II.

COMPUTATIONS
FINANCIAL MARKETS
Some Lessons from Capital Market History TOTAL DOLLAR RETURNS

on a non dollar investment, which

Overview of the Handouts: includes the sum of any dividend/interest
income, capital gains or losses, and
1. Risk, Return, and Financial Markets
currency gains or losses on the
2. Computations: Total Dollar Returns
investment.
3. Computations: Percentage Returns
4. Financial Investments Formula: Total Dollar Return = income from
5. Variability of Returns investment + capital gain (loss) due to change to
6. Average Returns price
7. Capital Market Efficiency
8. Notes PROBLEM:

You bought a bond for $800 one year ago.

I. Risk, Return, and Financial Markets You have received two coupons of $70 each.
You can sell the bond for $900 today. What is
Risk-return tradeoff - an investment principle your total dollar return?
that indicates that the higher the risk, the higher
the potential reward. It is said here that there is ● Income = $70 + $70 = $140
a reward for bearing risk. ● Capital gain = $900 - $800 = $100
● Total Dollar Return = $140 + $100 =
● Investors consider this on individual $240
investments and across portfolios when
making investment decisions. III. COMPUTATIONS
HOW RISK-RETURN TRADEOFF ARE PERCENTAGE RETURNS
CALCULATED?
Generally, it is more intuitive to think in terms of
Alpha - measures the risk-adjusted percentages than dollar returns.
returns of a mutual fund scheme against
its underlying benchmark. Formula: Dividend yield = income / beginning
Beta - measures the volatility of the fund price
in line with its underlying benchmark. Capital gains yield = (ending price – beginning
● Higher or positive beta = fund is more price) / beginning price
volatile as compared to its
benchmark. Total percentage return = dividend yield + capital
● Lower or negative beta = volatility is gains yield
lower than the benchmark.
PROBLEM:
Sharpe Ratio - measures the potential
You bought a stock for $60 and you received
returns of a scheme against each unit of
dividends of $2.25. The stock is now selling
risk the scheme has undertaken.
for $85.
Standard deviation - measures the
● What is your dollar return?
individual returns of an investment over
time against its average return for the Dollar Return = $2.25 + ($85 - $60) = $27.25
same period.
● What is your percentage return?
Dividend yield = $2.25 / 60 = 3.75% more useful for long-term periods.
What was your average compound
● DIVIDEND YIELD - expressed as a
return per year over a particular
percentage, is a financial ratio
period?
(dividend/price) that shows how much a
2. Arithmetic Average Return -
company pays out in dividends each year
Return earned in an average year
relative to its stock price.
over a particular period. It is more
Capital gain yield = ($85 - $60) / $60 = 41.67% useful for short-term periods. What
was your return in an average year
● CAPITAL GAINS YIELD - the over a particular period?
percentage price appreciation on an
investment. VII. CAPITAL MARKET EFFICIENCY
Total percentage return = 3.75 + 41.67 = Efficient Capital History – market in
45.42% which security prices reflect available
information.
IV. FINANCIAL INVESTMENTS Efficient Market Hypothesis
● STOCKS - type of security that gives –hypothesis that actual capital markets
stockholders a share of ownership in a are efficient.
company.
● BONDS - are debt instruments in which TYPES OF MARKET EFFICIENCY
the authorized issuer owes the bond ✔ Efficient Market Reaction - price
holders a debt. instantaneously adjusts to and fully
● TREASURY BILLS - a short-term debt reflects new information; there is no
obligation issued by the U.S. Treasury tendency for subsequent increases and
and backed by the U.S. government with decreases.
a maturity of less than one year. ✔ Delayed Reaction - price partially
adjusts to the new information; eight
V. VARIABILITY OF RETURNS days elapse before the price completely
● FREQUENCY DISTRIBUTION – reflects the new information.
number of instances in which a ✔ Overreaction and correction - price
variable takes each of its possible over-adjusts to the new information; it
values. overshoots the new price and
● VARIANCE – average squared subsequently corrects.
difference between the actual return
and the average return. FORMS OF MARKET EFFICIENCY
● STANDARD DEVIATION – positive
✔ Strong Form Efficiency – All
square root of the variance.
information of every kind is reflected in
● NORMAL DISTRIBUTION (BELL
stock prices.
CURVE) - symmetric, bell-shaped
✔ Semi-strong Form Efficiency – All
frequency distribution that is
public information is reflected in the stock
completely defined by its average
price.
and standard deviation.
✔ Weak Form Efficiency – The current
price of a stock reflects its own past
VI. Average Returns
prices.
1. Geometric Average Return -
VIII. NOTES
Average compound return earned per
✔ Risk Premium – return over and above
year over a multiyear period. It is
the risk-free rate.
✔ When stocks are in equilibrium, they
are fairly priced