Module Two

Chapter 10 – Lessons from

capital market history

. 21
What did we learn so far
How to forecast the CF /
Initial investment:
FINANCIAL PLANNING

How to estimate the

required rate of return
(for taking risky
How to make capital budgeting investments)?
(or investment) decision based
on key investment metrics

Source: https://www.educba.com/net-present-value-formula/
22
Learning Objectives
By the end of this module, you should be able to:
A. Understand the historical returns and risks on various
important types of investments.
B. Understand the implications of market efficiency.
C. Understand how to calculate the return on an investment.

23
 Revisit fundamental finance concepts
Returns
A
• At the beginning of the year, the stock was selling for $37 per
share. If you had bought 100 shares, you would have had a total
outlay of $3,700.
• Suppose that, the stock paid a dividend of $1.85/ share during
the year. Also, the value of the stock has risen to $40.33 per
share by the end of the year.
• How much is your total returns on investment (in $)?
A. $185
B. $333
C. $508 DOLLAR RETURN
D. $518
E. $4,218

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 Revisit fundamental finance concepts
Returns
A
[SAME EXAMPLE]
At the beginning of the year, the stock was selling for $37 per
share. If you had bought 100 shares, you would have had a total
outlay of $3,700. Suppose that, over the year, the stock paid a
dividend of $1.85 per share. Also, the value of the stock has
risen to $40.33 per share by the end of the year.
• How much is your total returns on investment (in %)?

PERCENTAGE =
= RETURN

25
 Revisit fundamental finance concepts
Returns
A
• Why we need to calculate % return?
ØPercentage (%) return brings any returns on investment to a
same unit, make it easy to compare.
ØIn other words, percentage return helps answer the question:
“How much do we get for $1 we invest?” (doesn’t depend on
how much you invested)

26
 Revisit fundamental finance concepts

A Real vs Nominal Returns

Example 1:
• You made $100 investment today, and expect it will be worth
$115.5 in one year. What is your percentage return?
Ø Answer: 15.5% Nominal return

Example 2:
• Suppose a pizza today costs $5. Assume that the inflation rate is
5%, or a pizza will cost 5% more, or $5.25, in one year. Measured
in pizzas, what is the rate of return on this investment?
ØWith $100 today, we can buy 20 pizzas.
ØIn 1 year, your $100 investment will grow to $115.5, or your worth
can pay for $115.50/$5.25 = 22 pizzas
Ørate of return (measured in pizza) is 22/20-1 = 10% Real return

27
 Revisit fundamental finance concepts

A Real vs Nominal Returns

What has been illustrated is that:
• Even though the nominal return on your investment is
15.5%,
• your purchasing power goes up by only 10% because of
inflation.
• In another words, you are only 10% richer
-> We say that the real return is 10%.
• The nominal rate on an investment is the percentage
change in the number of dollars you have.
• The real rate on an investment is the percentage change
in how much you can buy with your dollars—in other
words, the percentage change in your purchasing
power.
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 Revisit fundamental finance concepts

A The Fisher Effect

The Fisher effect explains the relationship
between nominal returns (R), real returns (r), and
inflation (h), as following:

(1 + R ) = (1 + r ) ´ (1 + h )
For simplicity, the nominal rate is approximately
equal to the real rate + the inflation rate.

R≈r+h

29
 Revisit fundamental finance concepts
The Fisher Effect –
A Example
Last year, you purchased a stock at a price of $47.10 a share.
Over the course of the year, you received $2.40 per share in
dividends while inflation averaged 3.4%. Today, you sold your
shares for $49.50 a share.
What is your approximate real rate of return on this investment?
A. 6.3%
B. 6.79%
C. 7.18% $49.50 − $47.10) + $2.40
Nominal return = = 10.19%
$47.10
D. 9.69%
E. 10.19% Approximate real return = 10.19% - 3.4% = 6.79%

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 Statistics – How did $1 invested in
Different Types of Portfolios change
B from 1979-2011
Quarter-To-Quarter returns

Small Caps

All Ords

10y bond & Bills

CPI

31
 Average Returns:
B The First Lesson
• The history of capital market returns is too complicated to
use in its undigested form.
• One way to summarize all these numbers is to calculate
average returns.
• The average returns on different investments are
calculated by :
§ simply adding up returns for a number of periods and
§ divide by the number of periods (e.g. years, months, days,
etc.)

