Download CHAPTER Capital Market Theory: An Overview Chapter Outline 9.1

9-0
Chapter Outline
CHAPTER
9
Capital Market Theory:
An Overview
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9.1
9.2
9.3
9.4
Returns
Holding-Period Returns
Return Statistics
Average Stock Returns and Risk-Free
Returns
9.5 Risk Statistics
9.6 Summary and Conclusions
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-2
9.1 Returns
9.1 Returns
Dollar Return = Dividend + Change in Market Value
Dollar Returns
the sum of the cash received
and the change in value of the
asset, in dollars.
Dividends
percentage return =
Ending
market value
=
Time
0
Initial
investment
McGraw-Hill/Irwin
Corporate Finance, 7/e
1
•Percentage Returns
–the sum of the cash received and the
change in value of the asset divided by
the original investment.
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-4
dollar return
beginning market value
dividend + change in market value
beginning market value
= dividend yield + capital gains yield
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-5
9.2 Holding-Period Returns
The holding period return is the return that
an investor would get when holding an
investment over a period of n years, when
the return during year i is given as ri:
holding period return =
= (1 + r1 ) × (1 + r2 ) × L × (1 + rn ) − 1
Holding Period Return: Example
An investor who held this investment would have
actually realized an annual return of 9.58%:
Year Return
1
10%
2
-5%
3
20%
4
15%
Geometric average return =
(1 + rg ) 4 = (1 + r1 ) × (1 + r2 ) × (1 + r3 ) × (1 + r4 )
rg = 4 (1.10) × (.95) × (1.20) × (1.15) − 1
= .095844 = 9.58%
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421 = (1.095844) 4
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1
9-6
9-7
The Future Value of an Investment
of $1 in 1925
Holding Period Return: Example
$1,775.34
Note that the geometric average is not the same
thing as the arithmetic average:
Year Return
1
10%
2
-5%
3
20%
4
15%
Arithmetic average return =
=
1000
$59.70
r1 + r2 + r3 + r4
4
$17.48
10
10% − 5% + 20% + 15%
= 10%
4
Common Stocks
Long T-Bonds
T-Bills
0.1
1930
1940
1950
1960
1970
1980
1990
2000
Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-8
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-9
Historical Returns, 1926-2002
9.3 Return Statistics
average return
R=
( R1 + L + RT )
T
the standard deviation of those returns
SD = VAR =
Standard
Deviation
Large Company Stocks
12.2%
20.5%
Small Company Stocks
16.9
33.2
Long-Term Corporate Bonds
6.2
8.7
Long-Term Government Bonds
5.8
9.4
U.S. Treasury Bills
3.8
3.2
Inflation
3.1
4.4
( R1 − R ) 2 + ( R2 − R ) 2 + L ( RT − R ) 2
T −1
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-10
Distribution
– 90%
0%
+ 90%
Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
the frequency distribution of the returns.
McGraw-Hill/Irwin
Corporate Finance, 7/e
Average
Annual Return
Series
The history of capital market returns can be summarized
by describing the
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-11
9.4 Average Stock Returns
and Risk-Free Returns
The Risk-Return Tradeoff
The Risk Premium is the additional return (over and
above the risk-free rate) resulting from bearing risk.
One of the most significant observations of stock market
data is this long-run excess of stock return over the riskfree return.
18%
Annual Return Average
The average excess return from large company common stocks
for the period 1926 through 1999 was 8.4% = 12.2% – 3.8%
The average excess return from small company common
stocks for the period 1926 through 1999 was 13.2% = 16.9% –
3.8%
The average excess return from long-term corporate bonds for
the period 1926 through 1999 was 2.4% = 6.2% – 3.8%
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Small-Company Stocks
16%
14%
Large-Company Stocks
12%
10%
8%
6%
T-Bonds
4%
T-Bills
2%
0%
5%
10%
15%
20%
25%
30%
35%
Annual Return Standard Deviation
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
2
9-12
9-13
Rates of Return 1926-2002
Risk Premiums
60
Rate of return on T-bills is essentially risk-free.
Investing in stocks is risky, but there are
compensations.
The difference between the return on T-bills and
stocks is the risk premium for investing in stocks.
An old saying on Wall Street is “You can either
sleep well or eat well.”
40
20
0
-20
Common Stocks
Long T-Bonds
T-Bills
-40
-60 26
30
35
40
45
50
55
60
65
70
75
80
85
90
95 2000
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-14
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-15
Normal Distribution
9.5 Risk Statistics
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
There is no universally agreed-upon definition of
risk.
The measures of risk that we discuss are variance
and standard deviation.
Probability
The probability that a yearly
return will fall within 20.1
percent of the mean of 13.3
percent will be
approximately 2/3.
The standard deviation is the standard statistical
measure of the spread of a sample, and it will be the
measure we use most of this time.
Its interpretation is facilitated by a discussion of the
normal distribution.
– 3σ
– 49.3%
– 2σ
– 28.8%
– 1σ
– 8.3%
0
12.2%
+ 1σ
32.7%
+ 2σ
53.2%
+ 3σ
73.7%
Return on
large company common
stocks
68.26%
95.44%
99.74%
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-16
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9-17
Normal Distribution
The 20.1-percent standard deviation we
found for stock returns from 1926 through
1999 can now be interpreted in the
following way: if stock returns are
approximately normally distributed, the
probability that a yearly return will fall
within 20.1 percent of the mean of 13.3
percent will be approximately 2/3.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
9.6 Summary and Conclusions
This chapter presents returns for four asset
classes:
Large Company Stocks
Small Company Stocks
Long-Term Government Bonds
Treasury Bills
Stocks have outperformed bonds over most of
the twentieth century, although stocks have also
exhibited more risk.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3
9-18
9.6 Summary and Conclusions
The stocks of small companies have
outperformed the stocks of small
companies over most of the twentieth
century, again with more risk.
The statistical measures in this chapter are
necessary building blocks for the material
of the next three chapters.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
4