Introduction to Finance: Class 7

Introduction to Finance: Class 7

August 12, 2014 Investor Education, Introduction Course
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(Last Updated On: November 18, 2015)

Introduction to Finance: Class 7

Lessons from Capital Market History


What is a capital market?

Capital markets channel savings and investment between suppliers of capital such as retail investors and institutional investors, and users of capital like businesses, government and individuals. Capital markets are vital to the functioning of an economy, since capital is a critical component for generating economic output. Capital markets include primary markets, where new stock and bond issues are sold to investors, and secondary markets, which trade existing securities.  Source 

Capital Market Video

  · · · · · Key Concepts:

  • Importance of Financial Markets
  • Return on Investments
  • Historical Returns on Investments
  • Risks of Investments
  • Historical Risks of Investments

 

Importance of Financial Markets


  • Financial markets allow companies, governments, and individuals to increase their utility
    • Savers have the ability to invest in financial assets so they can defer consumption and earn a return to compensate them for doing so
    • Borrowers have better access to the capital that is available, allowing them to invest in productive assets
  • Financial markets also provide us with information about the returns that are required for various levels of risk
  • We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets
  • Lessons from capital market history:
    • There is a reward for bearing risk
    • The greater the risk, the greater the potential reward
    • This is called the risk-return trade-off

Return on Investments


ROI Video

Dollar Returns

  • Total dollar return = income from investment + capital gain (loss) due to change in price
  • Example:
    • You bought a bond for $950 one year ago. You have received two coupons of $30 each. You can sell the bond for $975 today.
    • What is your total dollar return?
      • Income = $30 + $30 = $60
      • Capital gain = $975 – $950 = $25
      • Total dollar return = $60 + $25 = $85

Percentage Returns

  • It is generally more intuitive to think in terms of percentages than dollar returns
  • Dividend yield = income / beginning price
  • Capital gains yield = (ending price – beginning price) / beginning price
  • Total percentage return = dividend yield + capital gains yield

Example: Calculating Returns

  • You bought a stock for $35 and you received a dividend of $1.25. The stock is now selling for $40.
    • What is your dollar return?
      • Dollar return = 1.25 + (40 – 35) = $6.25
    • What is your percentage return?
      • Dividend yield = 1.25 / 35 = 3.57%
      • Capital gains yield = (40 – 35) / 35 = 14.29%
      • Total percentage return = 3.57 + 14.29 = 17.86%
      • Total percentage return = ($6.25 / 35) = 17.86%

 


Mean (Average) Returns

  • The mean (arithmetic average) return is a measure of the “center” of a distribution of returns.
  • The mean allows you to summarize a series of returns into one number
  • Calculating average returns: Untitled

Example:

  • Krispy Kreme had year-end stock prices of:
    • $20.75 (2000)
    • $44.20 (2001)
    • $33.77 (2002)
    • $36.60 (2003)
    • $12.60 (2004)
    • $5.74 (2005)
  • What was the mean percentage return of Krispy Kreme from 2001-2005 (ignoring any dividends)?

Screen Shot 2014-07-25 at 8.06.34 PM

 
 

Historical Returns on Investments


Untitled Screen Shot 2014-07-25 at 8.08.51 PM

Risks of Investments


What is a risk?

  • In finance we define risk as the chance that something other than what is expected occurs → variability of returns
  • An investment is risky if more than one future outcome is possible—that is, there are two or more possible payoffs associated with the investment
  • A probability distribution summarizes each possible outcome along with the chance, or probability, that outcome will occur
  • One estimate of the riskiness of an investment is the variance of the returns

Variance & Standard Deviation

  • We use variance (and standard deviation) to measure the volatility of asset returns
  • Variance:Untitled
  • Standard deviation:Untitled1

Example: Screen Shot 2014-07-25 at 8.18.59 PM

  • Variance = Sum of Square Deviations / (# of Observations – 1)
  • Variance = 2.056 / (5 – 1)
  • Variance = 0.514
  • Standard Deviation = Square Root of Variance
  • Standard Deviation = √0.514 = 0.514^(1/2)
  • Standard Deviation = 0.717
  • Standard Deviation = 71.7%

