Lecture Essentials of corporate finance (2/e) – Chapter 10: Some lessons from capital market history

This lecture introduces you to some lessons from capital market history. After completing this unit, you should be able to: Know how to calculate the return on an investment, understand the historical returns on various types of investments, understand the historical risks on various types of investments.

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Some lessons from capital

market history

Chapter 10

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Key concepts and skills

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.

Slides prepared by David E Allen and Abhay K Singh

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Chapter outline

• Returns

• The historical record

• Average returns: The first lesson

• The variability of returns: The second

lesson

• More on average returns

• Capital market efficiency

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Risk, return and financial

• Lessons from capital market history:

– There is a reward for bearing risk.

– The greater the potential reward, the

greater the risk.

– This is called the risk–return trade-off.

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Dollar returns

• Total dollar return = the return on an

investment measured in dollars.

• $ return = Dividends + Capital gains

• Capital gains = Price received – Price paid

• Example:

– You bought a bond for $950 one year ago You

have received two coupons of $30 each You can sell the bond for $975 today What is your total

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Percentage returns

• It is generally more intuitive to think in

terms of percentages than dollar

returns.

• Total percentage return = the return on

an investment measured as a

percentage of the original investment.

– % return = $ return/$ invested

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Percentage returns (cont.)

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t

t t

t

t t

P

P P

D

CGY DY

P

P CGY

P

D DY

1 1

Return

%

Return

%

Yield Gains

Capital

Yield Dividend

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• Each share paid a $2 dividend.

• What was your total return?

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Dollars Percentage

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Quarter-by-quarter returns

• All Ordinaries Index—Figure 10.5

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Quarter-by-quarter returns

(cont.)

• Cash—Figure 10.7

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Quarter-by-quarter inflation

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Historical average returns

• Historical average return = simple, or

arithmetic, average

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T

return

yearly Return

Average Historical

T

1 i

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Average returns: The first

lesson 1985–2009

Investment Average Return

All Ordinaries Index 13.3%

10-year government bonds 9.7%

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– Excess return on a risky asset over

the risk-free rate

– Reward for bearing risk (the first

lesson)

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Historical risk premiums

Investment Average return Risk premium

All Ordinaries Index 13.3% 3.3%

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Return variability review

– Square root of the variance

– Sometimes called volatility

– Same ‘units’ as the average

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1 T

R

R σ

VAR(R)

T

1 i

2 i

2

VAR(R) σ

SD(R)

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Example: Calculating historical

variance and standard deviation

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Example: Work the Web

• How volatile are mutual funds?

• Standard deviations are widely reported

for mutual funds.

• iShares MSCI Australia Index Fund is a

mutual fund, based in the United States,

and set up to provide investors with

results similar to an investment in the

Australian share market.

• Click on the information icon, which takes you to < http://moneycentral.msn.com > for the quote of iShares MSCI Index.

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Return variability review and

concepts

• Normal distribution

– A symmetric frequency distribution

– The ‘bell-shaped curve’

– Completely described by the mean

and variance

• Does a normal distribution describe asset returns?

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The normal distribution

Figure 10.11

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– Answers the question: ‘What was your return in an

average year over a particular period?’

• Geometric average

– Average compound return per period over multiple

periods

– Answers the question: ‘What was your average

compound return per year over a particular period?’

• Geometric average < arithmetic average, unless all the returns are equal.

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Geometric average return:

Formula

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1 1

1

1 R 1 ) ( R 2 ) ( R N) 1 /T (

GAR

Where:

Π = product (like Σ for sum)

Ri = return in each period

T = number of periods

Equation 10.4 1

) 1

(

/ 1

1

T T

i

R GAR

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Calculating a geometric

average return—Example 10.4

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(1.4870)^(1/8):

Geometric Average Return:

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Arithmetic vs geometric mean

Which is better?

• The arithmetic average is overly optimistic for long horizons.

• The geometric average is overly

pessimistic for short horizons.

• Depends on the planning period under

consideration

– 15–20 years or less: use arithmetic average

– 20–40 years or thereabouts: split the

difference between them

– 40 + years: use the geometric average

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Efficient capital markets

• The efficient market hypothesis

– Stock prices are in equilibrium

– Stocks are ‘fairly’ priced

– Informational efficiency

• If true, you should not be able to earn

‘abnormal’ or ‘excess’ returns.

• Efficient markets DO NOT imply that

investors cannot earn a positive return

on the stock market.

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Reaction of stock price to new

information in efficient and inefficient

markets Figure 10.12

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What makes markets

made based on this information.

– Therefore, prices should reflect all

available public information.

• If investors stop researching share

prices, the market will no longer be

efficient.

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Common misconceptions

about EMH

• EMH does not mean that you can’t make

money.

• EMH does mean that:

– on average, you will earn a return appropriate for

– there is no bias in prices that can be exploited to

earn excess returns – market efficiency will not protect you from wrong

choices if you do not diversify—you still don’t want to put all your eggs in one basket

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Forms of market efficiency

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Strong-form efficiency

• Prices reflect all information, including

public and private.

• If the market were strong-form efficient, investors could not earn abnormal

returns regardless of the information

they possessed.

• Empirical evidence indicates that

markets are NOT strong-form efficient

and that insiders can earn abnormal

returns.

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Semistrong-form efficiency

• Prices reflect all publicly available

information, including trading

information, annual reports and press

releases.

• If the market is semistrong-form

efficient, investors cannot earn

abnormal returns by trading on public

information.

• Implies that fundamental analysis will

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Weak-form efficiency

• Prices reflect all past market

information such as price and volume.

• If the market is weak-form efficient,

investors cannot earn abnormal returns

by trading on market information.

• Implies that technical analysis will not

lead to abnormal returns.

• Empirical evidence indicates that

markets are generally weak-form

efficient.

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Quick quiz

• Which of the investments discussed

have had the highest average return

and risk premium?

• Which of the investments discussed

have had the highest standard

deviation?

• What is capital market efficiency?

• What are the three forms of market

efficiency?

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Chapter 10

END

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