Copyright 2004 McGraw-Hill Australia 10.2 Inflation and Returns 10.3 The Historical Record 10.6 Capital Market Efficiency Chapter Organisation... Copyright 2004 McGraw-Hill Australia
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10.2 Inflation and Returns
10.3 The Historical Record
10.6 Capital Market Efficiency
Chapter Organisation
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• Examine the effect of inflation on returns.
• Gain an appreciation of historical returns and their variability for different assets.
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– capital gain (or loss).
• Not necessary to sell investment to include capital gain or loss in return.
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Beginning market value
Dividends paid at Market value end of period at end of period
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$37.00
$37.00
$40.33
$1.85 Return
Per dollar invested we get 5 cents in dividends and 9
cents in capital gains—a total of 14 cents or a return of
14 per cent.
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Ending market value
t = 1
t
– $37 Time
Percentage Returns
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Inflation and Returns
• Real return is the return after taking out the effects of inflation.
• Nominal return is the return before taking out the effects of inflation.
• The Fisher effect explores the relationship between real
returns (r), nominal returns (R) and inflation (h).
( 1 + R ) ( = 1 + r ) ( × 1 + h )
R ≈ r + h
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Average Equivalent Returns
& Risk Premiums 1978–2002
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Average Returns: The First Lesson
Risky assets on average earn a risk premium (i.e there is a reward for bearing risk).
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deviation Std
0.022181
5
0.08872Variance
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The Historical Record
Conclusion: Historically, the riskier the asset, the
greater the return
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Variability: The Second Lesson
• The greater the risk, the greater the potential reward.
the short term.
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Capital Market Efficiency
of a security accurately reflects all available information.
• Implies also that all securities are fairly priced.
• If this is true then investors cannot earn ‘abnormal’ or
‘excess’ returns.
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Delayed reaction
Efficient market reactionPrice Behaviour in Efficient and
Inefficient Markets
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What Makes Markets Efficient?
• There are many investors out there doing research:
- As new information comes into the market, this information is analysed and trades are made
based on this information
- Therefore, prices should reflect all available
public information
• If investors stop researching stocks, then the
market will not be efficient
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Common misconceptions about EMH
• Efficient markets do not mean that you can’t make money
• They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken and that there is not a bias in prices that can be
exploited to earn excess returns
• Market efficiency will not protect you from making the wrong choices if you do not diversify—you still don’t want to put all your eggs in one basket
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adjusts to and fully reflects new information There
is no tendency for subsequent increases and decreases
new information Several days elapse before the price completely reflects the new information
information It ‘overshoots’ the new price and subsequently corrects itself
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Forms of Market Efficiency
• Weak form efficiency: Current prices reflect information contained in the past series of prices.
• Semi-strong form efficiency: Current prices reflect all publicly available information.
• Strong form efficiency: Current prices reflect all information of every kind.