1. Finance 300 Financial Markets Lecture 1 Professor J. Petry, Fall, 2002© http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/ http://webboard.cites.uiuc.edu/

2. 2 Introduction Economic activity has three principal participants and three principal markets ParticipantsMarkets HouseholdsLabor GovernmentsGoods & services FirmsFinancial Financial markets are the means by which financial assets are priced and traded b/n markets & participants Financial assets represent claims on real assets, they do not produce goods & services directly.

3. 3 Function of Financial Markets Function of Financial Markets (1) Facilitate the transfer of capital from those with excess supply to those with excess demand Increase liquidity through aggregation of supply Reduce transaction costs Thereby greatly expanding the ability of the other markets to function efficiently There are more controversial functions of capital markets...

4. 4 Function of Financial Markets Function of Financial Markets (2) Allocate funds to their most efficient use through the pricing mechanism Provide information about risk Which may only be best understood with a brief look at financial market history...

6. 6 Average Annual Returns: 1926-1997 InvestmentAverage Return Large cap stocks12.83% U.S. Treasury bonds 5.41% U.S. Treasury bills 4.10% Inflation 3.20% Source: © Stocks, Bonds, Bills and Inflation 1998 Yearbook™, Ibbotson Associates, Inc. Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved

7. 7 DatePoint Loss%Loss Oct. 19, 1987508.0022.6% Oct. 28, 1929 38.8812.8% Oct. 29, 1929 30.5711.7% Nov. 6, 1929 25.55 9.9% Dec. 18, 1899 5.57 8.7% Five Largest One-Day Percentage Declines in the Dow-Jones Industrial Average

8. 8 Period% Decline in S&P 500 October 10, 1983 - July 24, 1984-14.4% August 25, 1987 - October 19, 1987-33.2% October 21, 1987 - October 26, 1987-11.9% November 2, 1987 - December 4, 1987-12.4% October 9, 1989 - January 30, 1990-10.2% July 16, 1990 - October 11, 1990-19.9% February 18, 1997 - April 11, 1997- 9.6% The Great Bull Market of 1982 - 1998: “Bumps” Along the Way Adapted from the T. Rowe Price Report, Fall 1997 issue.

9. 9 The S&P, 9/11 in Perspective

10. 10 Risk Premiums & the First Lesson Rate of return on T-bills is essentially risk-free. Investing in stocks is risky. The difference between the return on T-bills and stocks is the risk premium for investing in stocks. This is the additional return we receive for bearing risk, or “There is a reward for bearing risk!”

12. 12 Historical Returns, Standard Deviations, and Frequency Distributions: 1926-1997 Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. –90%+ 90%0% Average Standard Series Annual Return DeviationDistribution Large Company Stocks13.0%20.3% Small Company Stocks17.733.9 Long-Term Corporate Bonds6.18.7 Long-Term Government Bonds5.69.2 U.S. Treasury Bills3.83.2 Inflation3.24.5

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14. 14 Lessons From Market History Risk premiums –The additional compensation we receive for investing in a risky asset. The first lesson –There is a reward for bearing risk. The second lesson –The greater the potential reward, the greater the risk. Bottom-line –The only way to induce investors (those with financial assets) to take on additional risk, is to provide higher returns. Why would anyone invest in a riskier asset if the probable reward wasn’t higher? –Financial markets pool capital and allocate it via the pricing mechanism according the trade-off between risk & reward.

15. 15 Efficient Market Hypothesis We now know what markets are supposed to do, but how well do they really function? Efficient Market. A market is efficient when the price of an asset reflects all information relevant to the asset. This means that the price of an asset must reflect the information, expectations, and risk adjustment of all investors. Efficient Market Hypothesis A market is informationally efficient if prices fully reflect all available relevant information. Efficient markets mean that the expected returns implicit in the price of the security should reflect its risk: there are no abnormal returns. No one can “beat” the market.

16. 16 Efficient Market Hypothesis 3 Forms of Informational Efficiency Weak form Prices fully reflect historical price and trading data. Technical analysis is bologna. Semi-strong form Prices fully reflect all publicly available information. No systematic profit can be earned by analyzing earning reports, management reports, etc. It’s already in prices the second it is announced! Strong form Prices fully reflect all information, whether public or not. Hence there is no systematic profit to be made from insider information.