2201afe vw week 8 some lessons from capital market history

7/27/2019 2201AFE VW Week 8 Some Lessons From Capital Market History

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2201AFE Corporate FinanceWeek 8:

Some Lessons from Capital Market History

Readings: Chapter 10


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Agenda

Last Lecture

Some Lessons from Capital Market History Key Concepts and Skills

Real World Application

The Non-Normal Fidelity Magellan Fund

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Last Lecture

Evaluation of NPV Estimates

Scenario Analysis

Sensitivity Analysis

Simulation Analysis

Break-even

Accounting Cash

Financial

Operating Leverage

Other consideration in Capital Budgeting

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Some Lessons from Capital Market History

Chapter 10

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1. Introduction & Financial

Statements

2. Time Value of Money

3. Valuing Shares & Bonds

7. Mid-semester Exam

8. Some Lessons from Capital

Market History

11. Financial Leverage & Capital

Structure Policy

13. Options & Revision

9. Return, Risk & the Security

Market Line

5. Making Capital Investment

Decisions & Project Analysis

12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

4. Net Present Value & Other

Investment Criteria

10. Cost of Capital


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Key Concepts and Skills

Returns

Holding period returns

Return statistics: Arithmetic Mean (AM) & Geometric Mean

(GM)

Risk

Variance (VAR or 2) & Standard Deviation (SD or) Historical risk and returns on various types of investments

Lessons from history

Efficient Market Hypothesis (EMH)

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The financial markets generally are unpredictable. So that

one has to have different scenarios. The idea that you can

actually predict what's going to happen contradicts my

way of looking at the market.

George Soros

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History of Australia Stock Exchange

Read more on: http://www.asxgroup.com.au/history.htm

http://globaltrendtraders.com/stock-market-analysis/stock-market-history-3-

ways-to-use-it-to-your-advantage/

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Returns

Dollar Returns (Investment Profit)

the sum of the cash received and

the change in value of the asset, indollars.

Percentage Returns

the cash received and the change

in value of the asset divided by theoriginal investment.

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Dividends

Ending market

value

Year 0 Year 1

Initial investment


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Returns

Dollar Return = Dividend + Change in Market Value

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yieldgainscapitalyielddividend

P

PP

P

C

P

)P(PCR

yieldgainscapitalyielddividend

valuemarketbeginning

valuemarketinchangedividend

valuemarketbeginning

returndollarReturnPercentage

1t

1tt

1t

t

1t

1tttt


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Example Calculating Returns

You bought a bond for $950 one 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

What is the percentage return?

Total dollar return / Beginning value

85 / 950 = 8.95%

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Example Calculating Returns

You bought a stock for $35 and you received dividends of

$1.25. The stock is now worth $40.

What is your dollar return?

Dollar return = 1.25 + (40 35) = $6.25

What 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%

or Dollar return / Beginning price:

6.25 / 35 = 17.86% (unrealised) Nominal vs. Real

Realised vs. Unrealised

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Holding Period Return

The holding period return

The return that an investor would get when holding an

investment over a period ofn years

Holding Period Return

= (1+r1) (1+r

2) (1+r

n) 1

where r1, r2 ... rn are yearly returns

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Holding Period Return: Example

Suppose your investment provides the following returns

over a four-year period:

Your holding period return:

= (1+r1) (1+r2) (1+r3) (1+r4) 1

= (1.10) (0.95) (1.20) (1.15) 1

= 0.4421 = 44.21%

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Year Return

1 10%

2 -5%

3 20%

4 15%


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Geometric Mean

An investor who held this investment would have earned an

annual average compound return of 9.58%:

Geometric Mean = GM = Rg = [1+R]1/t1

Rg = [(1+R1)(1+R2)(1+R3)(1+R4)]1/t 1 =

Rg = [(1.10)(0.95)(1.20)(1.15)]1/4 1 = 9.58%

So, our investor made 9.58% per year, for four years, earning a

holding period return of 44.21%

= (1.095844)4 = 1.4421 1

= 0.4421 = 44.21%

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Year Return

1 10%

2 -5%

3 20%

4 15%


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Arithmetic Mean

Arithmetic Mean = AM = Ra

Our investor earned 10% return in an average year, over

the four year investment period.

