Fundamentals of corproate finance 3e chapter 10

Chapter Ten Some Lessons from Capital Market History Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 + Percentage return = Beginning market value Copyright  2004 McGraw-Hill Australia Pty Ltd 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 cents in dividends and cents in capital gains—a total of 14 cents or a return of 14 per cent Copyright  2004 McGraw-Hill Australia Pty Ltd 10-6 Percentage Returns Total $42.18 Inflows Dividends $1.85 Ending market value $40.33 Time Outflows t t=1 – $37 Copyright  2004 McGraw-Hill Australia Pty Ltd 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) ( + R ) = ( + r ) × (1 + h ) R≈r+h Copyright  2004 McGraw-Hill Australia Pty Ltd 10-8 Average Equivalent Returns & Risk Premiums 1978–2002 Copyright  2004 McGraw-Hill Australia Pty Ltd 10-9 Average Returns: The First Lesson Risky assets on average earn a risk premium (i.e there is a reward for bearing risk) Copyright  2004 McGraw-Hill Australia Pty Ltd 10-10 Frequency of Returns on Ordinary Shares 1978–2002 Copyright  2004 McGraw-Hill Australia Pty Ltd 10-11 Variance • Measure of variability • The mean of the squared deviations from the average return [ 2 Var ( R ) = × ( R1 − R ) + + ( RT − R ) T −1 Copyright  2004 McGraw-Hill Australia Pty Ltd ] 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 10-13 Example—Variance Copyright  2004 McGraw-Hill Australia Pty Ltd 10-14 Example—Variance 0.08872 Variance = = 0.02218 (5 −1 ) Std deviation = 0.02218 = 0.1489 or 14.89% Copyright  2004 McGraw-Hill Australia Pty Ltd 10-15 The Historical Record Conclusion: Historically, the riskier the asset, the greater the return Copyright  2004 McGraw-Hill Australia Pty Ltd 10-16 The Normal Distribution Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 +2 +4 +6 +7 Days relative to announcement day Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 10-21 Common misconceptions about EMH • Efficient markets not mean that you can’t make money • They 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 not diversify—you still don’t want to put all your eggs in one basket Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 10-24 .. .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... Australia Pty Ltd 10- 10 Frequency of Returns on Ordinary Shares 1978–2002 Copyright  2004 McGraw-Hill Australia Pty Ltd 10- 11 Variance • Measure of variability • The mean of the squared deviations... 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