Capital Market History

1
Capital Market History
Ch 12
Sprott School of Business

• Security Returns
• and
• Efficient Markets

2
Calculate Risk Premiums.

• The risk premium is the difference between a
  risky investments return and that of a riskless
  asset. Based on historical data

Investment Er Stdr Risk Premium Common
stocks 13.2 16.6 Small stocks 14.8 23.7 LT
bonds 07.6 10.6 SP (Cdn) 15.6 16.9 Treasur
y bills 03.8 03.2 0
3
ExampleUsing capital market history

• Suppose the current T-bill rate is 5. An
  investment with average risk relative to a
  typical share of stock offers a 10 return. Is
  this a good investment?

4
ExampleUsing capital market history

• Suppose an investment is similar in risk to
  buying small Canadian company equities. If the
  T-bill rate is 5, what return would you demand?

5
Financial Markets Market Efficiency

• Market
• An exchange process between buyers and sellers of
  a particular good or service

6
ExampleMarket Efficiency 1

• Suppose markets are weak form efficient.
• You notice that Bell Canada stock price has been
  trending upward at 2 / month over the last 6
  months. The 5 year average return is only about
  8.
• If you buy now, do you expect to get about 24
  return over the next year?

7
ExampleMarket Efficiency 2

• Suppose markets are strong form efficient.
• You are sharing an apartment with Alan Greenspan,
  the Chairman of the U.S. Federal Reserve Board.
  One day, you overhear a telephone call about an
  unexpected interest rate decrease to be
  instituted the next day.
• If you call your broker and buy stocks, do you
  expect to make a killing?

8
Risk and Rates of Return
Ch 13
9
Components of an Assets Value
10
How Talk About Risk?

• Probability Distribution

11
Example Calculating Expected Return
12
Example Calculating E(R) and Var(R)
13
Example Calculating E(R) and Var(R)
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Practical Considerations

• How many periods?
• Regime changes?
• Er higher, but riskier?
• What investment horizon?

15
Example Calculating Expected Return Variance
of Return
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Portfolio Expected Returns
17
Portfolio Weights Need not be Positive Fractions
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Portfolio Variance

• For a portfolio of n stocks

• For a portfolio of 2 stocks

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Example Calculating Covariance