Chapter Outline

1
Chapter Outline

• Chapter 12Some Lessons from Capital Market
  History
• 12.1 Returns
• 12.2 The Historical Record
• 12.3 Average Returns The First Lesson
• 12.4 The Variability of Returns The Second
  Lesson
• 12.5 Capital Market Efficiency
• 12.6 Summary and Conclusions

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12.1 Returns

• return (cash in / cash out) - 1
• e.g. Bought a share of XYZ at 100 a year ago.
  Today you received 4 dividend and just sold the
  share at 106.
• Cash in 4 106 Cash out 100
• return ((4106)/100) 1 10 p.a.
• return (4/100) (106/100) 1
• (4/100) (106 100)/100
• dividend yield capital gains yield
• 4 6 10 p.a.
• Qu What are two parts of (total ) return?

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12.2 Capital Market HistoryFigure 1 A 1
Investment in Different Types of Portfolios
1948-1999
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12.2 Capital market history..

• 1. Why doesnt everyone just buy common stocks as
  investment?
• 2. What was the smallest return observed over
  the 50 years for each of these investments? When
  did it occur?
• 3. How many times did large Canadian stocks
  (common stocks) return more than 30? How many
  times did they return less than 20?
• 4. What was the longest winning streak (years
  without a negative return) for large Canadian
  stocks? For long-term bonds?
• 5. How often did the T?bill portfolio have a
  negative return?

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Fig 3 A 1 Investment in Different Types of
Portfolios 1926-1998 (US Comparison)
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Figure 4 Returns on TSE300 1948-1999
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Figure 5 Returns on Small Stocks 1970-1999
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Figure 6 Returns on Bonds 1926-1998
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Figure 7 Returns on Treasury Bills 1948-1999
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12.2 Capital Market History Summary

• Standard
• Mean Deviation
• TSE300 13.2 16.6
• Bonds 7.6 10.5
• T-bills 6.0 4.0
• Small Stocks 14.8 23.7
• Inflation 4.3 3.5

(data 1948-1999, except for small stocks
1970-1999)
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12.3 Average returns

• Lets use our knowledge of capital market
  history. Questions
• Suppose the current T-bill rate is 5. An
  investment has similar risk relative to TSE 300.
  It offers a 10 return. Is this a good
  investment?
• Suppose an investment is similar in risk to
  buying small Canadian company equities. If the
  T-bill rate is 5, what return would you demand?

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12.3 Average returns..

• The risk premium is the difference between a
  risky investments return and that of a riskless
  asset. Based on historical data, risk premiums
  are
• Investment Average Standard Risk return deviat
  ion premium
• Common stocks 13.2 16.6 ____
• Small stocks 14.8 23.7 ____
• LT Bonds 7.6 10.6 ____
• U.S. Common 15.6 16.9 ____ (SP 500 in C)
• Treasury bills 3.8 3.2 ____

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12.3 Average returns....

• Risk premiums First, we calculate risk
  premiums. The risk premium is the difference
  between a risky investments return and that of a
  riskless asset. Based on historical data
• Investment Average Standard Risk return deviat
  ion premium
• Common stocks 13.2 16.6 9.4
• Small stocks 14.8 23.7 11.0
• LT Bonds 7.6 10.6 3.8
• U.S. Common 15.6 16.9 11.8 (SP 500 in C)
• Treasury bills 3.8 3.2 0

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12.3 Average returns....

• Lets return to our earlier questions.
• Suppose the current T-bill rate is 5. An
  investment has similar risk relative to TSE 300.
  It offers a 10 return. Is this a good
  investment?No. The risk premium is 9.4 and
  the stock will need to return 59.414.4. Its
  return is only 10.
• Suppose an investment is similar in risk to
  buying small Canadian company equities. If the
  T-bill rate is 5, what return would you demand?
  
  Since the risk premium on small stocks
  has been 11, we would demand 16.

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12.3 Average returns....

