. Chapter Ten Lessons from capital market history Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Chapter Organisation 10.1Returns 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Chapter Objectives Understand how to calculate the return on an investment. Understand the historical returns on various important types of investments. Understand the historical risks on various important types of investments. Understand the implications of market efficiency. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Percentage Returns Dividends paid atChange in market end of periodvalue over period Percentage return = Beginning market value Dividends paid atMarket value end of periodat end of period 1 + Percentage return = Beginning market value + + Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Percentage Return Example P t = $37.00 P t+1 = $40.33 D t+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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Percentage Returns Inflows Outflows $42.18 $1.85 $40.33 Total Dividends Ending market value t = 1 t – $37 Time Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. The Fisher Effect 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. A$1 Invested in Different Types of Portfolios, Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Consumer Price Index (CPI) Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. All Ordinaries Accumulation Index Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Returns on Small Cap Shares Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Returns on 10-year Bonds Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Returns on 90-day Bank Bills Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Average Equivalent Returns & Risk Premiums 1979–2009 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Frequency of Returns on Ordinary Shares Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Example—Variance and Standard Deviation YearReturns % 20035% % % % ABC Co. has experienced the following returns in the last five years : Calculate the average return and the standard deviation. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Example—Variance and Standard Deviation Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Example—Variance and Standard Deviation Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Historical Returns and Standard Deviations, Conclusion: Historically, the riskier the asset, the greater the return. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Work the Web Example How volatile are managed funds? Morningstar provides information on managed funds, including volatility. Click on the web surfer to go to the Morningstar site. –Pick a fund, such as the Invesco European Growth (AEDCX). –Enter the ticker, press go and then click ‘Risk Measures’. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. The Normal Distribution Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. Price Behaviour in Efficient and Inefficient Markets Price ($) Days relative to announcement day –8–6 –4– Overreaction and correction Delayed reaction Efficient market reaction Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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 to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker

. 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  2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al. Slides prepared by Tim Whittaker