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AcF100 > Week 12 - Introduction to Capital Markets > Flashcards

Week 12 - Introduction to Capital Markets Flashcards

1
Q

What are the three levels of return?

A
  1. Required return
  2. Expected return
  3. Realised return
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2
Q

What is required return?

A

‘Before you buy’
What an investor can earn on similar risk assets

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3
Q

What is expected return?

A

‘If you buy’
What an investor can expect to earn by buying the asset under certain assumptions

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4
Q

What is realised return?

A

‘After you sell’
What an investor actually earned by buying and selling the asset

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5
Q

An eg of the 3 levels of return

A

A stock is currently priced at £12 and is expected to provide a dividend of £1 forever. Your required return is 8%.
Your expected return = £1 / £12 = 8.3%
If you buy 10 shares at £12 each and sell a year later for £12.50, your actual (realised) return:
R = (D_1 + P_1 - P_0) × N
/ P_0 × N
= 10 + 125 - 120
/120
= 0.125 or 12.5%

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6
Q

What is pound returns?

A

in monetary terms how much income youve got from your investments

if the price grows, called capital gains
if the price goes down, called capital loss

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7
Q

What is the equation for total pound return?

A

Total pound return = income from investment + capital gain/ loss due to change in price

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8
Q

An eg of pound returns

A

You bought a security for £950 one year ago and you have received £60 of income.
You sold the security for £975 today. What is your total pound return?

income = £60
capital gain = £975 – £950 = £25
total pound return = £60 + £25 = £85

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9
Q

What are 3 formulas in realised (actual) returns?

A

It is often more useful to think in terms of percentage rather than pound returns:
1. Dividend yield
2. Capital gains yield
3. Total return (R_t, %)

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10
Q

What is the dividend yield formula?

A

Dividend yield = income/ beginning price = D_1/ P_0

or more formally
DY = D_t/ P_t-1

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11
Q

What is the capital gains yield formula?

A

(ending price - beginning price)/ beginning price = P_t - P_t-1 / P_t-1

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12
Q

What is the total return (R_t, %) formula?

A

Total return (R_t,%) = dividend yield + capital gains yield = D_t/ P_t-1 + P_t - P_t-1 / P_t-1

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13
Q

What is the income called we get from bonds rather than dividend yield for stocks?

A

coupon

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14
Q

An eg of Realised (actual) returns

A

You bought a stock for £35, and you received dividends of £1.25. The stock is now selling for £40.

What is your pound return?
£1.25 + (40-35) = 6.25
What is your expected percentage return?
£1.25/£35 +(£40-£35)/ £35 = 17.86%

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15
Q

What does an average realised returns list include?

A

Investment:
Large stocks %
Small stocks % (usually best performing for average return)
Long-term Corporate Bonds %
Long-term Government Bonds %
U.S. Treasury Bills %
Inflation %

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16
Q

How do you calculate the arithmetic average return?

A

add the returns on a stock from eg 2019 to 2022 4.9% -2.6% 7.3% and 1.4% then divide by 4 since there are 4 values

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17
Q

What are risk premiums?

A

there is a reward for bearing risk (over a reasonably long period of time) and the ‘extra’ return (reward) earned for taking on risk is the risk premium

Treasury bills (less than one year) are proxies for risk-free rate
The risk premium is the return over and above the risk-free rate

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18
Q

What is risk measured by?

A

the dispersion, spread or volatility of returns

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19
Q

What are 3 measures included in risk?

A
  1. Variance
  2. Standard deviation
  3. The greater the volatility the greater the uncertainty
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20
Q

What is variance?

A

var(R) or σ^2
common measure of return dispersion

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21
Q

What is another name for variance?

A

variability

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22
Q

What is standard deviation?

A

SD(R) or σ
square root of the variance
same ‘units’ as the average

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23
Q

What is standard deviation also called?

A

volatility

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24
Q

What makes uncertainty greater in risk

A

The greater the volatility the greater the uncertainty

25
Q

What is the return variance equation

A

σ^2 = E T i=1 (R_i - E(R))^2 / T - 1

T no of returns in your sample

26
Q

What is the standard deviation equation?

A

σ = sqr Var(R) = sqr σ

27
Q

What is normal distribution?

A

a symmetric frequency distribution
the ‘bell shaped curve’
completely described by the mean and variance

28
Q

What is arithmetic average?

A

return earned in an average period over multiple periods

29
Q

What is geometric average?

