Capital Markets Flashcards
(15 cards)
- What are the two parts of total return?
Income (typically from dividends or interest payments)
Capital gains or losses (the change in the value of the investment)
- Why are unrealized capital gains and losses included in the calculation of returns?
Because they represent a change in the value of the investment, which affects your wealth—even if the investment hasn’t been sold yet. Total return reflects all changes in value, realized or not.
- What is the difference between a dollar return and a percentage return? Why are percentage returns more convenient?
Dollar return is the total amount gained or lost in dollars.
Percentage return is the dollar return expressed as a percentage of the initial investment.
Percentage returns are more convenient because they allow for comparison across investments of different sizes.
- Why doesn’t everyone only buy small stocks as investments?
Small stocks tend to be riskier and more volatile than large stocks. Investors must weigh the higher potential return against the higher risk.
- How often did the Treasury Bill (T-Bill) portfolio have a negative return?
T-Bills almost never have a negative return in nominal terms. Negative returns might occur in real terms (after adjusting for inflation), but not often in nominal terms.
- What do we mean by excess return and risk premium?
Excess return: The expected return on an investment above the risk-free rate.
Risk premium: The return earned for taking on additional risk, typically measured as the difference between the return on a risky asset and the risk-free rate.
- What is the difference between the real risk premium and the nominal risk premium? How do we get from nominal to real?
Nominal risk premium: Not adjusted for inflation.
Real risk premium: Adjusted for inflation.
- What is the first lesson from capital market history?
Risk is rewarded: On average, riskier investments (like stocks) yield higher returns over time.
- In your own words, how do we calculate the variance of a set of returns?
Take each return, subtract the average return, square the result, then average those squared differences.
- With a normal distribution (bell curve) what is the probability of ending up more than one standard deviation away from the average?
About 32% (specifically, 68% of outcomes fall within one standard deviation, so the remaining 32% are outside that range).
- What is the second lesson from capital market history?
Greater potential return comes with greater risk and variability. There’s no reward without some uncertainty.
- If you want to forecast what the stock market is going to do over the next year, should you use an arithmetic or geometric average?
Use the arithmetic average for short-term forecasting (like one year) because it reflects the expected return in any given year.
- If you want to forecast what the stock market is going to do over the next century, should you use an arithmetic or geometric average?
Use the geometric average for long-term forecasting because it accounts for compounding over time and gives a more accurate picture of long-term performance.
- What do we mean by an efficient market? Is the NYSE an efficient market?
An efficient market is one where prices fully reflect all available information.
The NYSE is generally considered efficient, especially in the semi-strong form, meaning that all public information is already reflected in stock prices.
- What are the three forms of market efficiency?
Weak-form efficiency: Prices reflect all past market data (e.g., stock prices and volume).
Semi-strong form efficiency: Prices reflect all publicly available information.
Strong-form efficiency: Prices reflect all information, both public and private (i.e., insider information).
