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# FNCE+2P91-Corporate+Finance-Notes-Chapter+12-Lessons+from+Capital+Market+History.docx

7 Pages
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Department
Finance
Course Code
FNCE 2P91
Professor
Clarke Melville

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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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