Chapter 12

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Chapter 12 Some Lessons from Capital Market
History SELECTED PROBLEMS
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CRTC 12 1Question

• Given that Nortel was up by more than 300 percent
  in the 12 months ending in July 2000, why didnt
  all investors hold Nortel?

Agenda
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CRTC 12 1Answer

• Given that Nortel was up by more than 300 percent
  in the 12 months ending in July 2000, why didnt
  all investors hold Nortel?
• They all wish they had! Since they didnt, it
  must have been the case that the stellar
  performance was not foreseeable, at least not by
  most.

Agenda
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CRTC 12 3Question

• We have seen that, over long periods of time,
  stock investments have tended to substantially
  outperform bond investments.
• However, it is not at all uncommon to observe
  investors with long horizons holding entirely
  bonds.
• Are such investors irrational?

Learning Goals
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CRTC 12 3Answer

• We have seen that, over long periods of time,
  stock investments have tended to substantially
  outperform bond investments.
• However, it is not at all uncommon to observe
  investors with long horizons holding entirely
  bonds.
• Are such investors irrational?
• No, stocks are riskier. Some investors are highly
  risk averse, and the extra possible return
  doesnt attract them relative to the extra risk.
• Additionally, bonds can play a very important
  role in overall portfolio diversification because
  the returns on bonds are very weakly correlated
  with the returns on stocks.

Learning Goals
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CRTC 12 4Question

• Explain why a characteristic of an efficient
  market is that investments in that market have
  zero NPVs.

Terms
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CRTC 12 4Answer

• Explain why a characteristic of an efficient
  market is that investments in that market have
  zero NPVs.
• On average, the only return that is earned is the
  required returninvestors buy assets with returns
  in excess of the required return (positive NPV),
  bidding up the price and thus causing the return
  to fall to the required return (zero NPV)
  investors sell assets with returns less than the
  required return (negative NPV), driving the price
  lower and thus the causing the return to rise to
  the required return (zero NPV).

Terms
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CRTC 12 6Question

• If a market is semistrong form efficient, is it
  also weak form efficient? Explain.

Rewards
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CRTC 12 6Answer

• If a market is semistrong form efficient, is it
  also weak form efficient? Explain.
• Yes, historical information is also public
  information weak form efficiency is a subset of
  semi-strong form efficiency.

Rewards
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CRTC 12 7Question

• What are the implications of the efficient
  markets hypothesis for investors who buy and sell
  stocks in an attempt to beat the market?

Wealth
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CRTC 12 7Answer

• What are the implications of the efficient
  markets hypothesis for investors who buy and sell
  stocks in an attempt to beat the market?
• Ignoring trading costs, on average, such
  investors merely earn what the market offers the
  trades all have zero NPV. If trading costs exist,
  then these investors lose by the amount of the
  costs.

Wealth
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CRTC 12 8Question

• Critically evaluate the following statement
• Playing the stock market is like gambling. Such
  speculative investing has no social value, other
  than the pleasure people get from this form of
  gambling.

What is it?
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CRTC 12 8Answer

• Critically evaluate the following statement
• Playing the stock market is like gambling. Such
  speculative investing has no social value, other
  than the pleasure people get from this form of
  gambling.
• Unlike gambling, the stock market is a positive
  sum game everybody can win. Also, speculators
  provide liquidity to markets and thus help to
  promote efficiency.
• Efficient secondary markets make it possible for
  firms to raise capital in the primary markets.

What is it?
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CRTC 12 9Question

• There are several celebrated investors and
  stockpickers frequently mentioned in the
  financial press who have recorded huge returns on
  their investments over the past two decades.
• Is the success of these particular investors an
  invalidation of the EMH? Explain.

Process
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CRTC 12 9Question
Warren Buffet Berkshire Hathaway - 2006 report

• There are several celebrated investors and
  stockpickers frequently mentioned in the
  financial press who have recorded huge returns on
  their investments over the past two decades.
• Is the success of these particular investors an
  invalidation of the EMH? Explain.
• The EMH only says, within the bounds of
  increasingly strong assumptions about the
  information processing of investors, that assets
  are fairly priced. An implication of this is
  that, on average, the typical market participant
  cannot earn excessive profits from a particular
  trading strategy. However, that does not mean
  that a few particular investors cannot outperform
  the market over a particular investment horizon.
  Certain investors who do well for a period of
  time get a lot of attention from the financial
  press, but the scores of investors who do not do
  well over the same period of time generally get
  considerably less attention from the financial
  press.

Process
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Questions and Problems 12 1Question

• Suppose a stock had an initial price of 64 per
  share, paid a dividend of 1.75 per share during
  the year, and had an ending share price of 72.
• Compute the percentage total return.
• The return of any asset is the increase in price,
  plus any dividends or cash flows, all divided by
  the initial price. The return of this stock is
• R (72 64) 1.75 / 64 .1523 or 15.23

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Questions and Problems 12 1Answer

• Suppose a stock had an initial price of 64 per
  share, paid a dividend of 1.75 per share during
  the year, and had an ending share price of 72.
• Compute the percentage total return.
• The return of any asset is the increase in price,
  plus any dividends or cash flows, all divided by
  the initial price. The return of this stock is

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Questions and Problems 12 2Question

• In Problem 1, what was the dividend yield? The
  capital gains yield?

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Questions and Problems 12 2Answer

• In Problem 1, what was the dividend yield? The
  capital gains yield?

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Questions and Problems 12 4 (a)Question

• What is the arithmetic return for the SP/TSX
  Composite Index from 1996 to 2005?

