Fundamentals of corproate finance 3e chapter 10
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Chapter Ten
Some Lessons from Capital
Market History
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10-1
Chapter Organisation
10.1 Returns
10.2 Inflation and Returns
10.3 The Historical Record
10.4 Average Returns: The First Lesson
10.5 The Variability of Returns: The Second Lesson
10.6 Capital Market Efficiency
10.7 Summary and Conclusions
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10-2
Chapter Objectives
•
•
•
•
•
Distinguish between dollar returns and percentage returns.
Examine the effect of inflation on returns.
Gain an appreciation of historical returns and their variability
for different assets.
Calculate average return and standard deviation.
Discuss market efficiency and its three forms.
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10-3
Dollar Returns
•
The gain (or loss) from an investment.
•
Made up of two components:
– income (e.g. dividends, interest payments)
– capital gain (or loss).
•
Not necessary to sell investment to include capital gain or
loss in return.
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10-4
Percentage Returns
Dividends paid at
+
end of period
Change in market
value over period
Percentage return =
Beginning market value
Dividends paid at +
end of period
Market value
at end of period
1 + Percentage return =
Beginning market value
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10-5
Percentage Return Example
Pt = $37.00
Pt+1 = $40.33
Dt+1 = $1.85
$1.85 + ( $40.33 − $37.00 )
$37.00
= 0.14 or 14%
% Return =
Per dollar invested we get 5 cents in dividends and 9
cents in capital gains—a total of 14 cents or a return of
14 per cent.
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10-6
Percentage Returns
Total
$42.18
Inflows
Dividends
$1.85
Ending
market value
$40.33
Time
Outflows
t
t=1
– $37
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10-7
Inflation and Returns
•
•
•
•
Real return is the return after taking out the effects of
inflation.
Real return shows the percentage change in buying power.
Nominal return is the return before taking out the effects of
inflation.
The Fisher effect explores the relationship between real
returns (r), nominal returns (R) and inflation (h).
( 1 + R ) = ( 1 + r ) × (1 + h )
R≈r+h
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10-8
Average Equivalent Returns
& Risk Premiums 1978–2002
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10-9
Average Returns: The First Lesson
Risky assets on average earn a risk premium (i.e. there is a
reward for bearing risk).
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10-10
Frequency of Returns on Ordinary
Shares 1978–2002
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10-11
Variance
•
Measure of variability.
•
The mean of the squared deviations from the average return.
[
1
2
2
Var ( R ) =
× ( R1 − R ) + .... + ( RT − R )
T −1
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]
10-12
Example—Variance
ABC Co. have experienced the following returns in the last
five years:
Year
Returns
1998
-10%
1999
5%
2000
30%
2001
18%
2002
10%
Calculate the average return and the standard deviation.
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10-13
Example—Variance
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Example—Variance
0.08872
Variance =
= 0.02218
(5 −1 )
Std deviation = 0.02218 = 0.1489 or 14.89%
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10-15
The Historical Record
Conclusion: Historically, the riskier the asset, the
greater the return.
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10-16
The Normal Distribution
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10-17
Variability: The Second Lesson
•
The greater the risk, the greater the potential reward.
•
This lesson holds over the long term but may not be valid for
the short term.
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10-18
Capital Market Efficiency
•
The efficient market hypothesis (EMH) asserts that the price
of a security accurately reflects all available information.
•
Implies that all investments have a zero NPV.
•
Implies also that all securities are fairly priced.
•
If this is true then investors cannot earn ‘abnormal’ or
‘excess’ returns.
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10-19
Price Behaviour in Efficient and
Inefficient Markets
Price ($)
Overreaction and
correction
220
180
140
Delayed reaction
100
Efficient market reaction
–8 –6 –4 –2
0
+2 +4 +6 +7
Days relative
to announcement day
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10-20
What Makes Markets Efficient?
• There are many investors out there doing research:
-
As new information comes into the 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 stocks, then the
market will not be efficient.
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Common misconceptions about EMH
• Efficient markets do not mean that you can’t make
money.
• They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken
and that there is not a bias in prices that can be
exploited to earn excess returns.
• Market efficiency will not protect you from making
the wrong choices if you do not diversify—you still
don’t want to put all your eggs in one basket
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10-22
Price Behaviour in Efficient and
Inefficient Markets
• Efficient market reaction: The price instantaneously
adjusts to and fully reflects new information. There
is no tendency for subsequent increases and
decreases.
• Delayed reaction: The price partially adjusts to the
new information. Several days elapse before the
price completely reflects the new information.
• Overreaction: The price over-adjusts to the new
information. It ‘overshoots’ the new price and
subsequently corrects itself.
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10-23
Forms of Market Efficiency
•
Weak form efficiency: Current prices reflect information
contained in the past series of prices.
•
Semi-strong form efficiency: Current prices reflect all publicly
available information.
•
Strong form efficiency: Current prices reflect all information of
every kind.
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10-24
