Lectures Notes Finance first semester, Study notes of Economics

Download Lectures Notes Finance first semester and more Study notes Economics in PDF only on Docsity! Capital Markets and the Pricing of Risk Stocks are riskier than bonds → higher returns → the higher the risk, the higher the opportunity cost of capital Small stocks very valuable but also in SR very variable Probability distribution: assigning a probability Pr to each possible return R Expected return = E[R] = sum of PrxR Variance of the return distribution = sum of Pr x (R-E[R])^2 Standard deviation (volatility) of the return distribution = SD(R)=Var(R)^0.5 Realized return (that actually occurs) = Rt+1 = Dividend yield + Capital gain rate = (DIVt+1 / P) + ((Pt+1-Pt) / Pt) Reinvesting all dividends immediately and use them to purchase additional shares of the same stock/ security then 1+R = (1+Q1).x...(1+Qn), with Qn is return each time period Empirical distribution: plotting probabilities by their returns and how many years these returns occured Average Annual Return of a Security=R^=1/T (the sum of all R’s) Variance Estimate Using Realized R BUT: we do not know what investors expected in the past; we can only observe the actual returns that were realized. And the average return is just an estimate of the true expected return, and is subject to estimation error. Standard error of the estimate of the expected return: the standard deviation of the average return (the estimated value of the mean of the actual distribution around its true value) SD(Average of independent, identical risks)= SD(individual risk) / number of observations ^0.5 95% confidence interval = historical average return +/- (2 x standard error) BUT: individual stocks vary, and we have little data Excess return: difference between average return for investment and average return T bills (measures the risk premium) Volatility is okay for measuring risk of large portfolios but not for individual securities Common risk: earthquake, affects all houses at the same time Independent risk: theft, uncorrelated between the houses Diversification: averaging out of independent risk in a large portfolio (earthquakes are riskier than thefts) Firm-specific news: about the company itself (independent, firm-specific, idiosyncratic, unique, and diversifiable) risk → this risk decreases when the number of firms increase (volatility declines) Market-wide news: about the economy as a whole (systematic, undiversifiable, market) risk Investing in a competitive market with firms with I independent risk → no risk premium! (or temporarily arbitrage opportunity because of small risk) The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm- specific risk (risk premium is not affected by firm-specific risk)