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Finance
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FNCE 2P91
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Clarke Melville
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Lecture

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FNCE 2P91 - Section 05
Winter 2011 - Duration 03
22.03.11
FNCE 2P91: Corporate Finance-Notes-Chapter 12: Lessons from Capital
Market History
Notes
Slides will be posted on Sakai
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
o There is greater reward for bearing risk
o The greater the potential reward, the greater the risk
o This is called the risk-return trade-off
Figure 12.4 – If you invested $1 in $1957, how much would you have in 2008?
Diagram from the textbook
Average Returns 1957-2008 12.3
Diagram from the textbook
Risk Premiums
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
For this class Government issued Treasury Bonds (T-bills) are considered risk-free
Historical Risk Premiums 1957-2008
Variance and Standard Deviation 12.4
Variance and standard deviation measure the volatility of asset returns
The greater the volatility, the greater the uncertainty
Historically variance = sum of squared deviations from the mean / …
Example – Variance and Standard Deviation
Table 12.4 Historical Returns and Standard Deviations 1957-2008
Diagram from the textbook
Figure 12.6 – Normal Distribution and a Portfolio of Large Common Stocks
Diagram from the textbook
More on Average Returns 12.5
Capital Market Efficiency 12.6
Stock prices are in equilibrium or 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
Figure 12.7 – Reaction to New Information
Diagram from the textbook
What Makes Markets Efficient?
There are many investors…
Common Misconceptions about EMH
Efficient… FNCE 2P91 - Section 05
Winter 2011 - Duration 03
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 hey possessed
Empirical evidence indicates that markets are NOT strong...
Semi Strong Form Efficiency
Prices reflect all publicly available information including trading information, annual reports, press
releases, etc.
If the market is semi-strong 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 information 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
PROBLEMS
Question
ABC Company: Future expectations for returns of stock ABC
Probability 10% 20% 40% 20% 10%
Return -10% 5% 20% 35% 50%
Expected Return
( ) ( ) ( ) ( ) ( ) ( )
2
Variance of Returns (T ABC)
( ) ( ) ( ) ( ) (
)
Standard Deviation (TABC)
√
So what?
68% ± 1
-2 3.57% 20% 36.43% +2
-1 +1
So 68% certain that ABC would return 3.57% to 36.43% FNCE 2P91 - Section 05
Winter 2011 - Duration 03
Question
NEXT YEAR’S RETURNS
SCENARIO PROBABILITY TEPC UUU
Meltdown 10% -30% -80%
Shutdown Plant 30% -10% 10%
Re-Open Plant 60% 40% 33%
Part One:
What is the Expected Return of TEPC?
( ) ( ) ( ) ( )
What is the Expected Return of UUU?
( )
Part Two:
What is the Variance for TEPC?
( ) ( ) ( )
What is the Variance for UUU?
Part Three:
What is the Standard Deviation?
√
Part Four:
So what is the chance that the TEPC will generate returns greater than 50% next year?
Will be using the Z-score
12.30%
0.18 0.50
So the Z-score of 1.16 tells us that there is a 12.30% chance of TEPC generating returns next year
greater than 50% FNCE 2P91 - Section 05
Winter 2011 - Duration 03
What is the chance UUU will generate returns greater than 50%?
So 14.46% chance that returns of UUU will be greater than 50%
Part Fiv

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