Week 12 - Introduction to Capital Markets Flashcards
What are the three levels of return?
- Required return
- Expected return
- Realised return
What is required return?
‘Before you buy’
return that an investor requires to justify the investment, considering the risk associated with it
What is expected return?
‘If you buy’
what an investor anticipates earning based on the price and dividend assumptions
What is realised return?
‘After you sell’
What an investor actually earned by buying and selling the asset
This includes both the dividend received and the capital gain or loss from the change in stock price
How is realised return calculated?
You are buying 10 shares at £12 each, and after one year, you sell the shares for £12.50. The realised return is calculated as
R = [(D₁ + P₁ - P₀ ) x N] / (P₀ x N)
D₁ = Dividend received in the first year = £1 × 10 = £10
P₁ = Price at the time of sale = £12.50 × 10 = £125
P₀ = Price at the time of purchase = £12 × 10 = £120
N = Number of shares = 10
R = 12.5%
What is pound returns?
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
What does total pound return include?
both the income from the investment (like dividends or interest) and the capital gain or loss resulting from the change in the price of the asset
What is the equation for total pound return?
Total pound return = income from investment + capital gain/ loss due to change in price
An eg of pound returns
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
What are 3 formulas in realised (actual) returns?
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, %)
What is the dividend yield formula?
The dividend yield measures the income you receive as a percentage of the investment’s initial price
Dividend yield = income/ beginning price = D₁/ P₀
D₁ = Dividend received in the period
P₀ = Price of the asset at the beginning of the period (purchase price)
or more formally
DY = D_t/ P_t-1
What is the capital gains yield formula?
The capital gains yield measures the price change as a percentage of the initial price
(ending price - beginning price)/ beginning price = Pₜ - Pₜ₋₁ / Pₜ₋₁
Pₜ = Price of the asset at the end of the period (selling price)
Pₜ₋₁ = Price of the asset at the beginning of the period (purchase price)
What is the total return (R_t, %) formula?
Total return (R_t,%) = dividend yield + capital gains yield = (D_t/ P_t-1) + (Pₜ - Pₜ₋₁ / Pₜ₋₁ )
What is the income called we get from bonds rather than dividend yield for stocks?
coupon payment (the regular interest payments made to the bondholder, typically paid semiannually or annually)
An eg of Realised (actual) returns
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 and expected percentage return?
pound return:
£1.25 + (40-35) = 6.25
expected percentage return:
£1.25/£35 +(£40-£35)/ £35 = 17.86%
What does an average realised returns list include?
Investment:
Large stocks %
Small stocks % (usually best performing for average return)
Long-term Corporate Bonds %
Long-term Government Bonds %
U.S. Treasury Bills %
Inflation %
How do you calculate the arithmetic average return?
you simply add up all the individual returns and then divide by the number of periods
Arithmetic average return = (R₁ + R₂ + Rₜ…)/ T
R₁, R₂, …, Rₜ are the returns for each period.
T is the number of periods
What are risk premiums?
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
What is risk measured by?
the dispersion, spread or volatility of returns
What are 3 measures included in risk?
- Variance
- Standard deviation
- The greater the volatility the greater the uncertainty
What is variance?
var(R) or σ^2
the square of the standard deviation and measures the spread of the returns around the mean return. It provides the same information about risk but in squared units of return
What is another name for variance?
variability
What is standard deviation?
SD(R) or σ
square root of the variance
same ‘units’ as the average
It measures the spread or volatility of returns in the same units as the original returns (e.g., percentages)
It shows how much the returns of an asset deviate from the average return over time. A higher standard deviation means more variability in the returns, indicating higher risk
What is standard deviation also called?
volatility
When is volatility (standard deviation) often used?
often used in financial markets to describe how much the price of an asset fluctuates over time. Higher volatility means higher uncertainty about future price movements, implying greater risk
What makes uncertainty greater in risk
The greater the volatility the greater the uncertainty
What does it mean when the greater the volatility the greater the uncertainty
The greater the volatility (standard deviation), the greater the uncertainty about the future return of an asset. High volatility indicates that the asset’s price is more likely to change drastically, either upward or downward.
This is why investors consider volatility as an important risk measure when deciding whether to invest in an asset.
