Security Rates of Return and Capital Market Efficiency

Rate of Return Concepts Dollar return Number of $ received over a period (one year, say) Sum of cash distributed plus capital gain (loss) Percentage return Dollar return/(beginning-of-period value) % cash distribution + % capital gain Real vs. Nominal return Real % return, r, related to nominal % return, R, by: 1+R = (1+r)(1+h)

Other Rate of Return Concepts Expected return Anticipated return on investment (IRR, bond yield) Required return R, discount rate, opportunity cost, cost of capital, minimum acceptable return Realized return After-the-fact return, historical return

Sample Standard Deviation Variance and standard deviation give equal weight to observations above & below mean These make sense as risk measures if the return distribution is symmetrical

Efficient Capital Markets Three equivalent definitions. In an efficient capital market: 1.Security prices = discounted cash flow values (all relevant information reflected in security prices) 2.Expected security return = required return 3.Purchase of a traded security is a zero-NPV transaction

Efficiency is a Matter of Degree Efficiency is a consequence of market competition Factors leading to competition: low entry barriers, low transaction costs A given market falls along the efficiency spectrum Not either-or

Market Efficiency is About Expected and Required Returns Market Efficiency has nothing to do with realized returns “I’d rather be lucky than good” ≠

Implications of Market Efficiency No predictable patterns in security prices (effectiveness of fundamental vs. technical analysis Stock price changes follow a random walk Prices adjust rapidly to new information