 


Probability Distributions

  • Probability distributions graphically represent the expected return and the variability of the return

Untitled

  • Normal Distribution

Untitled


Arithmetic vs. Geometric Mean

  • Arithmetic average – return earned in an average period over multiple periods
  • Geometric average – average compound return per period over multiple periods

Untitled

  • Which is better?
    • The arithmetic average is overly optimistic for long horizons
    • The geometric average is overly pessimistic for short horizons
    • So the answer depends on the planning period under consideration (some rules of thumb below)
      • 15 – 20 years or less: use arithmetic
      • 20 – 40 years or so: split the difference between them
      • 40 + years: use the geometric

Example:

  • What are the arithmetic and geometric averages for the following returns?
    • Year 1:  5%
    • Year 2:  -3%
    • Year 3:  12%
  • Arithmetic average = (5 + (–3) + 12)/3
  • Arithmetic average = 4.67%
  • Geometric average = [(1+.05) x (1-.03) x (1+.12)]^(1/3) – 1
  • Geometric average = .0449 = 4.49%

 


Risk Premiums

  • The “extra” return earned for taking on risk
  • Treasury bills are considered to be risk-free
  • The risk premium is the return over and above the risk-free rate
  • RP = r – rRF

Historical Risks of Investments


  • U.S. Treasury Bills: 3.8 – 3.8 = 0 (by definition!)
  • Large Stocks: 12.3 – 3.8 = 8.5%
  • Small Stocks: 17.4 – 3.8 = 13.6%
  • Long-term Corporate Bonds: 6.2 – 3.8 = 2.4%
  • Long-term Government Bonds: 5.8 – 3.8 = 2.0%

· · · · ·

 Test Your Knowledge (answers found below)
  • Your stock investments return 8%, 12%, and -4% in consecutive years. What are the arithmetic and geometric mean returns?
  • What is the standard deviation of the above returns?
  • Using the standard deviation and mean that you just calculated, and assuming a normal probability distribution, what is the probability of losing 3% or more?
 
 

Wrap-Up


  • Financial market returns help us determine the appropriate returns on non-financial assets
  • Risky investments earn a risk premium
  • The greater the potential reward, the greater is the risk

· · · · ·

Solutions

  • Stock investments return: 8%, 12%, and -4%. What are the arithmetic and geometric mean returns?
    • Arithmetic = (8% + 12% – 4%) / 3
    • Arithmetic = 5.33%
  • Geometric = (1.08 x 1.12 x 0.96)^(1/3) – 1
  • Geometric = 5.11%
  • What is the standard deviation of the above returns?
    • Variance = [(8-5.33)^2 + (12-5.33)^2 + (-4-5.33)^2] / (3–1)
    • Variance = 69.35
    • Standard deviation = (69.35)^(1/2)
    • Standard deviation = 8.33%
  • Using the standard deviation and mean that you just calculated, and assuming a normal probability distribution, what is the probability of losing 3% or more?
    • A 3% loss (return of -3%) lies one standard deviation below the mean.
    • -3% = 5.33% – (1 x 8.33%)
    • There is 16% of the probability falling below that point
      • 68% falls between -3% and 13.66% (+/- 1σ)
      • So 16% lies below -3% and 16% lies above 13.66%

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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Victoria Tran

Ms. Tran is an undergraduate student at Drexel University’s LeBow College of Business, where she is pursuing her B.S. in Economics and Finance. As part of the STAR Scholars program at Drexel, she is working with Dr. Gray in undertaking Alpha Architect’s mission in empowering investors through education. With her work in the blog series on the introductory courses of finance, she aims to compile and provide the fundamentals of finance for readers. Besides from her involvement with STAR Scholars, Ms. Tran is an active member of the Delta Zeta Sorority, Drexel’s Student Activity Fee Allocation Committee, and Drexel’s Peer Leader program—among other organizations.