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Year Return

1 10%

2 -5%

3 20%

4 15%


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Example: Calculating AM and GM

What is the arithmetic and geometric mean for the

following returns?

Year 1 5%

Year 2 -3%

Year 3 12%

AM = [0.05 + (0.03) + 0.12] / 3

= 0.0467 = 4.67%

GM = (1+0.05) (10.03) (1+0.12)]

1/3

1= 0.0449 = 4.49%

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Arithmetic vs. Geometric Mean

Arithmetic mean returns earned in an average period

over multiple periods (used as estimated return).

Geometric mean average compound returns per period

over multiple periods.

The geometric average will be less than the arithmetic

average unless all the returns are equal.

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Arithmetic vs. Geometric Mean

Which is better?

The arithmetic average is overly optimistic for long horizons

use over short term.

The geometric average is overly pessimistic for short

horizons use over long term.

15-20 years or less: use arithmetic mean.

20-40 years or so: split the difference between them.

40+ years: use geometric mean.

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Risk

Risk is the chance or possibility of loss (Concise Oxford).

Risk is the chance of things not turning out as expected

(Economist).

Risk is the uncertainty of future outcomes (Reilly & Brown).

Perhaps the most important

Reports that say that something hasn't happened are alwaysinteresting to me, because as we know, there are known knowns;

there are things we know we know. We also know there are

known unknowns; that is to say we know there are some things

we do not know. But there are also unknown unknowns -- the

ones we don't know we don'tknow(former US DefenseSecretary Donald Rumsfeld).

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Risk Measurements

Main Measures:

Variance (VAR)

Standard Deviation (SD)

Variance = the average of the squared differences between

the actual return and the average return.

Standard Deviation = square root of Variance.

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Example VAR and SD

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Year

Actual

Return

R

Average

Return

Rmean

Deviation from

the Mean

R Rmean

Squared

Deviation

(R Rmean)2

1 0.15 0.105 0.045 0.002025

2 0.09 0.105 -0.015 0.000225

3 0.06 0.105 -0.045 0.002025

4 0.12 0.105 0.015 0.000225Total 0.42 0.00 = 0.0045

Average = 0.42 / 4 = 0.105


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Example Standard Deviation

SD = 3.87%

68% of possible outcomes will lie between 6.63% and 14.37%

(mean 1SD) = ( 1) = (10.50 3.87%).23

mean

6.63% 10.50% 14.37%

68%

95%

99%

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Historical Return Statistics

The history of capital market returns can be summarized by

describing:

The average return.

The standard deviation of those returns.

The frequency distribution of the returns.

Comparison is made on: Large-Company Common Stocks.

Small-company Common Stocks.

Long-term Bonds.

Short-term Bank Bills.

Inflation.

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FV f $1 i i 1979


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FV of $1 investment in 1979

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Hi t i l R t 1979 2009


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Historical Returns, 1979-2009

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L f C it l M k t Hi t


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Lessons from Capital Market History

Data reflects two features often observed in financial

markets.

There is a reward for bearing risk.

The larger the potential reward, the larger the risk.

This is called the risk-return trade-off.

There is a positive relationship between risk and return.

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Ri k P i


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Risk Premium

The extra return earned for taking on risk.

The risk premium is the return over and above the risk-free

rate.

Average Return Risk-free Rate = Risk Premium

What is a risk free rate?

Treasury bills are considered to be risk-free. Can use

Government bonds as well.

Considered risk free in terms of ability of pay interest

obligations.

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Average Annual Returns and Risk Premiums


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Average Annual Returns and Risk Premiums

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Efficient Capital Markets


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Efficient Capital Markets

Stock prices are in equilibrium or are fairly priced.

If this is true, then you should not be able to earnabnormal or excess returns.

Efficient markets DO NOTimply that investors cannot earn

a positive return in the stock market.

Efficient Market Hypothesis or EMH Eugene Fama 1970,

Journal of Finance.

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Why does it matter?


