong choices if you do not
researching stocks, then the market will not diversify - you still don't want to put all
be efficient
 your eggs in one basket

Strong Form Efficiency
● Prices reflect all information, including public and private 

● 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)


Semistrong Form Efficiency

● Prices reflect all publicly available information including trading information, annual reports,
press releases, etc. 

● If the market is semistrong form efficient, then investors cannot earn abnormal returns by
trading on public information 

● Implies that fundamental analysis will not lead to abnormal returns

Weak Form Efficiency
● Prices reflect all past market informatio such as price and volume . 

● If the market is weak form efficient, then investors cannot earn abnormal returns by trading
on market information

● Implies that technical analysis will not lead to abnormal returns

● Empirical evidence indicates that markets are generally weak form efficient




 TOP LINE
Do you have any questions?

Donna F. Sowondo


Thanks!
Laily Mumtahana


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