Lecture 6: Lessons from Capital Market History 2024 PDF

Chapter 12 Lessons from Capital Market History COMM 2FA3 Fall 2024 Sections C01, C02, and C03 Introduction to Finance Yingnan Zhao DeGroote School of Business McMaster University The original slides were prepared by Larbi Hammamai, Desautels Faculty of Management, McGill University...

Chapter 12 Lessons from Capital Market History COMM 2FA3 Fall 2024 Sections C01, C02, and C03 Introduction to Finance Yingnan Zhao DeGroote School of Business McMaster University The original slides were prepared by Larbi Hammamai, Desautels Faculty of Management, McGill University © 2022 McGraw-Hill Education Limited. All Rights Reserved. 1 / 33 Key Concepts and Skills 1. Know how to calculate the return on an investment 2. Understand the historical returns and risks of various types of investments 3. Know the implications of market efficiency 2 / 33 Chapter Outline ▶ 12.1-12.3, 12.5: Returns and average returns ▶ 12.4: The Variability of Returns ▶ 12.6: Capital Market Efficiency 3 / 33 12.1 Returns ▶ Total dollar return = Income from investment + capital gain (loss) due to change in price ▶ Example: You bought a bond for $950 1 year ago. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return? 4 / 33 Investment Returns on Coca-Cola 5 / 33 Rate of Return: Example You bought a stock for $35. You received dividends of $1.25 and sold the stock for $40 right after receiving the dividends. 1. What is your dollar return? 2. What is your percentage return? 6 / 33 12.5 More on Average Returns ▶ Many different ways of calculating returns over multiple periods: 1. Arithmetic average return 2. Geometric average return 7 / 33 Average Returns: Example ▶ You invested $100 in a stock five years ago. Over the last five years, annual returns have been 15%, -8%, 12%, 18%, and -11%. 1. What is the arithmetic average return? 2. What is your investment worth today? 3. What is your average annual rate of return? 8 / 33 Average Returns: Example (cont.) 2. What is the investment worth Today? F V = $100(1 + 0.15)(1 − 0.08)(1 + 0.12)(1 + 0.18)(1 − 0.11) = $124.44 9 / 33 Average Returns: Example (cont.) ▶ What equivalent rate of return would you have to earn every year on average to achieve this same future wealth? 124.44 = 100 × (1 + RG )5 1 RG = 1.2444 5 − 1 ⇒ RG = 4.47% < 5.2% ▶ The average return was lower than the arithmetic average because of the effects of compounding 10 / 33 Average Returns: General Formula ▶ Many different ways of calculating returns over multiple periods: 1. Arithmetic average return, Ra Ra = (R1 + R2 + · · · + RT ) /T 2. Geometric average return, Rg 1 Rg = [(1 + R1 ) × (1 + R2 ) × · · · × (1 + RT )] T − 1 11 / 33 Geometric vs. Arithmetic Average Returns 12 / 33 Returns to $1 investment, 1957–2019 13 / 33 The Equity Premium Puzzle: A Global Phenomenon 14 / 33 Risk and Return ▶ Modern finance theory assumes that investors are risk averse - In principle: Higher risk = Higher return (risk-return tradeoff) - Treasury bills are considered to be risk-free - Risk premium = Risky return - Risk-free return ▶ To estimate the expected return of a security, we need to measure its risk 15 / 33 What is Risk? Risk-Free Security ▶ When the actual return of a security is always equal to the expected return, there is no risk ⇒ A risk-free security 16 / 33 Figure 12.5 Frequency distribution of returns on Canadian common stocks 17 / 33 What is Risk? Return Distribution for Risky Security ▶ The deviation of the actual return of a security from its expected return (i.e., the volatility of asset returns) implies risk ⇒ Riskiness is measured by the variance and standard deviation of the distribution of actual returns. For a given expected return, the higher the variance, the greater the risk 18 / 33 12.4 The Variability of Returns ▶ Let R1 , R2 ,... , RN be N observations of asset returns. ▶ Then, the mean of returns is defined as N 1 1 X R= (R1 + · · · + RN ) = Ri N N i=1 ▶ The sample (historical) variance and standard deviation of returns are defined as N 1 X Var(R) = (Ri − R)2 N − 1 i=1 p Std. Dev.(R) = σ(R) = Var(R) 19 / 33 Table 12.4 Historical returns and standard deviations, 1957-2019 20 / 33 Figure 12.6 The normal distribution ▶ Normal distributions are determined by their mean and variance 21 / 33 12.6 Capital Market Efficiency 22 / 33 12.6 Capital Market Efficiency ▶ There are many investors out there doing research ▶ As new information comes to market, this information is analyzed and trades are made based on this information ▶ In an efficient capital market, prices of financial products should reflect all available information ▶ If investors stop researching stocks, then the market will not be efficient. 23 / 33 Price Behaviour in an Efficient Market ▶ How should the stock price of Firm A behave in an efficient market in the following scenarios? 1. You read on social media that Firm A is launching a profitable project 2. Firm A announces in a press conference that they have achieved the expected goal of the project. 3. Firm A announces in a press conference that the sales revenue increased by 20%, but the market expected the revenue to increase by at least 30%. 24 / 33 Figure 12.7 Reaction of stock price to new information in efficient and inefficient markets 25 / 33 Space Shuttle Challenger Disaster ▶ NASA launched the Space Shuttle Challenger on January 28, 1986, 11:38 am. 73 seconds into its flight, the space shuttle disintegrated 26 / 33 Six Months of Investigation ▶ Rogers Commission Report published on June 9, 1986, concluded that Morton Thiokol was at fault 27 / 33 Price Discovery of the Stock Market - Maloney, M. T., & Mulherin, J. H. (2003). The complexity of price discovery in an efficient market: the stock market reaction to the Challenger crash. Journal of corporate finance, 9(4), 453-479. 28 / 33 Efficient Market Hypothesis ▶ Proposed by Fama in the 1960s ▶ Well-organized capital markets (e.g., TSX, NYSE) are efficient markets ▶ Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market. Investors should not earn ”abnormal” or ”excess” returns 29 / 33 Three Forms of Market Efficiency 1. 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 possess ▶ Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns 30 / 33 Three Forms of Market Efficiency 2. Semistrong Form Efficiency ▶ Prices reflect all publicly available information including trading information, annual reports, press releases, etc. ▶ If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information ▶ Implies that fundamental analysis will not lead to abnormal returns 31 / 33 Three Forms of Market Efficiency 3. 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 studying past prices ▶ Implies that technical analysis will not lead to abnormal returns 32 / 33 Summary and Conclusions You should know that: 1. Risky assets earn a risk premium 2. Greater risk requires a larger required reward 3. In an efficient market, prices adjust quickly and correctly to new information 4. The three levels of market efficiency are strong form efficient, semi-strong form efficient, and weak form efficient. 33 / 33