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Essentials of Corporate Finance Ross 8th Edition Solutions Manual

Chapter 10 – Some Lessons from Capital Market History

Chapter 10
SOME LESSONS FROM CAPITAL MARKET
HISTORY
Some Lessons from Capital Market history
10 Chapter Organization Slide Slide Title
Introduction 10.2 Key Concepts and Skills
10.3 Chapter Outline
10.4 Risk-Return Tradeoff
10.1 Returns
Dollar Returns 10.5 Dollar and Percent Returns
Percentage Returns 10.6 Percent Return
10.7 Example: Calculating Total Dollar and Total Percent Returns
10.2 The Historical Record
A First Look 10.8 U.S. Financial Markets: The Historical Record 1925-2011
A Closer Look 10.9 Year-to-Year Total Returns
10.10 Year-to-Year Total Returns
10.11 Year-to-Year Total Returns
10.12 Year-to-Year Inflation
10.3 Average Returns: The First Lesson
Calculating Average Returns 10.13 Average Returns: The First Lesson 1925-2008
Average Returns: The Historical Record 10.14 Historical Average Returns
Risk Premiums 10.15 Risk Premiums
10.16 Historical Risk Premiums
The Variability of Returns: The Second
10.4
Lesson
10.17 Risk - Figure 10.9
10.18 Return Variability Review
Historical Variance & Standard Deviation 10.19 Return Variability: The Statistical Tools of Historical Returns
10.20 Example: Calculating Historical Variance & Standard Deviation
10.21 Example: Work the Web
The Historical Record 10.22 Historical Average Returns & Standard Deviation:Table 10.10
10.23 Return Variability Review and Concepts
Normal Distribution 10.24 The Normal Distribution - Figure 10.11
10.25 Record One-Day Losses
10.26 2008: The Bear Growled and Investors Howled
10.27 2008: S&P 500 Monthly Returns - Figure 10.12
10.5 More on Average Returns
Arithmetic vs. Geometric Mean 10.28 Arithmetic vs. Geometric Mean
10.29 Geometric Average Return: Formula
Calculating Geometric Average Returns 10.30 Geometric Average Return
10.31 Example 10.4: Calculating a Geometric Average Return
10.32 Geometric Average Return
10.33 Historical Geometric vs. Arithmetic Average Returns
Arithmetic or Geometric Average Return 10.34 Arithmetic vs. Geometric Mean: Which is better?
10.6 Capital Market Efficiency
10.35 Efficient Capital Markets
Price Behavior in an Efficient Market 10.36 Reaction of stock price to new information - Figure 10.14
The Efficient Market Hypothesis 10.37 Forms of Market Efficiency
10.38 Strong Form Efficiency
10.39 Semistrong Form Efficiency
10.40 Weak Form Efficiency
10.41 Efficient market Hypothesis
Some Common Misconceptions about EMH 10.42 Common Misconceptions about EMH
10.43 Chapter 10 END

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Chapter 10 – Some Lessons from Capital Market History

Ethics Note (at end of Chapter Outline): Discussion of problems in determining insider trading.

CHAPTER WEBSITES
Websites may be referenced more than once in a chapter. This table just includes the section for the
first reference.

Chapter Section Web Address

Introduction www.mhhe.com/rwj
10.1 finance.yahoo.com
www.smartmoney.com/marketmap
10.2 www.bigcharts.com
10.4 www.robertniles.com/stats
www.morningstar.com
10.6 www.investorhome.com
What’s On the Web? www.stls.frb.org

ANNOTATED CHAPTER OUTLINE

Slide 10.2 Key Concepts and Skills

Slide 10.3 Chapter Outline

Slide 10.4 Risk-Return Trade-off

Two key lessons from capital market history  risk-return trade-off.

Slide 10.5 Dollar and Percent Returns

Total Dollar Return
Income component = direct cash payments such as dividends or interest
Price change = capital gain or loss
Total dollar return = Income component + Capital gain (loss)

Total Percent Return = Total dollar return/Initial investment

Note that these calculations yield Holding Period Return and would need to be annualized for
correct comparison with other investment opportunities.

Emphasize that you do not have to actually sell the stock for you to earn the dollar return on
paper. The point is that you could.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 10 – Some Lessons from Capital Market History

Slide 10.6 Percent Return

Total Percent Return

Percentage return = Dividend yield + Capital gains yield

= Dollar return / Initial investment
Dividend yield = Dt+1 / Pt
Capital gains yield = (Pt+1 – Pt) / Pt

Slide 10.7 Example: Calculating Total Dollar and Total Percent Returns
A numerical example of return computation.

Slide 10.8 U.S. Financial Markets: The Historical Record 1925–2011

Chart (Figure 10.4) reflects data reported by Ibbotson and Sinquefield and presented in the
figures throughout the chapter.

• Large-company stocks—S&P 500 index, which contains 500 of the largest companies in
terms of total market value in the U.S.
• Small-company stocks—smallest 20% of stocks listed on the New York Stock Exchange
based on market value of outstanding stock.
• Long-term corporate bonds—high-quality corporate bonds with 20 years to maturity.
• Long-term government bonds—portfolio of U.S. government bonds with 20 years to
maturity.
• U.S. Treasury bills—portfolio of T-bills with a three-month maturity.

