Chapter 10 Capital Markets Key Concepts and Skills

Chapter 10 - Capital Markets!

Key Concepts and Skills n n 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 n n n 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 n n We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets Lessons from capital market history n Risk/reward relationship

Dollar Returns n n Total dollar return = income from investment + capital gain (loss) due to change in price Example: n 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? n Income = ? n Capital gain = ? n Total dollar return = ?

Percentage Returns n n Percentages versus dollar returns Dividend yield formula Capital gains yield formula Total percentage return formula

Example – Calculating Returns n You bought a stock for $35 and you received dividends of $1. 25. The stock is now selling for $40. n What is your dollar return? n n Dollar return = ? What is your percentage return? n n n Dividend yield = ? Capital gains yield = ? Total percentage return = ?

The Importance of Financial Markets n Financial markets allow companies, governments, and individuals to increase their utility n Savers - investment n Borrowers - capital

The Importance of Financial Markets (continued) n 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 U. S. Treasury Bills 5. 8% Inflation 3. 1% 3. 8%

Risk Premiums n n Defined Relationship to Treasury bills Nominal rate of return Real rate of return

Historical Risk Premiums n n 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 Variance and standard deviation – what do they measure? n Relationship of volatility to uncertainty n Historical variance n Standard deviation n

Example – Variance and Standard Deviation Year Actual Average 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 . 0045 Variance =. 0045 / (4 -1) =. 0015. 03873 Standard Deviation =

Work the Web Example n n n 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 n Pick a fund, such as the Aim European Development fund (AEDCX) n Enter the ticker in the “quotes” box, click on the right arrow, and then click on “risk measures”

Probability Distribution

Arithmetic vs. Geometric Mean n n Consider annual returns of 10%, 12%, 3% and -9% Arithmetic mean formula n n n Defined Geometric mean = (1. 1 x 1. 12 x 1. 03 x. 91)1/4 – 1=. 0366 = 3. 66% n Defined

Example S & P 500 Returns 11. 14 37. 13 43. 31 -8. 91 -25. 26 Product 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! n The Analyst Competition!