Chapter Ten Some Lessons from Capital Market History Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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 Summary and Conclusions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Percentage Returns Dividends paid at Change in market end of period value over period Percentage return = Beginning market value Dividends paid at Market value end of period at end of period 1 + Percentage return = Beginning market value + + Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Percentage Return Example Pt = $37.00 Pt+1 = $40.33 Dt+1 = $1.85 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Percentage Returns Total $42.18 Inflows Dividends $1.85 Ending market value $40.33 Time t t = 1 Outflows – $37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Real versus Nominal 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. Nominal return is the percentage change in the number of dollars you have. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Fisher Effect R ≈ r + h The Fisher effect explores the relationship between real returns (r), nominal returns (R), and inflation (h). The nominal rate is approximately equal to the real rate plus the inflation rate. R ≈ r + h Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Capital Market History Risky securities, such as stocks, have had higher average returns than riskless securities, such as Treasury Bills. Stocks of small companies have had higher average returns than those of large companies. Long-term bonds have had higher average yields and returns than short-term bonds. The cost of capital for a company, project, or division can be predicted using data from the markets. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

A$1 Invested in Different Types of Portfolios, 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Consumer Price Index (CPI) 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

All Ordinaries Accumulation Index 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Returns on Small Cap Shares 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Returns on 10-year Bonds 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Returns on 90-day Bank Bills 1979-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Average Returns: The First Lesson A way to calculate the average returns on different investments is simply to add up returns for a number of periods and divide by the number of periods (e.g. years, months, days, etc). The risk premium is the excess return required from an investment in a risky asset over a risk-free investment. Lesson from History: Risky assets, on average, earn a risk premium (i.e. there is a reward for bearing risk). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Average Equivalent Returns & Risk Premiums 1979–2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Frequency of Returns on Ordinary Shares 1901-2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Variance and Standard Deviation Measures of variability. Variance is the average squared deviation between the actual return and the average return. Standard deviation is the square root of the variance. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Variance and Standard Deviation ABC Co. have experienced the following returns in the last five years: Year Returns 2002 -10% 2003 5% 2004 30% 2005 18% 2006 10% Calculate the average return and the standard deviation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Variance and Standard Deviation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Variance and Standard Deviation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Historical Returns and Standard Deviations, 1979-2006 Conclusion: Historically, the riskier the asset, the greater the return. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Normal Distribution Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Price Behaviour in Efficient and Inefficient Markets Overreaction and correction 220 180 140 100 Delayed reaction Efficient market reaction Days relative to announcement day –8 –6 –4 –2 +2 +4 +6 +7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

EMH: Common misconceptions 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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 information contained in the past series of prices and all other publicly available information. Strong-form efficiency: Current prices reflect all available information (e.g. past series of prices, public information and private information). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Summary and Conclusions Risky assets, on average, earn a risk premium. The greater the potential reward from a risky investment, the greater the risk. In an efficient market, prices adjust quickly and correctly to new information. The Efficient Market Hypothesis (EMH) states that well organised capital markets are efficient and investors cannot make abnormal returns. Asset prices in efficient markets are rarely over or under priced because ‘all available’ information has already been factored into the price and investors get exactly what they pay for. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan