2201AFE Corporate Finance

Week 8: Some Lessons from Capital Market History Readings: Chapter 10

Agenda
Last Lecture Some Lessons from Capital Market History
Key Concepts and Skills

Real World Application

The Non-Normal Fidelity Magellan Fund

Last Lecture
Evaluation of NPV Estimates
Scenario Analysis Sensitivity Analysis Simulation Analysis

Break-even
Accounting Cash Financial

Operating Leverage Other consideration in Capital Budgeting

Some Lessons from Capital Market History

Chapter 10

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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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)

 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

History of Australia Stock Exchange

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

http://globaltrendtraders.com/stock-market-analysis/stock-market-history-3ways-to-use-it-to-your-advantage/

Returns
Dollar Returns (Investment Profit) the sum of the cash received and the change in value of the asset, in dollars. Percentage Returns the cash received and the change in value of the asset divided by the original investment.

Dividends

Ending market value

Year 0 Year 1

Initial investment
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Returns
Dollar Return = Dividend + Change in Market Value
Percentage Return dollar return beginning market value

dividend change in market value beginning market value dividend yield capital gains yield C t (Pt Pt 1 ) Ct Pt Pt 1 Rt Pt 1 Pt 1 Pt 1 dividend yield capital gains yield
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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 of n years Holding Period Return = (1+r1) (1+r2) (1+rn) 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:
Year 1 2 3 4
Return

10% -5% 20% 15%

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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Geometric Mean
An investor who held this investment would have earned an annual average compound return of 9.58%: Return Year

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

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%

1 2 3 4

10% -5% 20% 15%

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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Arithmetic Mean
Arithmetic Mean = AM = Ra
Year 1 2 3 4
Return

10% -5% 20% 15%

Our investor earned 10% return in an average year, over the four year investment period.

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Example: Calculating AM and GM

What is the arithmetic and geometric mean for the following returns?
Year 1 Year 2 Year 3 5% -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 always interesting 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't know (former US Defense Secretary 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

Year Actual Return R Average Return Rmean Deviation from the Mean R Rmean Squared Deviation (R Rmean)2

1 2

0.15 0.09

0.105 0.105

0.045 -0.015

0.002025 0.000225

3 0.06 4 0.12 Total 0.42 Average = 0.42 / 4 = 0.105

0.105 0.105

-0.045 0.015 0.00

0.002025 0.000225
= 0.0045

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Example Standard Deviation

SD = 3.87%

68% 95%

99%
6.63% mean 10.50% 14.37%

68% of possible outcomes will lie between 6.63% and 14.37% (mean 1SD) = ( 1) = (10.50 3.87%).
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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 of $1 investment in 1979

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Historical Returns, 1979-2009

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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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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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Efficient Capital Markets

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. Efficient Market Hypothesis or EMH Eugene Fama 1970, Journal of Finance.

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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

Price Fully (properly) Instantaneously Information New/surprise/unexpected Relevant

Price

Efficient Market

Information is reflected in share price instantaneously.

Event time

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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

Efficient Market: Prices would adjust up very quickly. Inefficient Market: Prices would drift upward for some time following the event.
Inefficient Market

Event time

Price

Price

Efficient Market

Event time

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Anticipated Favourable Event

Efficient Market: Prices would drift up for some time before the event and then stabilise.
Efficient Market

Inefficient Market: Prices would drift up for some time before the event and continue up after.
Inefficient Market

Event time

Price

Price

Event time

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Stock Price Reaction

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Case study: Apple Inc.

On Wednesday, August 24, 2011, near the close of the market (just before 4:00), Steve Jobs resigned as CEO

Reaction to Unanticipated Unfavourable Event

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Why does it matter?

If prices DO fully 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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Common misconceptions about EMH

An efficient market doesnt mean you cant make money! It means 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 dont want to put all your eggs in one basket
Three forms: weak, semi-strong and strong

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Weak form efficiency

Prices reflect all past 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. Empirical evidence indicates that markets are generally weak form efficient.

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Semi-strong form efficiency

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

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.

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Real World Application

The Non-Normal Fidelity Magellan Fund

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The Non-Normal Fidelity Magellan Fund

Fidelity Magellan One of the worlds most popular mutual funds, the Fidelity Magellan fund is the largest actively managed mutual fund in the 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 1987 through October 2007 (n = 247) Just how normal are monthly returns from the fund?
Arithmetic Average (%) This Month (%) Comparison to Average (+/-) Volatility (%) Skewness Kurtosis Minimum return (%) Maximum return (%) Range 0.98 1.44 (Oct 07) + 0.45 4.53 -1.09 vs N(0,1) = 0 7.63 vs N(0,1) = 3 -25.80 (Oct 87) 11.91 (Dec 91) 37.71

Histogram - Full Sample

Fidelity Magellan (1987-2007, monthly) 15% 12% 9% 6% 3% 0% -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 PDF N(0,1) ` 100% 80% 60% 40% 20% 0%

Return Distribution (Fidelity)

CDF (Fidelity)

CDF N(0,1)

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Non-Normal Monthly Returns

Fidelity Return Distribution
20 1

15

Skewness Kurtosis

-1.09 vs N(0,1) = 0 7.63 vs N(0,1) = 3

0.8

0.6 10 0.4 5 0.2

0 -26%

0 -22% -18% -14% -11% -7% -3% 1% 4% 8% Monthly Return

Oct 87

Aug 98

Sep02

= 0.98 Sep 01

Aug90

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Next Week
Next week, we will look at returns, risk and the security market line.

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