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# CHAPTER 10 SOME LESSONS FROM CAPITAL MARKET HISTORY

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Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the share cheap before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists. Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the share is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Under (4), this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully reflected in the current share price.

## Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. 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 share is: R = [(\$87 78) + 1.25] / \$78 R = .1314 or 13.14% 2. The dividend yield is the dividend divided by price at the beginning of the period price, so: Dividend yield = \$1.25 / \$78 Dividend yield = .0160 or 1.60% And the capital gains yield is the increase in price divided by the initial price, so: Capital gains yield = (\$87 78) / \$78 Capital gains yield = .1154 or 11.54% 3. Using the equation for total return, we find: R = [(\$71 78) + 1.25] / \$78 R = .0737 or 7.37% And the dividend yield and capital gains yield are: Dividend yield = \$1.25 / \$78 Dividend yield = .0160 or 1.60% Capital gains yield = (\$71 78) / \$78 Capital gains yield = .0897 or 8.97% Heres a question for you: Can the dividend yield ever be negative? No, that would mean you were paying the company for the privilege of owning the share, however, it has happened on bonds.

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The total dollar return is the change in price plus the coupon payment, so: Total dollar return = \$1,063 1,090 + 80 Total dollar return = \$53 The total percentage return of the bond is: R = [(\$1,063 1,090) + 80] / \$1,090 R = .0486 or 4.86% Notice here that we could have simply used the total dollar return of \$53 in the numerator of this equation. Using the Fisher equation, the real return was: (1 + R) = (1 + r)(1 + h) r = (1.0486/1.03) 1 r = .0181 or 1.81%

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To find the average return, we sum all the returns and divide by the number of returns, so: Average return = (.25 +.36 + .09 + .11 + .17)/5 Average return = .0960 or 9.60%

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Using the equation to calculate variance, we find: Variance = 1/4[(.25 .096)2 + (.36 .096)2 + (.09 .096)2 + (.11 .096)2 + (.17 .096)2] Variance = 0.048780 So, the standard deviation is: Standard deviation = (0.048780)1/2 Standard deviation = 0.2209 or 22.09%

21. To find the average return, we sum all the returns and divide by the number of returns, so: Average return = (0.14 0.12 + 0.11 + 0.24 + 0.16 + 0.17)/6 Average return = 0.1167 or 11.67% Using the equation to calculate variance, we find: Variance = 1/5[(.14 .1167)2 + (.12 .1167)2 + (.11 .1167)2 + (.24 .1167)2 + (.16 .1167)2 + (.17 + .1167)2 ] Variance = 0.01531 So, the standard deviation is: Standard deviation = (0.01531)1/2 Standard deviation = 0.1237or 12.37%

22. To find range of returns we assume a normal distribution and the properties around average returns and standard deviations. The annual return on government bonds is 9.7% and the standard deviation is 5.4% At 68% level: Range of returns 1 = 9.7% (5.4%) = 4.30% to 15.10% At 95% level: Range of returns 2 = 9.7% 2(5.4%) = -1.10% to 20.50% 23. To find range of returns we assume a normal distribution and the properties around average returns and standard deviations. The annual return on Company shares as measured by the all ordinaries index is 13.3% and the standard deviation is 17.4% At 68% level: Range of returns 1 = 13.3% (17.4%) = -4.10% to 30.70% At 95% level: Range of returns 2 = 13.3% 2(17.4%) = -21.50% to 48.10% Intermediate 27. To find the real return each year, we will use the Fisher equation, which is: 1 + R = (1 + r)(1 + h) Using this relationship for each year, we find: Cash Dec-87 Mar-88 Jun-88 Sep-88 Dec-88 Mar-89 Jun-89 Sep-89 Dec-89 Totals 2.70% 2.82% 3.27% 2.77% 3.77% 4.34% 3.53% 4.66% 27.86 Inflation 84.6 86.5 87.8 90.1 92.4 92.5 94.8 97.4 99.2 CPI Rate 2.25% 1.50% 2.62% 2.55% 0.11% 2.49% 2.74% 1.85% 16.11 Real Return 0.44% 1.30% 0.63% 0.21% 3.66% 1.81% 0.77% 2.76% 11.58

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The average return for cash over this period was: Average return = 0.2786 / 8 Average return = 0.0348 or 3.48% And the average inflation rate was: Average inflation = 0.1611 / 8 Average inflation = 0.0201 or 2.01%

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Using the equation for variance, we find the variance for Cash over this period was:

Variance = 1/7[(.0270 .0348)2 + (.0282 .0348)2 + (.0327 .0348)2 + (.0277 .0348)2 + (.0377 .0348)2 + (.0434 .0348)2 + (.0353 .0348)2 + (.0466 .0348)2] Variance = 0.000054 And the standard deviation for Cash was: Standard deviation = (0.000054)1/2 Standard deviation = 0.0074 or 0.74% The variance of inflation over this period was: Variance = 1/7[(.0225 .0201)2 + (.0150 .0201)2 + (.0262 .0201)2 + (.0255 .0201)2 + (.0011 .0201)2 + (.0249 .0201)2 + (.0274 .0201)2 + (.0185 .0201)2] Variance = 0.000077 And the standard deviation of inflation was: Standard deviation = (0.000077)1/2 Standard deviation = 0.0088 or 0.88% c. The average observed real return over this period was: Average observed real return = 0.1158 / 8 Average observed real return = 0.0145 or 1.45% d. The statement that cash has no risk refers to the fact that there is only an extremely small chance of default, so there is little default risk. Since cash is short term, there is also very limited interest rate risk. However, there is inflation risk, i.e. the purchasing power of the investment may decline over time even if the investor is earning a positive return.

31. It is impossible to lose more than 100 percent of your investment. Therefore, return distributions are truncated on the lower tail at 100 percent, and cannot truly follow a normal distribution.