What is the return variance equation
σ^2 = ET i=1 (R_i - E(R))ˆ2 /( T-1)
R_i = return for each period i in the sample
E(R) = expected return (or mean return) over the periods
T = number of periods
T no of returns in your sample
What is the standard deviation equation?
SD (R) = σ = sqr Var(R) = sqr σ
What is normal distribution?
a symmetric frequency distribution
the ‘bell shaped curve’
completely described by the mean and variance
What is arithmetic average (or mean)?
average of all returns over a period of time
What is geometric average?
average compound return per period over multiple periods
What is the geometric average also called?
geometric mean or compound annual growth rate
Is arithmetic or geometric average greater?
Geometric average < arithmetic average unless all the returns are equal
Why is Geometric average < arithmetic average?
Compounding Effect: The geometric average reflects the compounded effect of returns over time, meaning it accounts for the fact that a gain of 10% in the first year does not simply add to the second year’s return, but compounds with it.
If returns fluctuate significantly from one period to the next, the geometric mean will be lower than the arithmetic mean because it effectively smooths out the highs and lows of the returns
What answers the question
What was your average compound return per year over a particular period?
geometric average
What answers the question
What was your return in an average year over a particular period?
arithmetic average
How do you calculate geometric returns?
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
A geometric returns example
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%
Which is better, arithmetic or geometric average?
The arithmetic average is overly optimistic for long horizons
The geometric average is overly pessimistic for short horizons
Why is the arithmetic average is typically overly optimistic for long-term investments?
because it doesn’t account for the compounding of returns over time. It treats each return independently, so when returns fluctuate, it tends to overestimate the expected future return.
Over short periods, the arithmetic average may be closer to the true average return, especially if returns are relatively consistent
Why is the geometric average is overly pessimistic for short horizons?
The geometric average accounts for compounding and gives a more accurate measure of long-term growth. It’s a more realistic estimate of the true growth rate over time, especially when returns vary.
However, it tends to be more pessimistic over short periods because it smooths out high positive or negative fluctuations and doesn’t give as much weight to these short-term movements
What time periods are arithmetic or geometric average better for?
15-20 years or less
20-40 years
40+ years
15-20 years or less - arithmetic
20-40 years or so - split the difference between them
40+ years - use the geometric average
What do financial prices respond to?
to changing views about the future
What are examples of financial prices?
stocks/ bond prices
What do stocks and bond prices reflect?
don’t just reflect what has happened in the past, but more importantly, they are forward-looking. This means that markets react to new information (or “news”) because they attempt to anticipate how this news will impact future performance
For example, if a company announces a new product or faces a major challenge, investors adjust their expectations, and this change in sentiment is reflected immediately in the price of the stock
What do markets look to do?
look forward
The market is primarily concerned with what is likely to happen in the future, not necessarily what has already happened. The past serves only as a tool for forecasting.
For instance, the price of a stock today is largely driven by investors’ beliefs about the company’s future earnings, risks, or potential developments, not its historical performance alone.
What do we expect (stock) market prices to do even if everyone acts ‘rationally’?
to be volatile as they immediately ‘embody’ changing views about all future prospects for companies
Even if investors act “rationally” (making decisions based on available information), market prices can still be volatile. This is because prices change rapidly as new information comes in and traders re-evaluate their expectations
What is the efficient market hypothesis (EMH)?
a theory in financial economics that suggests markets are highly efficient in processing and incorporating all available information into the prices of securities
What is efficiency (in context of EMH)?
a market is informationally efficient if the prices of securities (such as stocks) instantly and accurately reflect all relevant information available to market participants
What are the 4 key elements of the Efficient Market Hypothesis
- securities are efficient if the prices incorporate all available information (informational efficiency)
- securities are ‘fairly’ priced (no securities are underpriced or overprices, expected return = required return)
- price changes only if new information
- if true, you should not be able to earn ‘abnormal’ or ‘excess’ returns
Why are securities efficient if the prices incorporate all available information (informational efficiency?
When new information becomes available—whether it’s about a company’s earnings, a new economic policy, or a global event—market participants adjust their actions accordingly. The price of a security adjusts rapidly in response to this information, ensuring that its market price always reflects its true value.