Slide 10.9 Year-to-Year Total Returns: Figure 10.5

Large-company stock returns.

Slide 10.10 Year-to-Year Total Returns: Figure 10.6

Small-company stock returns.

Slide 10.11 Year-to-Year Total Returns: Figure 10.7

Long-term government bond and U.S. Treasury bill returns.

Slide 10.12 Year-to-Year Inflation: Figure 10.8

Year-to-year percentage change in the CPI.

Slide 10.13 Average Returns: The First Lesson

Clearly, small-cap stocks provided the highest return over the 86-year period detailed.

Slide 10.14 Historical Average Returns

The arithmetic average return equals the sum of the observed returns, divided by the number of
observations.

10-3
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 10 – Some Lessons from Capital Market History

Slide 10.15 Risk Premiums

Using the T-bill rate as the risk-free return and aggregate common stocks as an average risk,
define excess return as the difference between an average-risk return and returns on T-bills.

Risk premium—reward for bearing risk, the difference between a risky investment return and the
risk-free rate.

Slide 10.16 Historical Risk Premiums

The risk premiums over the 86-year period are computed as the average return minus the average
T-bill return.

Slide 10.17 Risk: Figure 10.9

In finance, risk is measured by the dispersion of returns.

Figure 10.9 graphically represents the dispersion of returns for common stocks for the period
1926–2011. The curve is skewed slightly to the right (>0) but centered about 11.8%.

Slide 10.18 Return Variability Review

In finance, the two metrics used to measure spread or dispersion are variance and standard
deviation.

Variance is typically referred to as “variability,” while standard deviation is termed “volatility.”

While both measure dispersion, standard deviation is more frequently used because it is
presented in the same units as the average, making it more intuitive to interpret.

Slide 10.19 Return Variability: The Statistical Tools for Historical Returns
A review of the formulas for variance and standard deviation.

Emphasize that these formulas are for historical returns, not expectational.

Slide 10.20 Example: Calculating Historical Variance and Standard

Deviation (Excel link)
The sample data are taken from the first 5 years for large-cap stocks in Table 10.1.

Clicking on the Excel icon brings up a spreadsheet that performs the computations.

It would be advisable to go through the steps in each column of the example.

Slide 10.21 Example: Work the Web (Web link)

Use the Morningstar website to view risk measures for various mutual funds.

10-4
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Chapter 10 – Some Lessons from Capital Market History

Slide 10.22 Historical Average Returns and Standard Deviations

Table 10.10 recaps both average returns and standard deviations for the six categories of
investments and inflation for the period 1926–2011 as well as displaying the dispersion of
returns graphically.

With the added information on risk, we can now see that while small-cap stocks provided the
highest average return, they also had the highest risk metric.

Slide 10.23 Return Variability Review and Concepts

The Normal Distribution is the well-known “bell-shaped curve.”

Historical returns on securities have probability distributions that are approximately normal.
(Figure 10.10 versus Figure 10.11 on the next slide.)

Slide 10.24 The Normal Distribution: Figure 10.11

The normal distribution is completely described by its mean and variance. An observation on a
normally distributed random variable has a 68% chance of being within plus or minus one
standard deviation from the mean, a 95% chance of being within plus or minus two standard
deviations, and a 99% chance of being within plus or minus three standard deviations of the
mean.

Slide 10.25 Record One-Day Losses

These days represent the extreme left tail of the distribution of returns.

Slide 10.26 2008—The Bear Growled and Investors Howled

It is important to note that while the markets declined severely during 2008, there was a reversal
of prices in the years following. It is also worth noting how Treasury returns moved inversely to
the S&P 500 during 2008 due to the “flight to quality” effect.

Slide 10.27 2008—S&P 500 Monthly Returns: Figure 10.12

Slide 10.28 Arithmetic versus Geometric Mean

While students should be comfortable with the arithmetic mean or “simple average,” the
geometric average may be unfamiliar to them

Slide 10.29 Geometric Average Return: Formula

This slide shows Equation 10.4 from the text. A more general, compact formula (not in the text)
is shown on the next slide.

Slide 10.30 Geometric Average Return

This formula uses the π function (PI), which works for multiplication like the Sigma (Σ) works
with addition. This will likely be new to students, so an example on the next two slides details
the calculations.

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Chapter 10 – Some Lessons from Capital Market History

Slide 10.31 Example: Calculating a Geometric Average Return (Ex 10.4)

Slide 10.32 Geometric Average Return (Excel link)
Slide 10.31 demonstrates calculating GAR more or less manually.

Slide 10.32 uses the TVM keys on the BAII+ to find the GAR.

Slide 10.33 Historical Geometric versus Arithmetic Average Returns

It is worth noting how the geometric return is less than the arithmetic return and that the
difference is proportional to the standard deviation.

Slide 10.34 Arithmetic versus Geometric Mean: Which Is Better?

Outlines the biases in each metric and when to choose each one.