32
B Capital Market History

What are observations on the historical data?

• Stocks of small companies have had higher average returns
than those of large companies.
• Treasury bills: the lowest average rate of return - because the
government can always raise taxes to pay its bills, the debt
represented by T-bills is basically risk-free over its short life.
Thus, the rate of return on such debt is also known as the risk-
free return.
• Risky securities (e.g. stocks), earned higher average returns
than Treasury Bills. This “excess” return is the additional
earning rewarded for investors to move from a risk-free
investment to a risky one (i.e. a reward for bearing risk), or we
also call it as “risk premium” (e.g. 14.42% - 8.97% = 5.45%)

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 Consumer Price Index (CPI)
B 1979-2009

34
 All Ordinaries
B Accumulation Index 1979-
2009

35
 Returns on Small Cap Shares
B 1979-2009

36
 Returns on 10-year
B Bonds 1979-2009

37
 Returns on 90-day Bank Bills
B 1979-2009

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 Average Equivalent Returns
B & Risk Premiums 1979–2009

Investment Average Risk

Equivalent Premium
Returns
Ordinary shares 14.8% 5.96%
Small shares 18.48% 9.64%
90-day bank bills 9.26% 0.43%
10-year govt bonds 8.84% 0.00%

39
 Variability of returns:
B The Second Lesson
• We have seen that the returns on stocks tend to be more
volatile than the returns on long-term government bonds.
• In other words, the level of changing, in QoQ returns (%) on
common stocks > that of long-term bonds.
• How to measure the volatility?
=> The simplest measurement of the variability of returns is
variance.

Variance is the averaged squared deviation

between the actual return and the average return.

40
 Variance and Standard Deviation
B
• Are 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.

41
 Variability of returns:
B 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.

42
 Frequency of Returns on
B Ordinary Shares 1901-2009

43
 Example
B Variance and Standard Deviation
ABC Co. has experienced the following returns
in the last 5 years:
Year Returns
2002 -10%
2003 5%
2004 30%
2005 18%
2006 10%

Calculate the average return and the standard deviation.

44
 Example
B Variance and Standard Deviation

Year Actual return Average Deviation

Deviation Squared
Squared
return Deviation
Deviation
A B C=A-B
C=A-B D=C^2
D=C^2
2002 -10.0% 10.6% -20.6%
-20.6% 0.04244
0.04244
2003 5.0% 10.6% -5.6%
-5.6% 0.00314
0.00314
2004 30.0% 10.6% 19.4%
19.4% 0.03764
0.03764
2005 18.0% 10.6% 7.4%
7.4% 0.00548
0.00548
2006 10.0% 10.6% -0.6%
-0.6% 0.00004
0.00004
Sum 0.08872
0.08872

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 Example
B Variance and Standard Deviation
Series Average Standard
Annual Deviation
Returns
Ordinary shares 14.8 22.3
Small shares 18.5 32.7
Govt bonds 8.8 4.4
Inflation 4.9 3.3

Conclusion: Historically, the riskier the asset

(greater variance/std dev), the greater the return.

