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Chapter Nine
Capital Market
Corporate Finance
Ross Westerfield Jaffe
Theory: An Overview   9
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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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
– the sum of the cash received and
the change in value of the asset, in Dividends
dollars.
Ending
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

dividend  change in market value


beginning market value

 dividend yield  capital gains yield

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9.1 Returns: Example

• Suppose you bought 100 shares of BCE 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 $25 × 100 = $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).
$520
• Your percentage gain for the year is 20.8% 
$2,500

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9.1 Returns: Example

• Dollar Returns
– $520 gain
$20

$3,000

Time 0 1
•Percentage Returns
$520
20.8% 
-$2,500 $2,500

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9.2 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 ri:

holding period return 

 (1  r1 )  (1  r2 )   (1  rn )  1

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Holding Period Return: Example

• Suppose your investment provides the following
returns over a four-year period:
Year Return Your holding period return 
1 10%
 (1  r1 )  (1  r2 )  (1  r3 )  (1  r4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%

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Holding Period Return: Example

• An investor who held this investment would have
actually realized an annual return of 9.58%:
Year Return Geometric average return 
1 10% (1  r ) 4  (1  r )  (1  r )  (1  r )  (1  r )
g 1 2 3 4
2 -5%
3 20% rg  4 (1.10)  (.95)  (1.20)  (1.15)  1

4 15%  .095844  9.58%

• So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421  (1.095844) 4

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Holding Period Return: Example

• Note that the geometric average is not the same
thing as the arithmetic average:
Year Return
1 10%
2 -5%
3 20%
4 15%

r1  r2  r3  r4
Arithmetic average return 
4
10%  5%  20%  15%
  10%
4
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Holding Period Returns

• A famous set of studies dealing with the rates of returns on
common stocks, bonds, and Treasury bills in the U.S. was
conducted by Roger Ibbotson and Rex Sinquefield.
• James Hatch and Robert White examined Canadian returns.
• The text presents year-by-year historical rates of return
starting in 1948 for the following five important types of
financial instruments:
– Large-Company Canadian Common Stocks
– Large-Company U.S. Common Stocks
– Small-Company Canadian Common Stocks
– Long-Term Canadian Bonds
– Canadian Treasury Bills
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The Future Value of an Investment of $1 in 1948

1000
$1  (1  r1948 )  (1  r1949 )    (1  r2000 )  $383.82

$41.09
$21.48
10

Common Stocks
Long Bonds
T-Bills

0.1
1948 1958 1968 1978 1988 1998

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9.3 Return Statistics

• The history of capital market returns can be summarized by
describing the
– average return

( R1    RT )
R
T
– the standard deviation of those returns

( R1  R) 2  ( R2  R) 2   ( RT  R) 2
SD  VAR 
T 1
– the frequency distribution of the returns.

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Historical Returns, 1948-2000

Average Standard
Investment Annual Return Deviation Distribution

Canadian common stocks 13.09% 16.48%

Long Bonds 7.78 10.49

Treasury Bills 6.20 4.11

Inflation 4.23 3.48

– 60% 0% + 60%

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9.4 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.
• One of the most significant observations of stock and bond
market data is this long-run excess of security return over
the risk-free return.
– The average excess return from Canadian large-
company common stocks for the period 1948 through
2000 was
6.89% = 13.09% – 6.20%
– The average excess return from Canadian long-term
bonds for the period 1948 through 2000 was
1.58% = 7.78% – 6.20%

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Risk Premia
• Suppose that The National Post announced that the current
rate for one-year Treasury bills is 5%.
• What is the expected return on the market of Canadian large-
company stocks?
• Recall that the average excess return from Canadian large-
company common stocks for the period 1948 through 2000
was 6.89%
• Given a risk-free rate of 5%, we have an expected return on
the market of Canadian large-company common stocks of
11.89% = 6.89% + 5%

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The Risk-Return Tradeoff

18%

16%
Annual Return Average

14%
Large-Company Stocks
12%

10%

8%

6%
Long Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25%
Annual Return Standard Deviation
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Rates of Return 1948-2000

Common Stocks
60
Long Bonds
50 T-Bills
40
30
20

10
0
-10

-20
-30
1945 1955 1965 1975 1985 1995

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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 Bay Street is “You can either sleep
well or eat well.”

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U.S. Stock Market Volatility

60
The volatility of stocks is not constant from year to year.

50

40

30

20

10

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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9.5 Risk Statistics

• There is no universally agreed-upon definition of risk.
• The measures of risk that we discuss are variance and
standard deviation.
– The standard deviation is the standard statistical measure
of the spread of a sample, and it will be the measure we
use most of this time.
– Its interpretation is facilitated by a discussion of the
normal distribution.

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Normal Distribution
• A large enough sample drawn from a normal distribution
looks like a bell-shaped curve.
Probability

68%

95%

> 99% Return on

large company
–3 –2 –1 0 +1 +2 +3 common
– 36.35% – 19.87% – 3.39% 13.09% 29.57% 46.05% 62.53%
stocks

The probability that a yearly return will fall within 16.48-percent of the mean of
13.09-percent will be approximately 2/3.

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Normal Distribution
• The 16.48-percent standard deviation we found for stock
returns from 1948 through 2000 can now be interpreted in
the following way: if stock returns are approximately
normally distributed, the probability that a yearly return will
fall within 16.48-percent of the mean of 13.09-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
12

Return frequency
Std. Dev. = 20.4% 11

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 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
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9.6 Summary and Conclusions

• This chapter presents returns for five asset classes:
– Canadian Large-Company Common Stocks
– U.S. Large-Company Common Stocks
– Canadian Small-Company Common Stocks
– Canadian Long-Term Bonds
– Canadian Treasury Bills
• Stocks have outperformed bonds over most of the twentieth
century, although stocks have also exhibited more risk.
• The statistical measures in this chapter are necessary
building blocks for the material of the next three chapters.

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