Types of Information: Information can come in different forms, including public information (like earnings reports, press releases, or macroeconomic data), and private information (which, in the case of strong-form EMH, would also be included in price adjustments). The idea is that all this information is processed and priced into the security by the time it reaches the public, making it impossible to outperform the market by using any kind of known data.
Why are securities ‘fairly’ priced (no securities are underpriced or overprices, expected return = required return)
Fair Pricing: In an efficient market, the price of a security is considered “fair” if it is set according to all available information. This means that the market price represents the intrinsic value of the security.
No Underpricing or Overpricing: In such a market, there should be no opportunities to buy an underpriced stock or sell an overpriced stock for a profit. If a security is underpriced, it would quickly be bought by investors, pushing its price up to its fair value. Similarly, if it were overpriced, investors would sell it, driving the price down to the correct level.
Expected Return = Required Return: The expected return of a security reflects the return that an investor anticipates, based on factors like the risk associated with the investment. In an efficient market, this expected return should be equal to the required return (the return an investor demands to compensate for the risk they are taking on). If a stock offers a higher expected return than its required return, it suggests that the market has missed something, and this discrepancy would quickly be corrected.
Why are there price changes only if there is new information?
Immediate Reaction to New Information: When new information comes to light—such as an earnings report, regulatory changes, or a shift in macroeconomic conditions—the price of the affected securities should immediately adjust to reflect this information.
Price Adjustment: This is the essence of price efficiency: new information leads to price changes, and as soon as the information is incorporated into the market, the price settles at a new equilibrium. The faster the market absorbs new data, the more efficient it is considered to be.
Example: If a company announces a groundbreaking new product, its stock price will rise almost immediately to reflect this information, as investors anticipate future profits from the new product. Conversely, if the company faces a scandal or legal issue, the stock price will fall as the market reflects the potential negative impact.
Why if true, you should not be able to earn ‘abnormal’ or ‘excess’ returns
Abnormal or Excess Returns: These refer to returns on an investment that exceed what would be expected based on the risk associated with that investment. In a perfectly efficient market, no investor should be able to consistently outperform the market by using publicly available information.
Why This Happens: Because all information is already reflected in the price of securities, any attempt to find undervalued or overvalued stocks (or other assets) would be futile. Any new information or changes in the market would already be incorporated into the price as soon as it becomes available. As such, an investor cannot expect to achieve returns that consistently beat the market (often referred to as “alpha”) unless they take on greater risk.
Implications: If the market is truly efficient, active stock-picking strategies, like trying to identify undervalued stocks or timing the market, should not be able to consistently generate “excess” returns. The only way an investor might earn a higher return would be by accepting higher levels of risk. This is why passive investment strategies (e.g., index funds) are often seen as a more reasonable approach in efficient markets, as they don’t attempt to “beat the market” but instead aim to match the overall market’s performance.
What type of efficiency is it when securities are efficient if the prices incorporate all available information
informational efficiency
What does it mean when securities are ‘fairly’ priced?
no securities are underpriced or overpriced
expected return = required return
What is the efficient market reaction?
the price instantaneously adjusts to and fully reflects new information
when new information (such as a company’s earnings report, a new product launch, or a change in government policy) becomes available, the market reacts immediately
Why does the efficient market reaction happen?
efficient markets ensure that all relevant information is incorporated into prices right away because investors rapidly process and respond to new data. Thus, there is no opportunity for investors to profit from publicly available information after it’s released
Example of efficient market reaction
If a company announces a breakthrough in its research and development, the stock price will rise immediately to reflect the positive impact of this news. Investors who react to the information right after its release will see the price move in real-time.
What is the delayed reaction?
In an inefficient market, the reaction to new information is not immediate. Instead, the stock price reacts slowly and only partially adjusts at first. Over a period of time (in this case, eight days), the price continues to adjust until it fully incorporates the new information
Why does the delayed market reaction happen?
The market may take time to fully understand the implications of the new information, or there might be uncertainty, misinterpretation, or lack of awareness among investors. Sometimes, certain market participants may not act quickly enough, and the full effect of the news takes time to spread across the market
How does the delayed reaction impact investors?
