Lesson 4. Capital market theory: an overview

Transcription

1 Lesson 4. Capital market theory: an overview Prof. Beatriz de Blas May 2006

2 4. Capital market theory: an overview 2 Introduction Previous lessons: discount rate for risk-free assets Next: determine discount rate for risky projects Need to measure risk measure risk of an asset (Chapter 9) measure risk of a portfolio (Chapter 10) Plan of the lesson: 8 >< >: 1. Returns 2. Holding-period returns 3. Return statistics

3 4. Capital market theory: an overview 3 1. Returns Dollar returns The return got on an investment % Dividend to shareholders (income component) & Capital gain (or capital loss): change in market value Total dollar return = Dividend income + Capital gain (or loss)

4 4. Capital market theory: an overview Percentage returns Summarize information about returns in percentage terms than in dollars. How much return do we get for each $ invested? market value Let P t be the beginning Dividend yield = Div t+1 P t Capital gains yield = (P t+1 P t ) P t Total percentage return: R t+1 = Div t+1 P t + (P t+1 P t ) P t

5 4. Capital market theory: an overview 5 Example: Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25: Over the last year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of the year, the stock sells for $30: How did you do?

6 4. Capital market theory: an overview 6 Example: Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25: Over the last year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of the year, the stock sells for $30: How did you do? Quite well. You invested $ = $2; 500 At the end of the year, you have stock worth $3; 000 and cash dividends of $20: Your dollar gain was $520 = $20 + ($3; 000 $2; 500) What is your percentage gain?

7 4. Capital market theory: an overview 7 Example: Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25: Over the last year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of the year, the stock sells for $30: How did you do? Quite well. You invested $ = $2; 500 At the end of the year, you have stock worth $3; 000 and cash dividends of $20: Your dollar gain was $520 = $20 + ($3; 000 $2; 500) Your percentage gain for the year is 20:8% = $520 $2; 500

8 4. Capital market theory: an overview 8 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 r i : holding period return = (1 + r 1 ) (1 + r 2 ) ::: (1 + r n ) 1

9 4. Capital market theory: an overview 9 Example: Suppose your investment provides the following returns over a fouryear period: then, your holding period return is Year Return 1 10% 2 5% 3 20% 4 15%

10 4. Capital market theory: an overview 10 Example: Suppose your investment provides the following returns over a fouryear period: then, your holding period return is Year Return 1 10% 2 5% 3 20% 4 15% (1 + r 1 ) (1 + r 2 ) (1 + r 3 ) (1 + r 4 ) 1 = (1:10) (0:95) (1:20) (1:15) 1 = 0:4421 = 44:21%

11 4. Capital market theory: an overview 11 An investor who held this investment would have actually realized an annual return of 9:58% : (1 + r g ) 4 = (1 + r 1 ) (1 + r 2 ) (1 + r 3 ) (1 + r 4 ) = q 4 (1:10) (0:95) (1:20) (1:15) 1 = 0:0958 = 9:58% So, our investor made 9:58% on his money for four years, realizing a total period return of 44:21% 1:4421 = (1:095844) 4

12 9-11 The Future Value of an Investment of $1 in $1, $ $17.48 Common Stocks Long T-Bonds T-Bills 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.

13 9-13 Historical Returns, Average Standard Series Annual Return Deviation Distribution Large Company Stocks 12.2% 20.5% Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation % 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. McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

14 4. Capital market theory: an overview Return statistics The history of capital market returns can be summarized by describing average stock return R = (R 1 + ::: + R T ) T the std. deviation of those returns std:dev: = p s (R var = 1 R) 2 + ::: + (R T R) 2 T 1 frequency distribution of the returns

15 4. Capital market theory: an overview 13 Risk premium: average stock returns and risk-free returns The risk premium is the additional return (over and above the risk-free rate) resulting from bearing risk. In the data ( ): long-run excess of stock return over the risk-free return. Rate of return on T-bills is essentially risk-free. The di erence between the return on T-bills and stocks is the risk premium for investing in stocks. The risk-return tradeo

16 9-16 The Risk-Return Tradeoff 18% 16% Small-Company Stocks Annual Return Average 14% 12% 10% 8% 6% 4% 2% Large-Company Stocks T-Bonds T-Bills 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.

17 9-17 Rates of Return Common Stocks Long T-Bonds T-Bills 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.