Slide 10.35 Efficient Capital Markets

An efficient capital market is a market in which current market prices fully reflect available
information. In such a market, it is not possible to devise trading rules that consistently “beat the
market” after taking risk into account.

Slide 10.36 Reaction of Stock Price to New Information: Figure 10.14

In a truly efficient market, stock prices would react immediately and sharply to new information,
settling into a new equilibrium price. This is shown by the solid line.

The dotted lines show over- and under-reaction to news.

Slide 10.37 Forms of Market Efficiency

Efficient markets hypothesis (EMH)—asserts that modern U.S. stock markets are
informationally efficient. An important implication of the EMH is that financial securities are
zero NPV investments. The expected return on securities is their risk-adjusted required return.

Key insight: competition among investors and traders makes a market efficient.

Noted finance academician, Eugene Fama, defined the three forms of market efficiency relative
to the information incorporated into the stock price:
• Strong form efficiency—all information, both public and private.
• Semistrong form efficiency—all public information.
• Weak form efficiency—all market information, including prices and volume.

Slide 10.38 Strong Form Efficiency

All information, both public and private is already incorporated in the price.

Empirical evidence indicates that this form of efficiency does NOT hold.

See Ethics Note at end of Chapter Outline for discussion of Insider Trading.

10-6
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Chapter 10 – Some Lessons from Capital Market History

Slide 10.39 Semistrong Form Efficiency

All public information is already incorporated in the price.

You cannot consistently earn excess returns using available information to do fundamental
analysis.

Evidence is mixed, but suggests that it holds for widely held firms.
• Empirical evidence suggests that some stocks are semistrong form efficient, but not all.
• Larger, more closely followed stocks are more likely to be semistrong form efficient.
• Small, more thinly traded stocks may not be semistrong form efficient, but liquidity costs
may wipe out any abnormal returns that are available.

Slide 10.40 Weak Form Efficiency

All market information, including prices and volume, is included in the price.

You cannot consistently earn excess returns by looking for patterns in past price and volume
information, such as is done by technical analysts.
• Evidence suggests that markets are weak form efficient based on the trading rules that we
have been able to test.
• Emphasize that, while technical analysis shouldn’t lead to abnormal returns, that doesn’t
mean that you won’t earn fair returns using it—efficient markets imply that you will.
• You might also want to point out that there are many technical trading rules that have
never been empirically tested, so it is possible that one of them might lead to abnormal
returns. But if it is well publicized, then any abnormal returns that were available will
soon evaporate.

Slide 10.41 Efficient Market Hypothesis

Graph portrays the increasing coverage of each form of efficiency—i.e., if markets are
semistrong form efficient, then they are also weak form efficient.

Slide 10.42 Common Misconceptions about EMH

Market efficiency does NOT imply that it doesn’t make a difference how you invest, because the
risk-return trade-off still applies, but rather that you can’t expect to consistently earn excess
returns using costless trading strategies.

Stock price fluctuations are evidence that the market is efficient because new information is
constantly arriving—prices that don’t change are evidence of inefficiency.

Slide 10.43 Chapter 10 END

10-7
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Essentials of Corporate Finance Ross 8th Edition Solutions Manual

Chapter 10 – Some Lessons from Capital Market History

Ethics Note: Insider Trading

Insider trading is illegal, but the determination of what constitutes insider trading is difficult.
Rule 10B-5 of the Securities Exchange Act of 1934 states: “It shall be unlawful for any person,
directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the
mails, or of any facility on a national securities exchange, (1) to employ any device, scheme, or
artifice to defraud, (2) to make any untrue statement of a material fact or omit to state a material
fact necessary in order to make the statements made, in light of the circumstances under which
they were made, not misleading, (3) to engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person, in connection with the purchase
or sale of any security.”

Additionally, several court cases have sought to more clearly define insider trading. For insider
trading to exist, there must be a fiduciary relationship between the parties. Actions of the inside
trader do not have to meet the legal requirements of fraud; they merely have to have the
appearance of acting as a fraud or deceit. Accidental discovery does not constitute a fiduciary
relationship.

The court decided in Chiarella v. United States that an employee of a printing firm, who was
requested to proofread proxies that contained unannounced tender offers (and unnamed targets)
was not guilty of insider trading because the employee determined the identity of the target
through his own expertise.

However, a member of a company’s board of directors, who has knowledge of the company’s
future prospects, may not individually trade on this information prior to public disclosure. The
details of the case may be found in SEC v. Texas Gulf Sulfur, 401 F.2d 833 (2d Cir. 1968).

Despite the passage of increasingly severe penalties for insider trading (see the Insider Trading
Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988),
the evidence suggests that the practice persists in one form or another. One of the more recent
cases deals with Martha Stewart, who recently completed a five-month prison sentence for
obstruction of justice for allegedly lying to investigators during the investigation into violations
of insider trading laws. The investigation stems from a sale of 4,000 shares of Imclone stock a
day before it announced that the FDA rejected the company’s application for a proposed cancer
drug. Stewart and Imclone’s then-CEO, Samuel Waksal, were friends and shared the same stock
broker. Waksal pleaded guilty to insider trading and was sentenced to seven years in prison and
was fined $4.3 million.

10-8
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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