Investors who react early in the process may be able to take advantage of this delayed reaction, profiting from the price increase before the full adjustment occurs. However, this opportunity is only available because the market is inefficient.
Example of delayed reaction
If a company announces new plans to expand into an international market, it might take several days for investors to fully grasp the potential impact, leading to gradual price increases as more information becomes clear or as investors adjust their expectations over time.
What is overreaction?
the price over adjusts to the new information and subsequently corrects
After the initial overreaction, the price will eventually correct itself as the market recalibrates and reflects the true value of the information. This overreaction can be due to factors such as emotional responses, irrational investor behaviour, or excessive speculation in the short term
Why does an overreaction happen?
Investors may be overly optimistic or pessimistic about the new information, leading to extreme price movements. Over time, as more investors process the news and the reality sets in, the price corrects back to a more reasonable level.
How does an overreaction impact investors?
If an investor can identify when the market is overreacting, they might be able to profit by betting on the eventual correction (buying after the overreaction if the price falls too far, or selling if it rises too much).
Example of overreaction
A company reports a minor issue in its production line, but the stock price falls sharply because investors panic. However, after a few days, it becomes clear that the issue is not as significant as initially feared, and the price rises back to its original level or even higher, once the correction happens.
What makes markets efficient?
Market efficiency is driven by the actions of investors who constantly analyse and trade based on new information.
if investors stop researching or trading securities, then the markets will not be efficient
How are markets efficient from research?
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
What are the different levels of the efficient market hypothesis?
most basic level - weak form market efficiency
mid level form - semi strong form market efficiency
most extreme level - strong for efficiency
What is weak form efficiency?
prices reflect all past market information such as historical prices and trading volume
if true, then investors cannot earn abnormal returns by trading on market information
What does weak form efficiency imply?
implies that technical analysis will not lead to abnormal returns
empirical evidence indicates that markets are generally weak form efficient
Why does empirical evidence support weak form efficiency?
Many studies have found that past price data cannot be used to systematically outperform the market, providing evidence that most markets are at least weak form efficient.
The lack of consistent success among technical traders and trend-following strategies suggests that historical price movements do not provide a reliable edge in trading
Why is technical analysis ineffective in weak form efficiency?
Technical analysis is a trading strategy that uses historical price movements, trends, and chart patterns to predict future prices.
If markets are weak form efficient, then technical analysis should not work because price movements are random and do not follow predictable patterns.
Since all past price data is already reflected in current prices, traders cannot gain an advantage by analysing charts or past trends
What is semi-strong form efficiency?
prices reflect all publicly available
information including: trading information, company annual reports, press releases, government policies, economic reports etc
if true then investors cannot earn abnormal returns by trading on public information
Why cannot investors earn abnormal profits by trading on public information (semi strong efficiency)?
If the market is semi-strong efficient, then trading based on earnings reports, news, or financial analysis does not provide a consistent edge.
Any strategy that relies on public information is ineffective because the market has already priced in this data before an investor can act on it.
Why is fundamental analysis ineffective in semi strong efficiency?
that fundamental analysis will not lead to abnormal returnsFundamental analysis involves studying financial statements, earnings reports, industry trends, and economic conditions to estimate a stock’s intrinsic value.
If markets are semi-strong efficient, then fundamental analysis will not consistently result in excess returns, because all publicly available information is already embedded in stock prices.
This means investors cannot “beat the market” by analysing financial statements, as the market has already factored this information into the current price.
What is strong form efficiency?
prices reflect all information, including public and private, undisclosed information such as:
insider knowledge (eg upcoming mergers, financial results before public release), government decisions before official announcements, non-public company reports
if true, then investors cannot earn abnormal returns regardless of the information they possess
Why can no one earn abnormal returns, even with insider information, strong form efficiency?
If strong form efficiency were true, then not even corporate executives, insiders, or government officials with access to non-public information could consistently earn excess returns.
Since all information (public and private) is already reflected in the price, no investor could gain an advantage—making even insider trading useless.
What does strong form efficiency indicate?
empirical evidence indicates that markets are not strong form efficient
insiders can earn abnormal returns
How does empirical evidence suggest markets are not strong form efficient?
