McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.0 Chapter 10 Some Lessons...

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved

10.1

Chapter

10Some Lessons from Capital Market History


10.2

Key Concepts and Skills

Know how to calculate the return on an investment

Understand the historical returns on various types of investments

Understand the historical risks on various types of investments


10.3

10.1 Returns


10.4

Risk, Return and Financial Markets

Lesson from capital market historyThere is a reward for bearing riskThe greater the potential reward, the greater the riskThis is called the risk-return trade-off


10.5

Dollar Returns

Total dollar return = income from investment + capital gain (loss) due to change in price

Example:You bought a bond for $950 1 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 = 30 + 30 = 60 Capital gain = 975 – 950 = 25 Total dollar return = 60 + 25 = $85


10.6

Percentage Returns

It’s generally more intuitive to think in terms of percentages than dollar returns

Dividend yield = income / beginning priceCapital gains yield = (ending price – beginning

price) / beginning priceTotal percentage return = dividend yield +

capital gains yield


10.7

Example – Calculating Returns

You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40.What is your dollar return?

Dollar return = 1.25 + (40 – 35) = $6.25What is your percentage return?

Dividend yield = 1.25 / 35 = 3.57% Capital gains yield = (40 – 35) / 35 = 14.29% Total percentage return = 3.57 + 14.29 = 17.86%


10.8

10.2 The Historical Record


10.9

The Importance of Financial Markets“Financial Markets” allow companies, governments

and individuals to increase their utility Savers: defer consumption, invest in financial assets, 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 assetsFinancial markets also provide information about the

returns that are required for various levels of risk


10.10Figure 10.4A $1 investment in different types of portfolios: 1926 – 99Note: 1. Stocks produce a higher return higher risk

2. Stocks are more volatile than bonds.Index

$10,000

$1,000

$100

$10

$1

$0.11925 1935 1945 1955 1965 1975

Year-end1985 19951999

Small-companystocks

Large-companystocks

Inflation

Treasury bills

Long-termgovernment bonds

$6,640.79

$2,845.63

$40.22

$15.64

$9.39


10.11

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%


10.12

Year-to-Year Total ReturnsNotice Volatility and Returns

Large Companies

Long-Term Government Bonds

U.S. Treasury Bills

Large-Company Stock Returns

Long-Term Government

Bond Returns

U.S. Treasury Bill Returns


10.13

10.3 Average Returns: The First Lesson


10.14

Calculating Average Returns

Simply add up the yearly returns and divide by the number of observations

The result is the historical average of the individual values.

Example: If you add up the returns for the Large-Company Stocks in Table 10.1 (Pg 284) and divide by 74 (years) you will get 13.3%.


10.15Table 10.2 (Pg 286) Average Returns (1926 – 99)As Calculated from Table 10.1 (Pg 284)Note how much larger the stock returns are than the bond returns!

Investment Average Return

Large stocks 13.3%

Small Stocks 17.6%

Long-term Corporate Bonds 5.9%

Long-term Government Bonds 5.5%

U.S. Treasury Bills 3.8% (Risk-free rate)

Inflation (Consumer Price Index) 3.2%


10.16

Average Returns: The Historical RecordThe previous Average Returns Calculated are

Nominal – have not been adjusted for inflation

The average inflation rate (measured by the Consumer Price Index - CPI) was 3.2 percent per year over the 74-year spanTable 10.1: Add up the CPI for the 74 years and

divide by 74


10.17

Average Returns: The Historical RecordThe nominal return on U.S. Treasury Bills

was 3.8 percent per year (excludes inflation)Real Return = Nominal Return - InflationExample: The Average “Real” Return on

U.S. Treasury Bills was: 3.8% – 3.2% = .6%


10.18

Risk Premiums

Risk Premium – is the excess return required from an investment in a risky asset over that required from a risk-free investmentThe “extra” return earned for taking on riskTreasury bills are considered to be risk-freeThe risk premium is the return over and above the

risk-free rate


10.19Historical Risk Premiums 1926 - 1999

Simply subtract the Risk Free Rate of ReturnIf the risk premium is the return over and above the

risk-free rate: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%Long-term government bonds: 5.5 – 3.8 = 1.7%

Note how much larger the stock risk premiums are than the bond risk premiums!


10.20

The First Key Lesson:

Risky assets, on average, earn a risk premiumThere is a reward for bearing risk


10.21

10.4 The Variability of Returns:The Second Lesson


10.22

Frequency Distribution

Figure 10.9 (Page 288)The number of times the annual return on a

large stock portfolio fell within each 10 percent rangeThe height of 12 in the range 20 to 30% means that

12 of the 74 annual returns were in that rangeNotice that the most frequent returns are in the 10 to

20% range and the 30 to 40% range


10.23

Figure 10.9

1936 193719741930

1973196619571941

199019811977196919621953194619401939193419321929

19941993199219871984197819701960195619481947

1988198619791972197119681965196419591952194919441926

199919981996198319821976196719631961195119431942

1997199519911989198519801975195519501945193819361927

195619351928

19541933

1 12

4

12 1211

13 13

23

0-50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90

Return (%)


10.24

Variance and Standard DeviationWe want to measure the “spread” in returns

How far the actual return deviates from the average in a typical year?