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Why does it matter?

If markets are efficient:

Prices reflect true value: Equilibrium value consistent with

information.

Cannot profit from present information that is available.

Price reaction can fluctuate but no observable trend.

No over-reaction or under-reaction.

No lags and also leads.

Price changes are independent and random.

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Market Efficiency Defined


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Market Efficiency Defined

Price Information

Fully (properly) New/surprise/unexpected

Instantaneously Relevant

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Efficient Market

Pr

ice

Event time t

Information is reflected in

share price instantaneously.

Key issues


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Key issues

What happens when something unanticipated occurs and how

quickly do asset prices adjust?

1. How does the market react if the market is efficient?

2. How does the market react if the market is inefficient?

What happens when something anticipated occurs?

1. How does an efficient market react to anticipated events?

2. How does an inefficient market react to anticipated events?

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Unanticipated Favourable Event


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Unanticipated Favourable Event

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Efficient Market

Price

Event time t

Inefficient Market

Price

Event time t

Efficient Market: Prices would

adjust up very quickly.

Inefficient Market: Prices would

drift upward for some timefollowing the event.

Anticipated Favourable Event


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Anticipated Favourable Event

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Efficient Market: Prices would

drift up for some time beforethe event and then stabilise.

Inefficient Market: Prices would

drift up for some time before theevent and continue up after.

Efficient Market

Price

Event time t

Inefficient Market

Price

Event time t

Stock Price Reaction


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Stock Price Reaction

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Why does it matter?


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Why does it matter?

If prices DOfully reflect all current information, it would

not be worth an investors time to use information to find

under-valued securities.

If prices DO NOT fully reflect information, FIND AND USE

THAT INFORMATION, and perhaps you will be able to make

a killing in the market.

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Semi-strong form efficiency


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g y

Prices reflect all publicly available information including

trading information, annual reports, press releases, etc.

If the market is semi-strong form efficient, then investors

cannot earn abnormal returns by trading on public

information.

Implies that fundamental analysis will not lead to abnormal

returns.

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Strong form efficiency


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g y

Prices reflect all information, including public and private.

If the market is strong form efficient, then investors couldnot earn abnormal returns regardless of the information

they possessed.

Empirical evidence indicates that markets are NOT strongform efficient and that insiders could earn abnormal

returns.

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Real World Application


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Fidelity Magellan

One of the worlds most popularmutual funds, the Fidelity

Magellan fund is the largestactively managed mutual fund inthe world

The fund started on May 2, 1963.Peter Lynch became legendary as

the Magellan fund manager(retired in 1990)

FUM stands at US$47billion

Monthly data: April 1987through October 2007 (n = 247)

Just how normal are monthlyreturns from the fund?

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Histogram - Full Sample

Fidelity Magellan (1987-2007, monthly)

0%

3%

6%

9%

12%

15%

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

0%

20%

40%

60%

80%

100%

Return Distribution (Fidelity) CDF (Fidelity) CDF N(0,1) PDF N(0,1)

`

37.71Range

11.91 (Dec 91)Maximum return (%)

-25.80 (Oct 87)Minimum return (%)

7.63 vs N(0,1) = 3Kurtosis

-1.09 vs N(0,1) = 0Skewness

4.53Volatility (%)

+ 0.45Comparison to Average (+/-)

1.44 (Oct 07)This Month (%)

0.98Arithmetic Average (%)

37.71Range

11.91 (Dec 91)Maximum return (%)

-25.80 (Oct 87)Minimum return (%)



4.53Volatility (%)

+ 0.45Comparison to Average (+/-)

1.44 (Oct 07)This Month (%)

0.98Arithmetic Average (%)

Non-Normal Monthly Returns


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Oct 87 Aug 98 Sep02 = 0.98

Aug90

Sep 01

Fidelity Return Distribution

0

5

10

15

20

-26% -22% -18% -14% -11% -7% -3% 1% 4% 8%

Monthly Return

0

0.2

0.4

0.6

0.8

1





Next Week


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Next week, we will look at returns, risk and the security

market line.

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2201afe vw week 8 some lessons from capital market history

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