Topic 7 - Investment Risk, Returns And The History of Capital Markets

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 296-322.

Investment Risk, Returns And The History of Capital Markets

A corporate manager should examine returns in financial markets to determine the appropriate return on real assets & how much he must earn for the investors of the company. Capital market history shows there is a reward for bearing risk (risk-return trade-off). The higher the risk the greater the potential reward.

Computing Investment Returns

[1]

  • Total Dollar Return = Dividends + Capital Gains = Dividends + Price Sold – Price Bought
  • % Return = (Dollar Return) / (Dollar Investment)
  • Arithmetic Average = Return earned in an average period over multiple periods=(Total Summed Returns)/(# of Periods)
  • Geometric Average= Average compounded return per period over multiple periods = FINS161371.jpg

Historical Returns

[2] Stocks have produced greater returns but with more variability.

FINS161372.jpg

Risk Premiums

[3] The risk free rate is the return on a riskless investment e.g. treasury bills they have 0 risk premium. A risk premium is the excess return (expected) over the risk free rate as a reward for bearing risk.

Risk is measured by the dispersion, spread or volatility of returns. Variance is a common measure of return dispersion but is not the same units as the average return. The standard deviation is termed ‘volatility’ & is in the same units as the average.

FINS161373.jpg

For the stock market, the normal distribution approximates return distribution.

[Investment, Return, Deviation] – {All Ords, 13.3%, 17.4%), {10 Govt. Bonds, 9.7%, 5.4%}, {Cash, 8%, 1.8%}, {CPI, 3.8%, 10.7%}

Efficient Capital Markets

[4] Efficiency occurs when current market prices fully reflect available information. The efficient market hypothesis (EMH) states that stock prices are in equilibrium & are fairly priced due to informational efficiency. If so, than investors should not be able to earn abnormal returns as there is no inefficiencies in prices that can be exploited to earn excess returns. On average, the return will be based on the risk undertaken & market efficiency will protect you if you diversify. EMH occurs when investors cannot systematically use publicly available information to profit by outperforming the market.

Markets are efficient as there any many investors doing research (profit motive), as new information is released & analysed, prices reflect this (all publicly available information)

  • Strong Form Market Efficiencyall public & private data reflected in prices – no empirical evidence
    • Investors cannot earn abnormal returns regardless of the information they possess –
  • Semi Strong Form Market Efficiencyall public information reflected in prices
    • Investors cannot earn abnormal returns trading on public information (fundamental analysis not work)
  • Weak Form Market Efficiencyall historical price & trade information are reflected in the prices – empirical evidence
    • Investors cannot earn abnormal returns by trading upon past price information (tech analysis not work)

End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 297-299
  2. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 301-302
  3. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 305-315
  4. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 318-322
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