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 Ltd PPTs 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 Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 = = $60 Capital gain = 975 – 950 = $25 Total dollar return = = $ Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Ltd PPTs 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 Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Calculating returns Example 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 Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh DollarsPercentage Dividend$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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Average returns: The first lesson 1985–2009 InvestmentAverage Return All Ordinaries Index13.3% 10-year government bonds9.7% Cash8.% Inflation3.8% Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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) Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Historical risk premiums InvestmentAverage return Risk premium All Ordinaries Index13.3% 3.3% 10-year government bonds 9.7% 1.7% Cash8.% Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Risk Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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— Frequency distribution of returns on the All Ordinaries Index, 1985–2009

Return variability review Variance = VAR(R) or σ 2 – 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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: Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example: Calculating historical variance and standard deviation Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 for the quote of iShares MSCI Index Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh Where: Π = product (like Σ for sum) R i = return in each period T = number of periods Equation 10.4

Calculating a geometric average return—Example Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Strong-form efficient market Information = public or private ‘Inside information’ is of little use Semistrong-form efficient market Information = publicly available information Fundamental analysis is of little use Weak-form efficient market Information = past prices and volume data Technical analysis is of little use Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs 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? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter 10 END 10-39