• The first lesson
• Risky assets, on average, earn a risk premium.
• (There is a reward for bearing risk.)

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12.4 Variability of returnsFigure 8 TSE 300
Frequency of returns (1948-1999)
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Figure 9 Historical Returns and Standard
Deviations

• Investment Average Standard Frequency return d
  eviation
• Small stocks 14.8 23.7
• Common stocks 13.2 16.6
• LT Bonds 7.6 10.6
• Treasury bills 3.8 3.2

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Figure 10 The Normal Distribution
What is the probability of getting a return more
than one standard deviation below the average?
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Figure 11 Asset mean returns versus variability
1948-1999
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12.4 Variability of returns....

• The first lesson
• Risky assets, on average, earn a risk premium.
  (There is a reward for bearing risk.)
• The second lesson
• Higher the return, greater the risk. (There is a
  positive relation between risk and return.)

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12.5 Market Efficiency

• In an efficient market, prices fully reflect
  available information. Eugene Fama (1976).
  (See Figure 12). Depending upon information,
  we have weak, semi-strong and strong efficiency.
• Strong form Current prices reflect not just
  public information but all the private
  information as well, such as insider information.
• Semi-strong form Current prices reflect not
  only past prices but all other published
  information such as earnings announcements and
  macro economic news, etc.
• Weak form Current prices fully reflect all the
  information in the past prices.

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Figure 12 Reaction of Stock Price to New
Information in Efficient Inefficient Markets
Price ()
Overreaction andcorrection
220 180 140 100
Delayed reaction
Efficient market reaction
Days relativeto announcement day
4
6
4
2
0
2
7
8
6
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 8
days elapse before the price completely reflects
the new informationOverreaction The price
overadjusts to the new information it
overshoots the new price and subsequently
corrects.
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12.5 Market Efficiency..

• Prices do appear to respond very rapidly to new
  information, consistent with efficient market
  hypothesis
•   Evidence against market efficiency
• - 1987 crash (1/3 of entire stock market lost
  value in a single day)
• - Excess volatility
• - Size effect
• - January effect
• ? perhaps they imply animal spirit" or noise

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12.5 Market Efficiency..
October 9, 1999 Wall Street Journal Xerox Warns
3rd-Quarter Net Won't Meet Analysts' Estimates
STAMFORD, Conn. -- Xerox Corp. said Friday it
expects third-quarter earnings to miss analysts'
expectations, citing lower-than-expected revenue
and a realignment of the company's sales
strategy. Shares of Xerox dropped 11.75, or 27,
to 31 in midday trading Friday on the New York
Stock Exchange. Xerox said it now expects
earnings of 47 cents to 48 cents a share for the
period, 10 to 12 below the 53 cents it reported
in the year-ago quarter. Analysts surveyed by
First Call/Thomson Financial estimated Xerox's
third-quarter profit at 58 cents a share.
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12.6 Summary

• Return
• Calculation
• Two components
• Capital Market History
• Historical return data
• Lesson one
• Lesson two
• Market Efficiency
• Three forms of market efficiency
• Overall conclusions in market efficiency

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T12.19 Solution to Problems 12.1 and 12.2

• Suppose a stock had an initial price of 58 per
  share, paid a dividend of 1.25 per share during
  the year, and had an ending price of 45. Compute
  the percentage total return.
• The percentage total return (R)
• 1.25 (45 - 58)/58 - 20.26
  
• The dividend yield 1.25/58 2.16
• The capital gains yield (45 - 58)/58 -22.41

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T12.20 Solution to Problem 12.3

• Suppose a stock had an initial price of 58 per
  share, paid a dividend of 1.25 per share during
  the year, and had an ending price of 75. Compute
  the percentage total return.
• The percentage total return (R)
• 1.25 (75 - 58)/58 31.47
• The dividend yield 1.25/58 2.16
• The capital gains yield (75 - 58)/58 29.31