Some lessons from capital market history Chapter 10.
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Transcript of Some lessons from capital market history Chapter 10.
Some lessons from capital market history
Chapter 10
Key concepts and skills
Understand:– how to calculate the return on an
investment– the historical returns on various types of
investments– the historical risks of various types of
investments– the implications of market efficiency
10-2 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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
10-3 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Risk, return and financial markets
• We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets.
• 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.
10-4 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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 dollar return?
• Income = 30 + 30 = $60• Capital gain = 975 – 950 = $25• Total dollar return = 60 + 25 = $85
10-5 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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
10-6 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Percentage returns (cont.)
10-7 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
t
ttt
t
tt
t
t
P
PPD
CGYDY
P
PPCGY
P
DDY
11
1
1
Return%
Return%
- YieldGains Capital
YieldDividend
Calculating returnsExample 10.1
• You invest in a stock with a share price of $25. • After one year, the stock price per share is
$35. • Each share paid a $2 dividend.• What was your total return?
10-8 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Dollars PercentageDividend $2.00 $2/25 = 8%Capital gain $35 - $25 = $10 $10/25= 40 %Total return $2 + $10 = $12 $12/$25 = 48%
The historical record
A first look— Figure 10.4
10-9 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
$1 invested in three major domestic classes as from the beginning of 1900
Quarter-by-quarter returns
• All Ordinaries Index—Figure 10.5
10-10 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Quarter-by-quarter returns (cont.)
• 10-year government bonds—Figure 10.6
10-11 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Quarter-by-quarter returns (cont.)
• Cash—Figure 10.7
10-12 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Quarter-by-quarter inflation
10-13 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Historical average returns
• Historical average return = simple, or arithmetic, average
10-14 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
T
return yearly Return AverageHistorical
T
1i
Average returns: The first lesson1985–2009
Investment Average Return
All Ordinaries Index 13.3%
10-year government bonds 9.7%
Cash 8.%
Inflation 3.8%
10-15 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Risk premiums
• Risk-free rate– Rate of return on a riskless investment– Treasury bills are considered risk free
• Risk premium– Excess return on a risky asset over the
risk-free rate– Reward for bearing risk (the first lesson)
10-16 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Historical risk premiums
Investment Average return Risk premium
All Ordinaries Index 13.3% 3.3%
10-year government bonds
9.7% 1.7%
Cash 8.% 0.0
10-17 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Risk
10-18 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Risk is measured by the dispersion, spread or volatility of returns.
Figure 10.9—Frequencydistribution ofreturns on the AllOrdinaries Index,1985–2009
Return variability review
• Variance = VAR(R) or σ2
– Common measure of return dispersion – Also call variability
• Standard deviation = SD(R) or σ – Square root of the variance– Sometimes called volatility– Same ‘units’ as the average
10-19 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Return variability: The statistical tools for historical returns
• Return variance: (‘T’ = number of returns)
• Standard deviation:
10-20 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
1T
RR σ VAR(R)
T
1i
2
i2
VAR(R) σ SD(R)
Example: Calculating historical variance
and standard deviation
10-21 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
(1) (2) (3) (4) (5)
Average Difference: Squared:
Year Return Return: (2) - (3) (4) x (4)
1 0.10 0.04 0.06 0.0036
2 0.12 0.04 0.08 0.0064
3 0.03 0.04 -0.01 0.0001
4 -0.09 0.04 -0.13 0.0169
Sum: 0.16 Sum: 0.027
Average: 0.04 Variance: 0.009
0.0948683Standard Deviation:
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.
10-22 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Historical average returns
and standard deviation
Figure 10.10
10-23 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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?
10-24 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
The normal distribution Figure 10.11
10-25 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Arithmetic vs geometric mean• Arithmetic average
– Return earned in an average period over multiple periods– 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.
10-26 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Geometric average return: Formula
10-27 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
1111 121 /T
N)R(...)R()R(GAR
Where:
Π = product (like Σ for sum)
Ri = return in each period
T = number of periods
Equation 10.4
1)1(/1
1
TT
iiRGAR
Calculating a geometric average return—Example 10.4
10-28 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Percent One Plus CompoundedYear Return Return Return:
Mar-93 8.42 1.0842 1.0842Jun-93 5.35 1.0535 1.1422Sep-93 13.72 1.1372 1.2989Dec-93 11.91 1.1191 1.4536Mar-94 -4.84 0.9516 1.3833Jun-94 -2.19 0.9781 1.3530Sep-94 2.72 1.0272 1.3898Dec-94 -4.48 0.9552 1.3275
1.0360
3.60%
(1.4870)^(1/8):
Geometric Average Return:
Arithmetic vs geometric meanWhich 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
10-29 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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.
10-30 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Reaction of stock price to new information in efficient and inefficient markets
Figure 10.12
10-31 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
What makes markets efficient?
• There are many investors out there doing research.– As new information comes to market, this
information is analysed and trades are 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.
10-32 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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 the risk undertaken
– 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
10-33 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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.
10-35 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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 not lead to abnormal returns.
10-36 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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.
10-37 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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?
10-38 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Chapter 10
END
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