Chapter Ten
Some Lessons from Capital
Market History
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Chapter Organisation
10.1 Returns
10.2 Inflation and Returns
10.3 The Historical Record
10.4 Average Returns: The First Lesson
10.5 The Variability of Returns: The Second Lesson
10.6 Capital Market Efficiency
Summary and Conclusions
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Chapter Objectives
• Distinguish between dollar returns and percentage
returns.
• Examine the effect of inflation on returns.
• Gain an appreciation of historical returns and their
variability for different assets.
• Calculate average return and standard deviation.
• Discuss market efficiency and its three forms.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Dollar Returns
• The gain (or loss) from an investment.
• Made up of two components:
– income (e.g. dividends, interest payments)
– capital gain (or loss).
• Not necessary to sell investment to include capital
gain or loss in return.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Percentage Returns
Dividends paid at
end of period
+
Change in market
value over period
Percentage return =
Beginning market value
Dividends paid at
+
end of period
Market value
at end of period
1 + Percentage return =
Beginning market value
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Percentage Return Example
Pt = $37.00
Pt+1 = $40.33
Dt+1 = $1.85
$1.85  $40.33  $37.00 
% Return 
$37.00
 0.14 or 14%
Per dollar invested we get 5 cents in dividends and 9
cents in capital gains—a total of 14 cents or a return of
14 per cent.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Percentage Returns
Total
$42.18
Inflows
Dividends
$1.85
Ending
market value
$40.33
Time
Outflows
t
t=1
– $37
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Real versus Nominal Returns
• Real return is the return after taking out the effects of
inflation.
• Real return shows the percentage change in buying
power.
• Nominal return is the return before taking out the
effects of inflation.
• Nominal return is the percentage change in the
number of dollars you have.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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The Fisher Effect
• The Fisher effect explores the relationship between
real returns (r), nominal returns (R), and inflation (h).
1  R   1  r   1  h 
• The nominal rate is approximately equal to the real
rate plus the inflation rate.
R≈r+h
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Capital Market History
• Risky securities, such as stocks, have had higher
average returns than riskless securities, such as
Treasury Bills.
• Stocks of small companies have had higher average
returns than those of large companies.
• Long-term bonds have had higher average yields and
returns than short-term bonds.
• The cost of capital for a company, project, or division
can be predicted using data from the markets.
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A$1 Invested in Different Types of
Portfolios, 1979-2006
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Consumer Price Index (CPI) 19792006
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All Ordinaries Accumulation Index
1979-2006
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Returns on Small Cap Shares
1979-2006
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Returns on 10-year Bonds 19792006
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Returns on 90-day Bank Bills
1979-2006
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Average Returns: The First
Lesson
• A way to calculate the average returns on different
investments is simply to add up returns for a number
of periods and divide by the number of periods (e.g.
years, months, days, etc).
• The risk premium is the excess return required from
an investment in a risky asset over a risk-free
investment.
• Lesson from History: Risky assets, on average, earn
a risk premium (i.e. there is a reward for bearing risk).
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Average Equivalent Returns
& Risk Premiums 1979–2006
Investment
Risk
Premium
Ordinary shares
Average
Equivalent
Returns
17.0%
Small shares
21.1%
11.4%
90-day bank bills
9.7%
0.0%
10-year govt bonds
9.6%
-0.1%
7.3%
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Variability: The Second Lesson
• The greater the risk, the greater the potential reward.
• This lesson holds over the long term but may not be
valid for the short term.
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Frequency of Returns on Ordinary
Shares 1901-2006
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Variance and Standard Deviation
• Measures of variability.
• Variance is the average squared deviation between
the actual return and the average return.

1
2
2
Var R  
 R 1  R   ....  R T  R 
T 1

• Standard deviation is the square root of the variance.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Example—Variance and Standard
Deviation
ABC Co. have experienced the following returns in the last
five years:
Year
Returns
2002
-10%
2003
5%
2004
30%
2005
18%
2006
10%
Calculate the average return and the standard deviation.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Example—Variance and Standard
Deviation
Average return 
(-0.10  0.05  0.30  0.18  0.10)
5
 0.106
Year
2002
2003
2004
2005
2006
Actual
Return
– 0.10
0.05
0.30
0.18
0.10
0.53
Average
Return
0.106
0.106
0.106
0.106
0.106
Deviation
– 0.206
– 0.056
0.194
0.074
– 0.006
0
Squared
Deviation
0.042436
0.003136
0.037636
0.005476
0.000036
0.088720
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Example—Variance and Standard
Deviation
0.08872
Variance 
 0.02218
5  1 
Std deviation  0.02218  0.1489 or 14.89%
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Historical Returns and Standard
Deviations, 1979-2006
Series
Ordinary shares
Small shares
Bank bills
Govt bonds
Inflation
Average
Annual
Returns
17%
21%
10%
10%
5%
Standard
Deviation
21.2%
31.6%
4.5%
3.4%
3.4%
Conclusion: Historically, the riskier the asset, the
greater the return.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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The Normal Distribution
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Capital Market Efficiency
• The efficient market hypothesis (EMH) asserts that
the price of a security accurately reflects all available
information.
• Implies that all investments have a zero NPV.
• Implies also that all securities are fairly priced.
• If this is true then investors cannot earn ‘abnormal’ or
‘excess’ returns.
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Price Behaviour in Efficient and
Inefficient Markets
Price ($)
Overreaction and
correction
220
180
Delayed reaction
140
Efficient market reaction
100
–8 –6 –4 –2
0
+2 +4 +6 +7
Days relative
to announcement day
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What Makes Markets Efficient?
• There are many investors out there doing research:
– As new information comes into the market, this information is
analysed and trades are made based on this information.
– Therefore, prices should reflect all available public
information.
• If investors stop researching stocks, then the market
will not be efficient.
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EMH: Common misconceptions
• Efficient markets do not mean that you can’t make
money.
• They do mean that, on average, you will earn a return
that is appropriate for the risk undertaken and that
there is not a bias in prices that can be exploited to
earn excess returns.
• Market efficiency will not protect you from making the
wrong choices if you do not diversify—you still don’t
want to put all your eggs in one basket.
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Price Behaviour in Efficient and
Inefficient Markets
• 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. Several days elapse before the
price completely reflects the new information.
• Overreaction: The price over-adjusts to the new
information. It ‘overshoots’ the new price and
subsequently corrects itself.
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Forms of Market Efficiency
• Weak-form efficiency: Current prices reflect
information contained in the past series of prices.
• Semi-strong form efficiency: Current prices reflect
information contained in the past series of prices and
all other publicly available information.
• Strong-form efficiency: Current prices reflect all
available information (e.g. past series of prices,
public information and private information).
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Summary and Conclusions
• Risky assets, on average, earn a risk premium.
• The greater the potential reward from a risky
investment, the greater the risk.
• In an efficient market, prices adjust quickly and
correctly to new information.
• The Efficient Market Hypothesis (EMH) states that
well organised capital markets are efficient and
investors cannot make abnormal returns.
• Asset prices in efficient markets are rarely over or
under priced because ‘all available’ information has
already been factored into the price and investors get
exactly what they pay for.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
10-33