Download Chapter 10

Chapter 10 - Capital Markets!
Key Concepts and Skills
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Know how to calculate the return on an investment!!!
Understand the historical returns on various types of
investments!!!
Understand the historical risks on various types of
investments!!!
Impress your friends, family,
and significant other with your
knowledge!
Chapter Outline
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Returns!!!
The Historical Record
Average Returns: The First Lesson
The Variability of Returns: The Second
Lesson
More on Average Returns
Risk, Return, and Financial
Markets
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We can examine returns in the financial
markets to help us determine the appropriate
returns on non-financial assets
Lessons from capital market history
 Risk
 Risk/reward relationship
Dollar Returns
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Total dollar return = income from investment +
capital gain (loss) due to change in price
Example:
 You bought a bond for $950 1 year ago. You have
received two coupons of $30 each. You can sell the
bond for $975 today. What is your total dollar
return?
 Income = ?
 Capital gain = ?
 Total dollar return = ?
Percentage Returns
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Percentages versus dollar returns
Dividend yield formula
Capital gains yield formula
Total percentage return formula
Example – Calculating Returns
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You bought a stock for $35 and you
received dividends of $1.25. The stock is
now selling for $40.
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What is your dollar return?
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Dollar return = ?
What is your percentage return?
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Dividend yield = ?
Capital gains yield = ?
Total percentage return = ?
The Importance of Financial
Markets
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Financial markets allow companies,
governments, and individuals to increase
their utility
 Savers - investment
 Borrowers - capital
The Importance of Financial
Markets (continued)
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Information about required returns
Year-to-Year Total Returns
Large-Company Stock Returns
Long-Term Government
Bond Returns
U.S. Treasury Bill Returns
Average Returns
Investment
Average Return
Large stocks
12.4%
Small Stocks
17.5%
Long-term Corporate Bonds
6.2%
Long-term Government
Bonds
5.8%
U.S. Treasury Bills
3.8%
Inflation
3.1%
Risk Premiums
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Defined
Relationship to Treasury bills
Nominal rate of return
Real rate of return
Historical Risk Premiums
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Large stocks: 12.4 – 3.8 = 8.6%
Small stocks: 17.5 – 3.8 = 13.7%
Long-term corporate bonds: 6.2 – 3.8 =
2.4%
Long-term government bonds: 5.8 – 3.8
= 2.0%
Variance and Standard
Deviation
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Variance and standard deviation –
what do they measure?
Relationship of volatility to
uncertainty
Historical variance
Standard deviation
Example – Variance and Standard
Deviation
Year
Actual Average
Return Return
Deviation
from the
Mean
Squared
Deviation
1
.15
.105
.045
.002025
2
.09
.105
-.015
.000225
3
.06
.105
-.045
.002025
4
.12
.105
.015
.000225
Totals
.42
.00
.0045
Variance = .0045 / (4-1) = .0015
.03873
Standard Deviation =
Work the Web Example
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How volatile are mutual funds?
Morningstar provides information on mutual funds,
including volatility (standard deviation)
Click on the web surfer to go to the Morningstar site
 Pick a fund, such as the Aim European
Development fund (AEDCX)
 Enter the ticker in the “quotes” box, click on the
right arrow, and then click on “risk measures”
Probability Distribution
Arithmetic vs. Geometric Mean
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Consider annual returns of 10%, 12%,
3% and -9%
Arithmetic mean formula
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Defined
Defined
Geometric mean = (1.1 x 1.12 x 1.03 x
.91)1/4 – 1= .0366 = 3.66%
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Defined
Example
S & P 500 Returns
11.14
37.13
43.31
-8.91
-25.26
Product
X
X
X
X
1.1114
1.3713
1.4331
.9109
.7474
1.4870
The geometric average return is calculated as
1.48701/5 -1 = .0826 = 8.26%
End of Chapter 10!
Chapter 11 is next!
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The Analyst Competition!