econ 331 money and credit: part ii financial markets

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence

Course Topics

PART II Financial Markets

CH4 Understanding Interest RatesCH5 Behavior of Interest RatesCH6 Risk and Term Structure of Interest RatesCH7 The Stock Market


CHAPTER 7The Stock Market

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So far we have looked at loans and debt securities, which arefixed income securities.

Short run debt instruments (< 1 year) are traded in themoney market.e.g. T-bills, commercial paper, certificates of deposit, federalfunds

Long run debt instruments (> 1 year) are traded in thecapital market.e.g. T-notes and T-bonds, municipal bonds, corporate bonds,commercial loans, mortgages, consumer loans

The other major component of the capital market is equitycapital.


Aggregate US Household Portfolio Allocation

equities, 33.00%

US governement securities, 2.00%

corporate bonds, 2.00%

tax exempt securities, 1.00%

pension funds, 26.00%

life insurance reserves, 2.00%

checkable deposits and currency, 1.00%

savings and time deposits, 10.00%

money market funds, 5.00%

bond and equity funds, 10.00%

mortgages, 1.00%

other, 7.00%


Equities are shares of ownership, with no stated maturities.

1. Common stock: entitles the shareholder to vote atshareholders meetings, e.g. for electing board of directorsCommon stock shareholders are residual claimants on theincome and net worth of a corporation.

2. Preferred stock: no voting rights but first claim on residualvalue of the firm in case of bankruptcy.

Most equities offer dividends as payments out of net earningsof the firm.

The stockholder’s liability in case of bankruptcy is limited tothe value of the stock.


Stocks are traded on

1. Stock Exchanges,

Orders are delivered to the trading floor (often electronically)Trades occur face-to-face in trading areas in auctionseg. NYSE (since 1792, 2750 listed companies)Indices: Dow Jones Industrial Average, NYSE Composite,NYSE US 100, S&P’s 500.

2. Decentralized Over-the-Counter (OTC) markets,stocks are traded electronically via a network of dealers,

e.g. NASDAQ (since 1971, 3200 listed companies)Indices: NASDAQ Composite, NASDAQ 100


One-Period Valuation Model

To value a stock, calculate the present discounted value offuture cash flows.

Discount using the required return on equity investment,rather than the interest rate.

If you hold the stock for one year, the current price is:

P0 =D1

1 + ke+

P1

1 + ke

P0 = Current stock priceD1 = Dividend paid at the end of year 1ke = Required return on equity investmentP1 = Price at the end of year 1


One-Period Valuation Model

Example:

Suppose you want to earn a return of 12% on Intel stock.Intel promises to pay $0.16 dividend.You think next year’s price of Intel Stock is $60.

P0 =$0.16

1 + 0.12+

$60

1 + 0.12= $53.71

Your valuation of the stock is $53.71Market price might be different.


Generalized Dividend Valuation Model

Extend to n periods.

The value of a stock is the present value of all future cashflows:

P0 =D1

1 + ke+

D2

(1 + ke)2+ ...+

Dn

(1 + ke)n+

Pn

(1 + ke)n

For n far in the future (n→∞)

P0 =∞∑

t=1

Dt

(1 + ke)t

The stock value is the present value of the dividend streamfrom now into the infinite future.

Why do stocks of firms that do not pay dividends have value?


The Gordon Growth Model

Present value calculation is very complicated.

Many firms strive to increase dividends at a yearly constantrate g .

Under this assumption:

P0 =D0 × (1 + g)

1 + ke+

D0 × (1 + g)2

(1 + ke)2+ ...+

D0 × (1 + g)∞

(1 + ke)∞

D0 = Most recent dividend paidg = Expected dividend growth rate


The Gordon Growth Model

If g < ke , this formula simplifies to

P0 =D0 × (1 + g)

ke − g=

D1

ke − g


How the Market Sets Prices

Auctions on the trading floor.

The price is set by the buyer willing to pay the highest price,i.e. the buyer with the highest valuation.

Superior information about an asset reduces its risk and leadsto a better valuation.

Anytime new information is released, expectations change,and the price will change.

Stock prices respond continuously to new pieces ofinformation.

Sales and profitability figures, new product releases,...Oil prices, political events,...Monetary Policy.


Monetary Policy and Stock Prices

Monetary Policy affects stock prices in two ways:

1. Through ke : e.g. lower interest rates, bond returns decline,stock market investors are willing to accept lower equityreturns → higher P0

2. Through g : lower interest rates, economy expands, profitabilityand dividends increase. → higher P0

Stock market investors hang on every word of the FedChairman and Committee Members. (Fed watching).


Formation of Expectations

Expectations are crucial, but how are they formed?

