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Carleton University

Business

BUSI 2504

Robert Riordan

Fall

Description

CHAPTER12
SOME LESSONS FROM CAPITAL
MARKET HISTORY
Learning Objectives
LO1 How to calculate the return on investment.
LO2 The historical returns on various important types of investments.
LO3 The historical risks on various important types of investments.
LO4 The implications of market efficiency.
Answers to Concepts Review and Critical Thinking Questions
2. (LO4) As in the previous question, it’s easy to see after the fact that the investment was terrible, but it
probably wasn’t so easy ahead of time.
4. (LO4) On average, the only return that is earned is the required return—investors buy assets with
returns in excess of the required return (positive NPV), bidding up the price and thus causing the return
to fall to the required return (zero NPV); investors sell assets with returns less than the required return
(negative NPV), driving the price lower and thus the causing the return to rise to the required return
(zero NPV).
6. (LO4) Yes, historical information is also public information; weak form efficiency is a subset of semi-
strong form efficiency.
8. (LO4) Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
provide liquidity to markets and thus help to promote efficiency.
10. (LO4)
a. If the market is not weak form efficient, then this information could be acted on and a profit
earned from following the price trend. Under 2, 3, and 4, this information is fully impounded in
the current price and no abnormal profit opportunity exists.
b. Under 2, if the market is not semi-strong form efficient, then this information could be used to
buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.
Since 2 is stronger than 1, both imply that a profit opportunity exists; under 3 and 4, this
information is fully impounded in the current price and no profit opportunity exists.
c. Under 3, if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is
underpriced or that good news is imminent. Since 1 and 2 are weaker than 3, all three imply that a
profit opportunity exists. Under 4, this information does not signal any profit opportunity for
traders; any pertinent information the manager-insiders may have is fully reflected in the current
share price.
Solutions to Questions and Problems
Basic
2. (LO1) The dividend yield is the dividend divided by price at the beginning of the period price, so:
Dividend yield = $2.05 / $84 = .0244 or 2.44%
S12-1 And the capital gains yield is the increase in price divided by the initial price, so:
Capital gains yield = ($97 – 84) / $84 = .1548 or 15.48%
4. (LO1) The total dollar return is the increase in price plus the coupon payment, so:
Total dollar return = $920 – 940 + 60 = $40
The total percentage return of the bond is:
R = [($920 – 940) + 60] / $940 = .0426 or 4.26%
Notice here that we could have simply used the total dollar return of $40 in the numerator of this
equation.
Using the Fisher equation, the real return was:
(1 + R) = (1 + r)(1 + h)
r = (1.0426 / 1.04) – 1 = .0025 or 0.25%
6. (LO2) The nominal return is the stated return, which is 8.57 percent from Table 12.4. Using the Fisher
equation, the real return was:
(1 + R) = (1 + r)(1 + h)
r = (1.0857)/(1.0406) – 1 = .0433 or 4.33%
8. (LO2, 3)
Year Large co. stock return T-bill return Risk premium
1970 – 3.57% 6.89% −10.46%
1971 8.01 3.86 4.15
1972 27.37 3.43 23.94
1973 0.27 4.78 –4.51
1974 –25.93 7.68 –33.61
1975 18.48 7.05 11.43
24.63 33.69 –9.06
a. Large company stocks: average return = 24.63 / 6 = 4.105%
T T-bills: average return = 33.69 / 6 = 5.615%
U
b. Large company stocks:
variance = 1/5[(–.0357 – .04105) + (.0801 – .04105) + (.2737 – .04105) + (.0027 – .04105) + 2
(–.2593 – .04105) + (.1848 – .04105) ] = 0.034777
1/2
standard deviation = (0.034777) = 0.186486 = 18.65%
T-bills:
2 2 2 2
variance = 1/5[(.0689 – .05615) + (.0386–.05615) + (.0343–.05615) + (.0478–.05615) +
(.0768 – . 05615) + (.0705 – . 05615) ] = 0.00033001
standard deviation = (0.00033001) = 0.018165 = 1.82%
c. Average observed risk premium = –9.06 / 6 = –1.51%
variance = 1/5[(–.1046 + .0151) + (.0415 + .0151) + (.2394 + .0151) + 2
S12-2 (–.0451 + .0151) + (–.3361 + .0151) + (.1143 + .0151) ] = 0.03933388
standard deviation = (0.03933388) = 0.1983277 = 19.83%
d. Before the fact, for most assets the risk premium will be positive; investors demand compen-
sation over and above the risk-free return to invest their money in the risky asset. After the fact,
the observed risk premium can be negative if the asset’s nominal return is unexpectedly low, the
risk-free return is unexpectedly high, or if some combination of these two events occurs.
9. (LO1)
a. To find the average return, we sum all the returns and divide by the number of returns, so:
Average return = (.02 –.08 +.24 +.19 +.12)/5 = .0980 or 9.80%
b. Using the equation to calculate variance, we find:
Variance = 1/4[(.02 – .098) + (–.08 – .098) + (.24 – .098) + (.19 – .098) + 2
2
(.12 – .098) ]
Variance = 0.01672
So, the standard deviation is:
Standard deviation = (0.01672) 1/= 0.1293 or 12.93%
10. (LO1)
a. To calculate the average real return, we can use the average return of the asset, and the average
risk-free rate in the Fisher equation. Doing so, we find:
(1 + R) = (1 + r)(1 + h)
r = (1.0980/1.035) – 1 = .0609 or 6.09%
b. The average risk premium is simply the average return of the asset, minus the average risk-free
rate, so, the average risk premium for this asset would be:
RP = R – R = .0980 – .042 = .0560 or 5.60%
f
12. (LO2) T-bill rates were highest in the early e

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