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Questions and Problems 12 4 (a)Answer

• What is the arithmetic return for the SP/TSX
  Composite Index from 1996 to 2005?

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Questions and Problems 12 4 (b)Question

• What is the arithmetic return for the Scotia
  Capital Marketts long bonds from 1996 to 2005?

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Questions and Problems 12 4 (b)Answer

• What is the arithmetic return for the Scotia
  Capital Marketts long bonds from 1996 to 2005?

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Questions and Problems 12 5 (a)Question

• What is the geometric return for the SP/TSX
  Composite Index from 1996 to 2005?

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Questions and Problems 12 5 (a)Answer

• What is the geometric return for the SP/TSX
  Composite Index from 1996 to 2005?

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Questions and Problems 12 5 (b)Answer

• What is the geometric return for the Scotia
  Markets Long Bonds from 1996 to 2005?

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Questions and Problems 12 6Question

• Suppose you bought a 9 percent coupon bond one
  year ago for 1,050. The bond sells for 1,080
  today.
• Assuming a 1,000 face value, what was your total
  dollar return on this investment over the past
  year?
• What was your total nominal rate of return on
  this investment over the past year?
• If the inflation last year was 4 percent, what
  was your total real return on this investment?

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Questions and Problems 12 6Answer

• Suppose you bought a 9 percent coupon bond one
  year ago for 1,050. The bond sells for 1,080
  today.
• a. Assuming a 1,000 face value, what was your
  total dollar return on this investment over the
  past year?
• Total dollar return 1,080 - 1,050 90
  120.
• b. What was your total nominal rate of return on
  this investment over the past year?
• R (1,080 - 1,050) 90 / 1,050 .1143
• 11.43
• c. If the inflation last year was 4 percent, what
  was your total real return on this investment?
• Using the Fisher equation, the real return was
• (1 R) (1 r)(1 h)
• R (1.1143 / 1.04) 1 .0714 7.14

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Questions and Problems 12 9Question

• Using the following returns, calculate the
  arithmetic average returns, the variances, and
  the standard deviations for X and Y.

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Questions and Problems 12 9Answer

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Questions and Problems 12 10Question

• Refer to Table 12.1 in the text and look at the
  period from 1970 through 1975.
• Calculate the arithmetic average returns for
  large-company stocks and T-bills over this time
  period.
• Calculate the standard deviation of the returns
  for large-company stocks and T-bills over this
  time period.
• Calculate the observed risk premium in each year
  for the large-company stocks versus the T-bills.
  What was the average risk premium over this
  period? What was the standard deviation of the
  risk premium over this period?
• Is it possible for the risk premium to be
  negative before an investment is undertaken? Can
  the risk premium be negative after-the-fact?
  Explain.

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Questions and Problems 12 10Answer

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Questions and Problems 12 10Answer

d. Before the fact, for most assets the risk
premium will be positive investors demand
compensation over and above the risk-free return
to invest their money in the risky asset. After
the fact, the observed risk premium can be
negative if the assets nominal return is
unexpectedly low, the risk-free return is
unexpectedly high, or if some combination of
these two events occurs.
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Questions and Problems 12 15Question
You bought one of Great White Shark Repellant
Co.s 8 percent coupon bonds one year ago for
980. These bonds make annual payments and
mature six years from now. Suppose you decide to
sell your bonds today, when the required return
on the bonds is 9 percent. If the inflation
rate was 4.2 percent over the past year, what was
your total real return on investment?

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Questions and Problems 12 15Answer
To find the real return, we first need to find
the nominal return, which means we need the
current price of the bond. Going back to the
chapter on pricing bonds, we find the current
price is P1 80(PVIFA9,6) 1,000(PVIF9,6)
955.14 So the nominal return is R
(955.14 980) 80/980 .0563 or
5.63 And, using the Fisher equation, we find
the real return is 1 R (1 r)(1 h) r
(1.0563/1.042) 1 .0137 or 1.37

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Questions and Problems 12 18Problem
A stock has had the following year-end prices and
dividends What are the arithmetic and
geometric average returns for the stock?

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Questions and Problems 12 18Answer
First we will calculate the Holding Period
Returns for each year. What are the
arithmetic and geometric average returns for the
stock?

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Questions and Problems 12 18Answer
Now we can find both the arithmetic and the
geometric mean. What are the
arithmetic and geometric average returns for the
stock?

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Questions and Problems 12 19Question Using
Return Distributions
Suppose the returns on long-term government bonds
are normally distributed. Based on the
historical record, what is the approximate
probability that your return on these bonds will
be less than 3.6 percent in any given
year? What range of returns would you expect to
see 95 percent of the time? What range of
returns would you expect to see 99 percent of the
time?

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Questions and Problems 12 19Answer Using
Return Distributions
Suppose the returns on long-term government bonds
are normally distributed. Based on the
historical record, what is the approximate
probability that your return on these bonds will
be less than 3.6 percent in any given
year? Therefore the probability that the
bonds returns will be less than -3.6 percent in
any given year (based on the historical data
available) is 11.1. 1.00 - .111 .889
88.9 of the time, bond returns will be greater
than -3.6.

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Questions and Problems 12 19Answer Using
Return Distributions
Suppose the returns on long-term government bonds
are normally distributed. What range of
returns would you expect to see 95 percent of the
time?

42
Questions and Problems 12 19Answer Using
Return Distributions
Suppose the returns on long-term government bonds
are normally distributed. What range of
returns would you expect to see 99 percent of the
time?

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THE END!