46
 The Normal Distribution
B

47
C Capital Market Efficiency
• “Market efficiency” refers to the degree to which market
prices of securities reflect all available, relevant information.
• The efficient market hypothesis (EMH) says that: If markets
are “efficient”, then all information is already incorporated
into prices, and
• So, there is no way to "beat" the market (i.e. outperform
the market returns) because there are no undervalued or
overvalued securities available.
Ø Implies that all investments have a zero NPV (i.e.
there is no difference b/w the market value of an
investment and cost to acquire it – you get what you
pay for).
Ø Implies also that all securities are fairly priced.
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 Price Behaviors in
C Efficient vs Inefficient Markets
Inefficient The price over-adjusts to the new information; it
market overshoots the new price and subsequently corrects.

The price partially adjusts to the new

information; it takes 8 days delay
before the price completely reflects
Impact of
the new information.
new information

Current share
price

Efficient The price rapidly (i) adjusts to and

market (ii) fully reflects new information;
-> no tendency for subsequent
increases and decreases

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 What Makes Markets
C “Efficient”?
• If investors do researches:
• When new information comes into the market,
this information is analysed; and trades are
made by investors based on this information.
• Therefore, prices should reflect all available
public information.
• If investors stop researching stocks, then the market
will not be efficient.

50
 EMH:
C Common misconceptions
• Efficient markets do not mean that you can’t make
money.
• It means that, on average, you will earn a return level
which is appropriate for the risk undertaken, and there is no
bias in prices that you can take advantage to earn excess
returns.
• Market efficiency will not protect you from making the
wrong choices if you do not diversify (i.e. all your eggs in
one basket).

51
 3 Forms of Market Efficiency
C • If the market is strong form efficient, then all information
of every kind is reflected in stock prices (i.e. both public
& private information). In such a market, there is no such
thing as inside information.

• If a market is semi-strong form efficient, then all public

information (including past & current data) is reflected in
the stock.

• Lastly, weak-form efficiency suggests that, at a

minimum, the current price of a stock reflects its own
past prices.

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 Market Efficiency - Example
C
Which one of the following statements is correct concerning
market efficiency?
A. Real estate markets are more efficient than financial markets.
B. If a market is efficient, arbitrage opportunities should be
common.
C. In an efficient market, some market participants will have an
advantage over others.
D. A firm will generally receive a fair price when it issues new
shares of stock.
E. New information will gradually be reflected in a stock's price to
avoid any sudden change in the price of the stock.

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 Summary and Conclusions
C
1. Risky assets, on average, earn a risk premium.
2. The greater the potential reward from a risky investment, the
greater the risk.
3. In an efficient market, prices adjust quickly and correctly to
new information.
4. The Efficient Market Hypothesis (EMH) states that well
organised capital markets are efficient, and investors cannot
make abnormal returns (no free lunch).
5. Assets in efficient markets are not often over or under priced,
because ‘all available’ information has already been factored
into the price, and investors get exactly what they pay for.

54
 Module Two
Valuation, capital budgeting and risk

Chapter 11 – Return, risk and

The security market line

. 55
Learning Objectives

• Know how to calculate expected returns

• Understand the impact of diversification
• Understand the systematic risk principle
• Understand the security market line
• Understand the risk-return trade-off
• Be able to use the Capital Asset Pricing Model

56
Chapter Outline

A. Expected Returns and Variances

B. Portfolios
C. Announcements, Surprises, and Expected
Returns
D. Risk: Systematic and Unsystematic
E. Diversification and Portfolio Risk
F. Systematic Risk and Beta
G. The Security Market Line
H. The SML and the Cost of Capital: A Preview

57
A Expected Returns
• In the Ch10, we have discussed on average return & variance
of historical data. This Chapter will look at future returns &
variances, where uncertainties will involve.
• In uncertain environment, different scenarios/outcomes may
happen at different chances/probabilities.
• Expected returns are based on the probabilities of possible
outcomes. In this context, “expected” means AVERAGE if the
process is repeated many times.
• The “expected” return does not even have to be a possible
return
n
E ( R ) = å p i Ri
i =1

58
 Example:
A Expected Returns
• Suppose you have predicted the following returns for stocks C
and T in three possible scenarios of economy.

