CHAPTER
9
Capital Market Theory:
An Overview
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Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Chapter Outline
9.1 Returns
9.2 Holding-Period Returns
9.3 Return Statistics
9.4 Average Stock Returns and Risk-Free Returns
9.5 Risk Statistics
9.6 Summary and Conclusions
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9.1 Returns
Dollar Returns
Dividends
the sum of the cash received
and the change in value of the
Ending
asset, in dollars.
market value
Time 0 1
•Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset divided by
investment the original investment.
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9.1 Returns
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return =
beginning market value
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9-4
Dollar Return:
$20
$520 gain
$3,000
Time 0 1
Percentage Return:
$520
-$2,500 20.8% =
$2,500
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9-10
$59.70
$17.48
10
Common Stocks
Long T-Bonds
T-Bills
0.1
1930 1940 1950 1960 1970 1980 1990 2000
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.
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9-12
( R1 R) 2 + ( R2 R) 2 + ( RT R) 2
SD = VAR =
T 1
the frequency distribution of the returns.
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– 90% 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.
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Risk Premia
Suppose that The Wall Street Journal announced that the
current rate for on-year Treasury bills is 5%.
What is the expected return on the market of small-
company stocks?
Recall that the average excess return from small
company common stocks for the period 1926 through
1999 was 13.2%
Given a risk-free rate of 5%, we have an expected return
on the market of small-company stocks of 18.2% =
13.2% + 5%
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14%
8%
6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
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40
20
-20
Common Stocks
Long T-Bonds
-40
T-Bills
-60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000
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.
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Risk Premiums
Rate of return on T-bills is essentially risk-free.
Investing in stocks is risky, but there are
compensations.
The difference between the return on T-bills and
stocks is the risk premium for investing in stocks.
An old saying on Wall Street is “You can either
sleep well or eat well.”
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50
40
30
20
10
0
26
35
40
45
50
55
60
65
70
75
80
85
90
95
98
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
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.
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Normal Distribution
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability
– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 49.3% – 28.8% – 8.3% 12.2% 32.7% 53.2% 73.7%
Return on
68.26% large company common
stocks
95.44%
99.74%
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Normal Distribution
The 20.1-percent standard deviation we
found for stock returns from 1926 through
1999 can now be interpreted in the
following way: if stock returns are
approximately normally distributed, the
probability that a yearly return will fall
within 20.1 percent of the mean of 13.3
percent will be approximately 2/3.
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Normal Distribution
S&P 500 Return Frequencies
16
16
Normal
approximation 14
Mean = 12.8% 12 12
Return frequency
Std. Dev. = 20.4% 11 12
9 10
5 6
4
2 2
1 1 1 2
0 0
0
-58% -48% -38% -28% -18% -8% 2% 12% 22% 32% 42% 52% 62%
Annual returns
Source: © Stocks, Bonds, Bills, and Inflation 2002 Yearbook™, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
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