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Lecture 5

MGT 181 Lecture Notes - Lecture 5: Risk-Free Interest Rate, United States Treasury Security, Russell 2000 Index

Rady School of Management
Course Code
MGT 181
L Jean Dunn

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October 20th, 2015
The Importance of Financial Markets:
The financial markets allow companies, governments and individuals to increase their
Savers have the ability to invest in financial assets so that they can defer consumption
earn a return to compensate them for doing so.
Borrowers have better access to the capital that is available so that they can invest in
productive assets.
Financial Markets also provide us with information about the returns that are required for
various levels of risk.
Historical returns: S&P 500 - 11.5%; Russell 2000 - 20.5%; US Treasury Bonds - 5.2%; US
Treasury Bills - 3.6%.
Inflation: 3.1%
Risk Premium: The ‘extra’ return earned for taking on a risk. Treasury bills are considered to be
risk free. The risk premium is the return over and above the risk free rate.
Variance and Standard deviation:
Variance and standard deviation measure the volatility of asset returns. The greater the
volatility, the greater the uncertainty.
Historical variance = sum of squared deviations from the mean/ (Observances -1)
Standard deviation = square root of the variance
Efficient capital markets
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.
As new information comes to market, this information is analyzed and trades are made based
on this information. Therefore, prices should reflect all available public information. If investors
stop researching stocks, then the market will not be efficient.
Common misconceptions about the efficient market hypothesis:
the efficient market does not mean that you can’t make money. They do mean that, on average,
you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices
that can be exploited to earn excess returns.
Market efficiency will not protect you from wrong choices if you do not diversify.
Strong form efficiency: Prices reflect all information, including public and private. If the market is
strong form efficiency, then investors could not earn abnormal returns regardless of the
information they possessed. Weak form efficiency: Prices reflect all past market information
such as price and volume. If the market is weak form efficient, the investors cannot earn
abnormal returns by trading on market information. Markets are generally weak form efficient.
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