10. Lessons From Capital Market History

Transcription

1 10. Lessons From Capital Market History Chapter Outline How to measure returns The lessons from the capital market history Return: Expected returns Risk: the variability of returns 1 1

2 Risk, Return and Financial Markets We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets Lesson from capital market history There is a reward for bearing risk The greater the potential reward, the greater the risk This is called the risk-return trade-off 2 Measuring Returns: Percentage Returns It is generally more intuitive to think in terms of percentages than dollar returns Dividend yield = income / beginning price Capital gains yield = (end. price beg. price) / beg. price Total percentage return = dividend yield + capital gains yield 3 2

3 Example Calculating Returns You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40. What is your dollar return? Dollar return = (40 35) = $6.25 What is your percentage return? Dividend yield = 1.25 / 35 = 3.57% Capital gains yield = (40 35) / 35 = 14.29% Total percentage return = = 17.86% Alternatively, Total percentage return = ( )/35 = 17.86% 4 Measure of Returns: Expected Return The rate of return that investors expect from a security Example: You know that, depending on the future economic outcome, the ACME stock is predicted to have a return of either 20% if the economy is good or 10% if the economy is poor. The chances of a good economy and a bad economy are both predicted to be 50%. Then, what return do you expect from the ACME stock? 5 3

4 Measure of Returns: Expected Return Expected returns are based on the probabilities of possible outcomes In this context, expected means average if the process is repeated many times E(r) i p r Expected Return a State Probability of a State to Occur Return in a State 6 Example: Expected Returns Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom Normal Recession E(r C ) =.3(.15) +.5(.10) +.2(.02) =.099 = 9.99% E(r T ) =.3(.25) +.5(.20) +.2(.01) =.177 = 17.7% 7 4

5 R I S K *Risk is unexpected swings in price, not probability of losing money. In other words, it refers to both the downside risk and upside potential. 8 Measure of Risk: Variance and Standard Deviation Variance and standard deviation still measure the volatility of returns Weighted average of squared deviations where the weights are the probabilities for possible states. Variance Standard Deviation 9 5

6 Example: Variance and Standard Deviation Consider the previous example. What are the variance and standard deviation for each stock? Stock C 2 =.3( ) 2 +.5( ) 2 +.2( ) 2 = =.045 Stock T 2 =.3( ) 2 +.5( ) 2 +.2( ) 2 = = RISK and RETURN: DISTRIBUTION OF RETURNS <Figure: Frequency Distribution of monthly KOSPI returns> What does it look like? 11 6

7 Normal Distribution: A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation. In general, stock returns form a normal distribution (How nice!). 12 With the normal distribution feature of stock returns, we can describe the general pattern of returns and risk with two measures only: mean and standard deviation. The mean is the central point of the return distribution or the average expected return and the standard deviation can be used as a measure of variability in returns (i.e., price swings or risk). 13 7

8 If mean return = 10.5% and standard deviation ( r )= 3.9%, 14 We can make an educated guess about the Future performance of a stock. with a 68% chance r 1 r r % r 14.4% with a 95% chance r 2 r r % r 18.3% with a 99% chance r 3 r r % r 22.2% 15 8

9 The Risk-Return Principle in Financial Markets Financial markets provide us with information about the returns that are required for various levels of risk 16 $1 invested in various groups of securities in 1925 has grown to. U.S. Security Markets for the past 89 years ( ) 17 9

10 <Figure: Year-to-Year Total Returns from Different Types of Securities> 18 Historical Average Returns Investment Average Return Small Stocks 16.9% Large Stocks 12.1% Long-term Corporate Bonds 6.3% Long-term Government Bonds 5.9% U.S. Treasury Bills 3.5% Inflation 3.0% 19 10

11 Risk vs. Return It appears that there is a systematic relation existing between risk and return Assets with high risk tend to have high average returns Assets with low risk tend to have low average returns This relation is called the risk-return tradeoff or simply High Risk, High Return 20 Return that investors expect to earn from their investment (Investors Expected Return) An expected return consists of two parts: (1) risk-free rate (market interest rate): base return, common component for all investments in the market (2) risk premium: compensation for the amount of risk that a specific investment is exposed to 21 11

12 Return that investors expect to earn from their investment (Investors Expected Return) Suppose Stock ABC has 12% return where the risk-free rate is 4%. Then, Return expected = 12% Risk premium = 8% Risk-free rate = 4% 22 Risk Premiums The extra return earned for taking on risk or fair compensation for taking on extra risk. Treasury bills are considered to be risk-free The risk premium is the return over and above the risk-free rate Risk Premium = Return Risk Free Rate Alternatively, Return = Risk-Free Rate + Risk Premium 23 12

13 Historical Risk Premiums Average Return Risk-free Rate Risk Premium Small stocks % Large stocks % Long-term corporate bonds Long-term government bonds % % Treasury Bills % 24 13