Research shows that individuals with access to inside information (such as corporate executives or government officials) can and do earn excess returns, proving that markets are not strong form efficient.
Insiders can make profits because private information is not immediately incorporated into stock prices.
If markets were strong form efficient, insider trading wouldn’t be profitable, but studies show that insiders consistently earn higher returns compared to regular investors
Why should insider trading be banned (strong form efficiency)?
Unfair Advantage: Insiders have access to privileged information that regular investors do not, creating an uneven playing field.
Erodes Market Trust: If investors believe that the market is rigged in favour of insiders, they may lose confidence, reducing market participation and liquidity.
Legal and Ethical Issues: Many countries consider insider trading illegal and unethical, as it involves profiting from information that is not available to the public.
Why should insider trading not be banned (strong form efficiency)?
Prices Would Reflect All Information Faster: If insiders were allowed to trade freely, stock prices might adjust more quickly to reflect new private information, making markets more efficient.
Difficult to Enforce: Despite strict laws, insider trading still occurs, and it is challenging to detect and regulate every instance.
Some View It as a Legitimate Reward: Some argue that insiders deserve to profit from their knowledge because they are taking risks and contributing to company success.
What are common misconceptions about the efficient market hypothesis?
efficient markets dont imply that investors cannot earn a positive return in the stock market
A common mistake is assuming that if markets are efficient, investors cannot make money—this is false.
In reality, investors can still earn positive returns, but these returns are in line with the risk they take.
The EMH simply states that you cannot consistently earn “excess” returns (returns above what is justified by the level of risk taken) using publicly available information.
What does the efficient market hypothesis mean in terms of return?
on average, you will earn a return appropriate for the risk undertaken
the return you receive will be fair given the level of risk you assumed
market efficiency will not protect you from wrong choices if you dont diversify
Why is there no bias in prices that can be exploited for excess returns (EMH)?
if markets are efficient, then stock prices do not have predictable patterns that allow investors to consistently outperform the market.
Neither technical analysis (past price trends) nor fundamental analysis (financial statements, earnings reports) will help an investor systematically beat the market.
The only way to earn higher returns is by taking on more risk, not by finding mispriced stocks.
Why does market efficiency not protect you from bad investment decisions?
Even in an efficient market, diversification is still important.
If you put all your money into one stock (even if the market is efficient), you are exposed to company-specific risk, and a bad choice could wipe out your investment.
Market efficiency does not prevent individual stock losses—it simply means that prices are fair given the available information.
What are lessons from history about market efficiency?
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
Why do stock prices respond very quickly to new information?
Historical events, such as earnings reports, economic data releases, or major company announcements, show that stock prices adjust almost instantly once new information is made public.
Examples:
In 2020, when Pfizer announced positive vaccine trial results, its stock price jumped immediately—there was no delay for investors to take advantage of the news.
When companies announce earnings surprises (positive or negative), stock prices react almost instantly after the announcement.
Lesson: By the time you hear breaking news, the market has likely already adjusted, making it impossible to profit from publicly available information.
Why are stock prices in the near future very difficult to predict?
Many investors try to time the market, believing they can buy low and sell high. However, history shows that short-term price movements are highly unpredictable.
Examples:
Even professional investors struggle—most hedge funds and actively managed mutual funds fail to outperform the market consistently.
Market crashes (like the 2008 financial crisis or the 2020 COVID-19 crash) were not consistently predicted, even by experts.
Lesson: Timing the market is extremely difficult, and even professionals get it wrong.
How are there very underpriced or overpriced stocks (and cannot reliably spot them)?
Occasionally, markets misprice stocks, but it is nearly impossible to identify them before everyone else does.
Many investors think they have found “cheap” or “overvalued” stocks, but in most cases, their assumptions are already reflected in the price.
Bubble examples:
Dot-com bubble (1999-2000) – Many technology stocks were overvalued, but spotting the exact peak before the crash was nearly impossible.
GameStop (2021) – Some traders believed it was undervalued, while others saw it as an overhyped “meme stock.” Prices fluctuated wildly, proving how unpredictable markets can be.
Lesson: While mispriced stocks exist, it’s nearly impossible to consistently identify them before the market corrects itself.