Return of investment
Scenario probability (p) C T
Boom 30% 15% 25%
Normal 50% 10% 20%
Recession ??? 2% 1%

• What are the expected returns?

• RC = 0.3*15% + 0.5*10% + 0.2*2% = 9.9%

• RT = 0.3*25% + 0.5*20% + 0.2*1% = 17.7%

59
 Variance and
A Standard Deviation (SD)
• Variance and SD still measure the volatility of returns, of
expected return vs different scenarios of returns.
• How:
i. Calculate squared deviations from expected
returns
ii. Multiply each squared deviation by its probability
iii. Add these up -> variance
• Standard deviation, as usual, is the square root of
variance

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 Example: Variance and
A Standard Deviation
• Consider the previous example. What are the variance
and standard deviation for each stock’s return?

Return on investment Squared deviations Multiply each

from expected returns squared deviation
by its probability
State Probability C T C T C T
Boom 0.3 15% 25% 0.0026 0.0053 0.0008 0.0016
Normal 0.5 10% 20% 0.0000 0.0005 0.0000 0.0003
Recession 0.2 2% 1% 0.0062 0.0279 0.0012 0.0056

Expected return 9.9% 17.7%

Variance 0.0020 0.0074
Standard deviation 0.0450 0.0863

=(2% - 9.9%)2 = 0.0062 * 0.2

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A Another Example
• Consider the following information:

State Probability ABC, Inc. (%)

Boom 0.25 15%
Normal 0.50 8%
Slowdown 0.15 4%
Recession 0.10 -3%
• What is the expected return?
• What is the variance?
• What is the standard deviation?

• E(R) = 8.05%
• Variance = 0.00267475
• Standard Deviation = 5.1717985%

62
B Portfolios
• A portfolio is a collection of assets
• E.g. After Tet, your total Lucky
Money (or Lì Xì) is $1,000.
• And you decided to put:
Ø $300 into short-term deposit
Ø $200 into listed stocks
Ø The rest (i.e. $500) into Gov
bonds
• Your invested portfolio is portfolio weight
described on the right-hand side.

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Portfolio
Expected Returns
The expected return of a portfolio is the weighted average,
of the expected returns, of the respective assets in the portfolio.

64
Portfolio
Expected Returns
You have a portfolio consisting solely of stock A and stock B.
The portfolio has an expected return of 9.8%.
Stock A has an expected return of 11.4% while stock B is
expected to return 6.4%. What is the portfolio weight of stock A?
A. 59%
B. 68%
C. 74%
D. 81%
E. 87%
Denote as weight of stock A, we have the following equation
Ø 0.098 = [0.114 * ] + [0.064*(1 - )] = 0.05 * + 0.064
Ø = 68%

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Portfolio Variance
• Compute the portfolio return for each state (boom, normal,
recession):
RP = w1R1 + w2R2 + … + wmRm
• Compute the portfolio variance and standard deviation using
the same formulas as for an individual asset.
• Come back to the first example, assume that your portfolio
consists of 60% stock C & 40% stock T.
Return on Return on Squared deviations Multiply each
investment investment from expected squared deviation by
returns its probability
State Probability C T Portfolio consisting 60% stock C & 40% stock T
Boom 0.3 15% 25% 19.0% 0.0036 0.0011
Normal 0.5 10% 20% 14.0% 0.0001 0.0000
Recession 0.2 2% 1% 1.6% 0.0130 0.0026

Expected return 9.9% 17.7% 13.0%

Variance 0.0037
Standard deviation 0.0611 6.1%

66
=(10%*60% + 20%*40%) =(14% - 13%)2 =0.013*0.2
B Summary of
Portfolios risk & returns
• An asset’s risk and return are important in how they
affect the risk and return of the portfolio.
• The risk-return trade-off for a portfolio is measured
by the portfolio expected return and standard
deviation, just as with individual assets.

67