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Sources of Return on the Purchase of Stock
- Cash (dividends)
- Capital Gains
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Sources of Return on the Purchase of Bonds
- Cash (Coupons)
- Capital Gains
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Lessons from History
- 1. Stocks have the highest return over the long run
- The most profitable have been small cap stocks2. Stocks have the highest riskThe riskiest have been small cap stocks again
- The least risky investment:Treasury bills are considered risk free investments because they have backing of govt.
- 2nd Lesson
- 3. Higher returns come with higher risk
- risk premium is the extra return a risky investment offers over the risk-free rate
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Return Volatility
(Proxy for risk) How comfortable will you be if you invest in something in which the price chances every day - sometimes not the way you want it to change
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Axioms of Finance
- Investor prefer more to less
- Financial markets are competitive
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Efficience Markets Hypothesis
- Also called "Price is Right"
- A market in which stock prices fully reflect all available info
- EMH argues that info is immediatly incorporated into prices. Once info becomes available analyze it
- Misconception: doesnt mean that it doesnt make a difference how you invest, since the risk/return trade-off still applies, but rather that you can't expect to consistently "beat the market" on a risk-adjusted basis using costless trading strategies
- Price fluctuations are evidence that the market is efficient since new info is constantly arriving-prices that dont change are evidence of inefficiency
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Portfolio
collection of assets(combination of stocks, bonds, cash, etc.)
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Total Risk in a Stock
- Firm Specific + Market
- 1. Firm-Specific risk (unsystematic): also called diversifiable riskThese are company specific
- 2. Market risk (systematic): also called non diversifiable risk
- Affects all securities in the market. changes in interest rates and unemployment, terrist attack, hurricane, etc.
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Beta
- A measurement of systematic risk
- Beta is a number that measures the systematic (market) risk in a stock. It is related to how the stock's return in correlated with the return on the market
- Beta of the market is assumed to be 1
- B>1 indicates the company is riskier
- B=1 indicates equal risk
- B<1 indicates less risky
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Treynor Index
- Reward-to-Risk ratio that us a measure of how much return is obtained by bearing one unit of risk (variability)
- E(R)-Risk free rate/Beta
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Capital Asset Pricing Model
- CAPM
- In equilibrium, we can formulate a relation between systematic risk and expected returns
- E(R)=Rf+Bi(E(Rm)-Rf)
- Risk-free rate- the pure time value of money
- Market risk premium- the reward for bearing systematic risk
- The beta coefficient- a measure of the amount of systematic risk present in a particular asset
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Security Market Line
- SML
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Cost of capital
- Finance deals withhow corporations raise funds (capital structure) andhow they use these funds to make profits and maximize shareholders' worth (capital budgeting)
- The following all mean the same thing
- Required return
- Appropriate discout rate
- Cost of capital
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Percentage Returns for Stocks
- Dividend Yield= D(t+1)/PtCapital Gains Yield= (Pt+1Pt)/Pt
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Forms of Market Efficiency
- Weak form efficiency: A form of the theory that suggests you can't beat the market by knowing past prices.
- Semi-strong form efficiency: Perhaps the most controversial form of the theory, it suggests you can't consistently beat the market using publicly available information. That is, you can't win knowing what everyone else knows.
- Strong form efficiency: The form of the theory that states no information of any kind can be used to beat the market. Evidence shows this form does not hold.
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Capital market history and the EMH
- Casual evidence and empirical observation suggest the following statements are true.
- Prices respond very rapidly to new information.
- Future prices are difficult to predict.
- Mispriced stocks (those whose future price level can be predicted accurately) are difficult to identify and exploit on a consistent basis. (Note: the key here is consistency: anyone can "get lucky" at stock-picking, just as anyone can get lucky at the craps table. The important question is: can they do it time and time again?)
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