FIN 3403 – Unit 10: Risk, Return, and Financial Markets

Risk-Return Trade-Off

The greater the potential return on an investment, the greater the risk you generally must take.

Risk

The uncertainty of an investment's actual return. Higher risk means returns are less predictable.

Return

The money gained or lost from an investment.

Total Dollar Return

The total money earned from an investment, including income and any increase or decrease in its price.

Investment Income

Money received from owning an investment, such as dividends from stocks or coupon payments from bonds.

Capital Gain

When an investment's selling price is higher than its original purchase price.

Capital Loss

When an investment's selling price is lower than its original purchase price.

Percentage Return

The total investment gain or loss expressed as a percentage of the beginning investment price.

Dividend Yield

The percentage return earned from dividends relative to the stock's beginning price.

Formula: Dividend ÷ Beginning Stock Price

Capital Gains Yield

The percentage return from an increase or decrease in an investment's price.

Formula: (Ending Price − Beginning Price) ÷ Beginning Price

Total Percentage Return

The total return earned from investment income and price changes.

Formula: Dividend Yield + Capital Gains Yield

Historical Returns

Past investment returns used to understand how investments have performed and how risky they may be.

Average Return

The typical return an investment earned over a period of time.

Risk Premium

The extra return investors earn or expect for taking risk instead of investing in a risk-free asset.

Formula: Average Return − Risk-Free Rate

Risk-Free Rate

The return on an investment considered to have essentially no default risk. Treasury bills are commonly used as the risk-free benchmark.

U.S. Treasury Bills (T-Bills)

Short-term government securities considered nearly risk-free. They generally offer lower returns than risky stocks.

Large-Company Stocks

Stocks of large, established businesses. Generally less risky than small-company stocks, but still subject to significant market risk.

Small-Company Stocks

Stocks of smaller businesses that generally have higher risk and higher potential returns than large-company stocks.

Corporate Bonds

Debt issued by companies. Investors receive interest, but face the possibility that the company may fail to repay.

Government Bonds

Debt issued by governments. U.S. Treasury bonds have very low default risk but still face interest-rate risk.

Inflation

The increase in the general price level over time, reducing the purchasing power of money.

Lessons from Capital Market History

Investors generally require higher expected returns for taking greater risk. Higher potential rewards come with greater uncertainty.

Volatility

How much an investment's returns fluctuate over time. Greater volatility means greater uncertainty.

Variance

A measure of how spread out investment returns are from their average. Higher variance indicates greater volatility.

Standard Deviation (SD)

Measures how much returns typically vary from their average. Higher standard deviation means greater risk or volatility.

Formula: Standard Deviation = √Variance

Variance vs. Standard Deviation

Both measure volatility. Variance uses squared deviations, while standard deviation expresses volatility in the same units as returns.

Higher Standard Deviation

Indicates returns are more spread out, meaning greater volatility and uncertainty.

Lower Standard Deviation

Indicates returns are closer to their average, meaning less volatility and more consistency.

Frequency Distribution

A graph showing how often different investment returns occurred.

Normal Distribution

A bell-shaped distribution where most returns are near the average and extreme returns occur less frequently.

The 68–95–99.7 Rule

For a normal distribution:

• About 68% of returns fall within 1 standard deviation of the average.

• About 95% fall within 2 standard deviations.

• About 99.7% fall within 3 standard deviations.

Lower Range (LR)

The lower boundary of a return range based on the average and standard deviation.

Formula: Average Return − (Number of SDs × SD)

Upper Range (UR)

The upper boundary of a return range based on the average and standard deviation.

Formula: Average Return + (Number of SDs × SD)

Arithmetic Average Return

The simple average return earned per period. Add all returns and divide by the number of periods.

Formula: Sum of Returns ÷ Number of Periods

Geometric Average Return

The average compound return earned per period over multiple periods. It accounts for the effect of compounding.

Arithmetic vs. Geometric Average

Arithmetic measures the simple average of periodic returns. Geometric measures the compound growth rate over time.

Which Average Is Usually Higher?

The arithmetic average is greater than or equal to the geometric average. They are equal when all periodic returns are identical.

Compounding

When investment gains remain invested and future returns are earned on both the original investment and accumulated gains.

Why Is the Geometric Average Usually Lower?

Because fluctuations in returns reduce compound growth compared with the simple arithmetic average.

Efficient Market

A market where stock prices quickly and accurately reflect available information, making stocks fairly priced based on that information.

Efficient Market Hypothesis (EMH)

The idea that stock prices reflect available information, making it difficult to consistently earn abnormal returns using that information.

Fairly Priced Stock

A stock whose market price reflects the information available to investors.

Abnormal Return (Excess Return)

A return greater than what is appropriate for the investment's level of risk.

Efficient Market Reaction

Stock prices adjust immediately and fully to new information, without predictable further price changes caused by that same information.

Delayed Reaction

Stock prices adjust slowly to new information rather than reflecting it immediately.

Overreaction and Correction

When stock prices initially move too far in response to new information and later move back toward their appropriate value.

What Makes Markets Efficient?

Investors research companies, analyze information, and trade stocks. Their trading helps stock prices reflect available information.

Does an Efficient Market Mean Investors Cannot Make Money?

No. Investors can still earn positive returns, but they cannot consistently earn abnormal returns from information already reflected in prices.

Does Market Efficiency Eliminate Risk?

No. Investors can still lose money, and efficient markets do not eliminate investment risk.

Diversification

Spreading investments across different assets to reduce the risk associated with any single investment.

Weak-Form Efficiency

Stock prices reflect all past market information, including historical prices and trading volume.

Technical Analysis

Using historical stock prices, trading volume, and patterns to predict future price movements.

Weak-Form Efficiency and Technical Analysis

If markets are weak-form efficient, technical analysis cannot consistently generate abnormal returns.

Semi strong-Form Efficiency

Stock prices reflect all publicly available information, including past prices, financial reports, and company announcements.

Fundamental Analysis

Examining financial statements, earnings, company performance, and economic information to estimate a stock's value.

Semistrong-Form Efficiency and Fundamental Analysis

If markets are semistrong-form efficient, fundamental analysis of public information cannot consistently generate abnormal returns.

Strong-Form Efficiency

Stock prices reflect all information, including both public and private information.

Private Information (Inside Information)

Important company information that is not available to the general public.

Strong-Form Efficiency and Inside Information

If markets were strong-form efficient, even investors with private information could not earn abnormal returns from it. (Both public and private)

Which Form of Market Efficiency Is Generally Supported by Evidence?

Weak-form efficiency is generally supported. Strong-form efficiency is not supported because private information can provide an advantage.