A measure of how volatile the return is.Volatile – tendency to vary widely

Variance and standard deviation are the most commonly used measure of volatility

The greater the volatility the greater the uncertaintyVariance = sum of squared deviations from the mean /

(number of observations – 1)Standard deviation = the positive square root of the

variance


10.25

Example:Variance and Standard Deviation (Pg. 290)

Know This – Put on Formula Sheet! Year Actual

ReturnAverage Return

Deviation from the Mean (Average)

Squared Deviation

1 -.20 .175 -.375 .140625

2 .50 .175 .325 .105625

3 .30 .175 .125 .015625

4 .10 .175 -.075 .005625

Totals .70 / 4 = .175

.000 .267500

Variance = sum of squared deviations from the mean / (number of observations – 1)

= .26750 / (4-1) = .0892

Standard Deviation = the positive square root of the variance: = .2987


10.26

Variance and Standard Deviation

The larger the variance, the more the actual returns tend to differ from the average returnVariation about the mean (average)

The larger the variance or standard deviation, the more spread out the returns will be


10.27

Figure 10.10 (Pg 291) Historical average returns, standard deviations, and frequency distributions: 1926 – 99. Notice that the standard deviation for the small-stock portfolio is more than 10 times larger than the T-bill portfolio’s standard deviation.

90%

Large-companystocks 13.3% 20.1

Small-companystocks 17.6 33.6

Long-termcorporate bonds 5.9 8.7

Long-termgovernment 5.5 9.3

Intermediate-termgovernment 5.4 5.8

U.S. Treasurybills 3.8 3.2

Inflation 3.2 4.5

-90% 0%*The 1933 small-company stock total return was 142.9 percent.

*

SeriesAverageReturn

StandardDeviation Distribution


10.28Figure 10.11 – (Pg 291)The Normal Distribution (or bell curve) – a symmetric, bell-shaped statistical distribution that is completely defined by its mean and standard deviation. Here, Illustrated returns are based on the historical return and standard deviation for a portfolio of large common stocks.Assuming a normal distribution, with a 13.3% Average Return/Mean and a Standard Deviation of 20.1:The probability that the return w/b within 1 Standard Deviation is 68%The probability that the return w/b within 2 Standard Deviations is 95%The probability that the return w/b within 3 Standard Deviations is 99%

-3-47.0%

-2-26.9%

-1-6.8%

013.3%

+133.4%

+253.5%

+373.6%

Probability

Return onlarge commonstocks

68%

95%

>99%


10.29

The Second Key Lesson:

The greater is the risk, the greater the potential reward from a risky investment

On average, bearing risk is handsomely rewarded, but, in a given year, there is a significant chance of a dramatic change in value.


10.30

10.5 Capital Market Efficiency


10.31

Efficient Capital Markets

Efficient Markets Hypothesis (EMH) – is the hypotheses that actual capital markets, such as the NYSE, are efficient (i.e. fairly priced).

Efficient Capital Market - Security prices reflect all available information. Prices adjust quickly and correctly when new information arrives. 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


10.32

Chapter 10 #12 – The broken line and the dotted line

illustrate paths that the stock price might take in an inefficient market

-8 -6 -4 -2 0 +2 +4 +6 +8

100

140

180

220

Price ($)

Days relativeto announcement day(Day 0)

Overreactionand correction

Delayedreaction

Efficient marketreaction

Efficient market reaction: the priceinstantaneously adjusts to and fully reflectsnew information; there is no tendency forsubsequent increases and decreases.

Delayed reaction: The price partially adjuststo the new information; eight days elapsebefore the price completely reflects thenew information.

Overreaction and correction: The price over adjusts to the new information; itovershoots the new price and subsequentlycorrects.


10.33

What Makes Markets Efficient?

There are many investors out there doing researchAs 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 the market will not be efficient


10.34

Common Misconceptions about Efficient Markets Hypothesis (EMH)Efficient markets do not mean that you can’t make

moneyThey 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


10.35

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


10.36

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


10.37

Weak Form Efficiency

Prices reflect all past (historical) 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


10.38

Market Efficiency Recap

In an efficient market, prices adjust quickly and correctly to new information

Asset prices in efficient markets are rarely too high or too low.

How efficient capital markets (such as the NYSE) are is a matter of debateAt a minimum, they’re probably much more efficient

than most real asset markets


10.39

Chapter 10Suggested Homework & Test ReviewQuestions and Problems (Pgs 301 – 303):

1, 2, 5, 7, 9, 10, 16, 18, 19, 20, 21 Know how to calculate:

Dollar Returns (Dividends, Interest, Capital Gain) Percentage Returns:

Dividend yield Capital gains yield Total percentage return

Real Return and Risk Premium Average Return Variance Standard Deviation

Know chapter theories, concepts, and definitions

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.0 Chapter 10 Some Lessons...

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