Chapter 11 Risk & Return in Capital Markets

Key Concepts and Skills Know how to calculate return on an investment Understand historical returns on various types of investments Understand historical risks on various types of investments

Chapter Outline Returns The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second Lesson Capital Market Efficiency

Risk, Return and Financial Markets We can examine returns in the financial markets to help determine appropriate returns on non-financial assets Lesson from capital market history There is a reward for bearing risk Greater the potential reward, greater the risk Known as risk-return trade-off

Dollar Returns Total dollar return = income from investment + capital gain (loss) due to price change Example: A year ago, you bought a bond for $950. You have received two coupons of $30 each. You can sell the bond for $975 today. What is the total dollar return? Income = Capital gain = Total dollar return = Be sure to emphasize that you do not have to actually sell the stock for you to earn the dollar return. The point is that you could.

Percentage Returns Generally more intuitive to think in terms of % than $ returns Dividend yield = income / beginning price Capital gains yield = (ending price – beginning price) / beginning price Total percentage return = dividend yield + capital gains yield Note that the “dividend” yield is really just the yield on intermediate cash flow

Example – Calculating Returns You bought a stock for $35 and received dividends of $1.25. The stock is now selling for $40. What is your dollar return? Dollar return = What is your percentage return? Dividend yield = Capital gains yield = Total percentage return = You might want to point out that total percentage return is also equal to total dollar return / beginning price. Total percentage return = 6.25 / 35 = 17.86%

Example – Calculating Returns II A year ago, you bot a 10-yr, 6% bond for $950. Today, 1-yr later, it sells for $975. Based on your purchase price, what is the original interest yield (current yield)? What is the Cap Gains Yld? What’s the annual return on the bond?

Example – Calculating Returns II A year ago, you bot a 10-yr, 6% bond for $950. Today, 1-yr later, it sells for $975. For a one-yr rate of return can also use TVM: PV = FV = PMT = N = i = ? =

Importance of Financial Markets Financial markets allow companies, governments and individuals to increase their utility Savers have ability to invest in financial assets so they can defer consumption and earn a return to compensate them for doing so Borrowers have better access to capital that is available so that they can invest in productive assets Financial markets also provide us with information about returns required for various levels of risk

Figure 11. 1 Value of $100 Invested at the End of 1925 in U. S Figure 11.1 Value of $100 Invested at the End of 1925 in U.S. Large Stocks (S&P 500), Small Stocks, World Stocks, Corporate Bonds, and Treasury Bills

Figure 10.4

The Great Bull Market of 1982 – 1999, “Bumps Along the Way” Period % Decline in S&P 500 Oct. 10, 1983 – July 24, 1984 -14.4% Aug. 25, 1987 – Oct. 19, 1987 -33.2% Oct. 21, 1987 – Oct. 26, 1987 -11.9% Nov. 2, 1987 – Dec. 4, 1987 -12.4% Oct. 9, 1989 – Jan. 30, 1990 -10.2% July 16, 1990 – Oct. 11, 1990 -19.9% Feb. 18, 1997 – Apr. 11, 1997 -9.6% July 19, 1999 – Oct. 18, 1999 -12.1% Adapted from the T. Rowe Price Report, Fall 1997 issue and historical information from Yahoo! Investor

Figure 11. 3 Average Annual Returns in the U. S Figure 11.3 Average Annual Returns in the U.S. for Small Stocks, Large Stocks (S&P 500), Corporate Bonds, and Treasury Bills, 1926–2009

Figure 11. 2 The Distribution of Annual Returns for U. S Figure 11.2 The Distribution of Annual Returns for U.S. Large Company Stocks (S&P 500), Small Stocks, Corporate Bonds, and Treasury Bills, 1926–2009

Average Returns Investment Average Return Large stocks 13.3% 12.7% 12.4% Small Stocks 17.6% 17.3% 17.2% Long-term Corporate Bonds 5.9% 6.1% 6.3% Long-term Government Bonds 5.5% 5.7% 5.8% U.S. Treasury Bills 3.8% 3.9% 4.0% Inflation 3.2% 3.1% 3,1%

Risk Premiums “Extra” return earned for taking on risk Treasury bills are considered to be risk-free Risk premium = return over and above the risk-free rate

Historical Risk Premiums (2009 v. 1999) Large stocks: 11.74 – 4.09 = 7.65% Small stocks: 22.05 – 4.09 = 17.96% Long-term corp. bonds: 6.49 – 4.09 = 2.04% 1999 Large stocks: 13.3 – 3.8 = 9.5% Small stocks: 17.6 – 3.8 = 13.8% Long-term corporate bonds: 5.9 – 3.8 =2.1% Ask the students to think about why the different investments have different risk premiums.

Variance and Standard Deviation Variance and standard deviation measure volatility of asset returns Greater volatility = greater uncertainty Historical variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = square root of the variance

Example – Variance and Standard Deviation Year Actual Return Average Return Deviation from the Mean Squared Deviation 1 .15 2 .09 3 .06 4 .12 Totals .42 Remind students that the variance for a sample is computed by dividing by the number of observations – 1 The standard deviation is just the square root Variance = . Standard Deviation =

Figure 11. 2 The Distribution of Annual Returns for U. S Figure 11.2 The Distribution of Annual Returns for U.S. Large Company Stocks (S&P 500), Small Stocks, Corporate Bonds, and Treasury Bills, 1926–2009

Risks Common risk: linked across outcomes Independent risk: risks that bear no relation to each other. Diversification & risk Systematic risk: market-wide Unsystematic risk: due to firm or industry specific news

Efficient Capital Markets Stock prices are in equilibrium or are “fairly” priced If this is true, then you should not be able to earn “abnormal” or “excess” returns Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

Chapter 10 #12 Price ($) Overreaction and correction 220 180 -8 -6 -4 -2 +2 +4 +6 +8 100 140 180 220 Price ($) Days relative to announcement day (Day 0) Overreaction and correction Delayed reaction Efficient market reaction 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; eight days elapse before the price completely reflects the new information. Overreaction and correction: The price over adjusts to the new information; it overshoots the new price and subsequently corrects.

What Makes Markets Efficient? There are many investors out there doing research As new information comes to market, this information is analyzed and trades are made based on this information Therefore, prices should reflect all available public information If investors stop researching stocks, then market will not be efficient Point out that one consequence of the wider availability of information and lower transaction costs is that the market will be more volatile. It is easier to trade on “small” news instead of just big events. It is also important to remember that not all available information is reliable information. It’s important to still do the research and not just jump on everything that crosses the news wire. The case of Emulex, discussed earlier, is an excellent example.

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 there is not a 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

Strong Form Efficiency Prices reflect all information, including public and private If the market is strong form efficient, then 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 could earn abnormal returns Students are often very interested in insider trading. See the IM for a more detailed discussion.

Semistrong Form Efficiency Prices reflect all publicly available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns Empirical evidence suggests that some stocks are semistrong form efficient, but not all. Larger, more closely followed stocks are more likely to be semistrong form efficient. Small, more thinly traded stocks may not be semistrong form efficient but liquidity costs may wipe out any abnormal returns that are available.

Weak Form Efficiency Prices reflect all past market information such as price and volume If the market is weak form efficient, then 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 Emphasize that just because technical analysis shouldn’t lead to abnormal returns, that doesn’t mean that you won’t earn fair returns using it – efficient markets imply that you will. You might also want to point out that there are many technical trading rules that have never been empirically tested; so it is possible that one of them might lead to abnormal returns. But if it is well publicized, then any abnormal returns that were available will soon evaporate.

Chapter 11 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?