A

average compound return per period over multiple periods

30
Q

Is arithmetic or geometric average greater?

A

Geometric average < arithmetic average unless all the returns are equal

31
Q

What answers the question
What was your average compound return per year over a particular period?

A

geometric average

32
Q

What answers the question
What was your return in an average year over a particular period?

A

arithmetic average

33
Q

How do you calculate geometric returns?

A

GAR = [(1+R_1) x (1+R_2)x(1xR_3) x…x (1+R_N)] ^(1/N) -1

R refers to return in each period
N is the number of periods

34
Q

A geometric returns example

A

a stock has had returns of 11%, -8%, 6%, 21%, 24%, and 16% over the last six years.
What is the geometric return for this stock?
GAR = [(1+0.11)x(1+-0.08)x(1+0.06)x(1+0.21)x(1+0.24)x(1x0.16)] ^(1/6) -1
= 0.111 or 11.1%

35
Q

Which is better, arithmetic or geometric average?

A

The arithmetic average is overly optimistic for long horizons
The geometric average is overly pessimistic for short horizons

36
Q

What time periods are arithmetic or geometric average better for?
15-20 years or less
20-40 years
40+ years

A

15-20 years or less - arithmetic
20-40 years or so - split the difference between them
40+ years - use the geometric average

37
Q

What do financial prices respond to?

A

to changing views about the future

38
Q

What are examples of financial prices?

A

stocks/ bond prices

39
Q

What do markets look to do?

A

look forward
the past is only relevant in that it may help to predict the future

40
Q

What do we expect (stock) market prices to do even if everyone acts ‘rationally’?

A

to be volatile as they immediately ‘embody’ changing views about all future prospects for companies

41
Q

When are 4 times capital markets are efficient?

A
  1. securities are efficient if the prices incorporate all available information
  2. securities are ‘fairly’ priced
  3. price changes if new information
  4. if true, you should not be able to earn ‘abnormal’ or ‘excess’ returns
42
Q

What type of efficiency is it when securities are efficient if the prices incorporate all available information

A

informational efficiency

43
Q

What does it mean when securities are ‘fairly’ priced?

A

no securities are underpriced or overpriced
expected return = required return

44
Q

What is the efficient market reaction?

A

the price instantaneously adjusts to and fully reflects new information

45
Q

What is the delayed reaction?

A

the price partially adjusts to the new information; eight days elapse before the price completely reflects the new information

46
Q

What is overreaction?

A

the price over adjusts to the new information and subsequently corrects

47
Q

What makes markets efficient?

A

there are many investors out there doing research
if investors stop researching or trading securities, then the markets will not be efficient

48
Q

How are markets efficient from research?

A

as new information comes to market, this information is analysed and trades are made based on this information
therefore, prices should reflect all available information

49
Q

What is weak form efficiency?

A

prices reflect all past market information such as price and volume
if true, then investors cannot earn abnormal returns by trading on
market information

50
Q

What does weak form efficiency imply?

A

implies that technical analysis will not lead to abnormal returns
empirical evidence indicates that markets are generally weak form efficient

51
Q

What is semi-strong form efficiency?

A

prices reflect all publicly available information including trading information, annual reports, press releases etc
if true then investors cannot earn abnormal returns by trading on public information

52
Q

What does semi-strong form efficiency imply?

A

that fundamental analysis will not lead to abnormal returns

53
Q

What is strong form efficiency?

A

prices reflect all information, including public and private
if true, then investors cannot earn abnormal returns regardless of the information they possess

54
Q

What does strong form efficiency indicate?

A

prices reflect all information, including public and private
if true, then investors cannot earn abnormal returns regardless of the information they possess

55
Q

What does strong form efficiency indicate?

A

empirical evidence indicates that markets are not strong form efficient

insiders can earn abnormal returns

56
Q

What are common misconceptions about the efficient market hypothesis?

A

efficient markets dont imply that investors cannot earn a positive return in the stock market

57
Q

What does the efficient market hypothesis mean?

A

on average, you will earn a return appropriate for the risk undertaken

there is no bias in prices that can be exploited to earn excess returns

market efficiency will not protect you from wrong choices if you dont diversify

58
Q

What are lessons from history about market efficiency?

A

stock prices do respond very quickly to new information
stock prices in the near future are very difficult to predict (avoid trying to time the market)
very underprices or overprices stocks exist
buy and hold stocks based on analysis of company fundamentals and diversify

AcF100 (13 decks)

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