X et denotes the expected value of X in period t

Xt denotes the actual value of X in period t

Extrapolative Expectations

X et = Xt−1 + α (Xt−1 − Xt−2)

Adaptive Expectations:

X et = Xt−1 + α

(Xt−1 − X e

t−1

)Regressive Expectations:

X et = Xt−1 + α

(X̄ − Xt−1

)X̄ is long run equilibrium value.


Formation of Expectations

Critique:

Backward looking: only the past matters to predict the future

Systematic prediction errors

Rational, maximizing agents will abandon prediction rules that aresystematically wrong.

Muth (1961): The rational expectation of Xt coincides with the

prediction of the true underlying mathematical model describing the

behavior of Xt .


Rational Expectations

Rational Expectations: Expectations X et will be identical to optimal

forecasts X oft using all available information

Forward looking, and prediction error is purely random and thereforenot forecastable.

If there is a change in the way Xt moves, the way in which X et is

formed will change as well

Does not mean perfect foresight: X et is never perfectly accurate

In practice, expectations may not be fully rational in the strictsense, because

It takes too much effort to make the expectation the bestguess possible (rational inattention)Best guess will not be accurate because predictor is unaware ofsome relevant information


Efficient Markets: Application of Rational Expectations

RE in macroeconomics implies the efficient marketshypothesis in finance.

Recall: the rate of return of a security equals cash paymentsplus capital gain/loss divided by the current price:

R =C

Pt+

Pt+1 − Pt

Pt

R = rate of returnC = cash payment (coupon or dividend)Pt = current price of the security (at time t) Pt+1 price ofthe security at the end of the holding period (time t + 1)


Efficient Markets

At the beginning of the holding period, we know Pt and C .

Pt+1 is unknown and we must form an expectation Pet+1

Expected return is

Re =C

Pt+

Pet+1 − Pt

Pt

Expectations of future prices are equal to optimal forecastsconditional on all available information.

Pet+1 = Pof

t+1 ⇒ Re = Rof

How can we measure the value of Re to understand thebehavior of prices in financial markets?


Efficient Markets

Supply and demand analysis states Re = R∗ (the equilibriumreturn), so

Rof = R∗

Current prices in a financial market will be set so that theoptimal forecast of a security’s return using all availableinformation equals the security’s equilibrium return.

In an efficient market, a security’s price fully reflects allavailable information.

Suppose Rof > R∗, then Pt ↑⇒ Rof ↓Suppose Rof < R∗, then Pt ↓⇒ Rof ↑Market forces yield Rof = R∗


Efficient Markets

In an efficient market, all unexploited profit opportunitieswill be eliminated.

This does not mean that every participant in the market mustbe well informed or have rational expectations.

If a few do, prices will be driven to the point where all profitopportunities disappear. (smart money)


Efficient Markets

Stronger version of efficient markets hypothesis:

All necessary information about fundamental value is out there

Prices are always correct and exactly reflect the marketfundamentals

Price reflects all available information about intrinsic value

Any investment is as good as the other because the price isalways right

Managers can look at security prices for investment decisions,because they exactly reflect the cost of capital.


Evidence in Favor of Market Efficiency

Pretty convincing.

1. Nobody consistently beats the market.Having performed well in the past does not indicate that aninvestment advisor or a mutual fund will perform well in thefuture.

2. If information is already publicly available, a positiveannouncement does not, on average, cause stock prices to rise.

3. Stock prices follow a random walk and are unpredictable.

4. Technical analysis cannot successfully predict changes in stockprices.


If you want to invest in the stock market,...

put a monkey in charge of your portfolio.

Recommendations from investment advisors cannot help usoutperform the market

A hot tip is probably information already contained in theprice of the stock

Stock prices respond to announcements only when theinformation is new and unexpected

A “buy and hold” strategy is the most sensible strategy forthe small investor

Active traders pay brokerage fees all the time and have lowerpay-offs than passive traders.


Evidence Against Market Efficiency

Some anomalies:

1. Size effect ⇒ low liquidity, inappropriate risk measurement,high information costs

2. January Effect ⇒ Tax issues

3. Book-to-Market Effect

4. Momentum effect

5. Excessive Volatility and Excessive Volume

6. Post-earnings-announcement drift

7. Mean Reversion


Equity Premium Puzzle

Mehra and Prescott (1985): the average return on equity has farexceeded the average return on short-term virtually default-freedebt.

1889-1978 average real annual yield on the S&P 500 Indexwas 7%

average yield on short-term debt was less than 1%

Puzzle: can only be explained if agents are implausibly risk averseor risk is much larger than in sample.


Home Bias Puzzle

Both institutional and individual investors tend to hold adisproportionate amount of their portfolios in firms based in theirown countries and regions.

This may reflect a bias to purchase familiar stocks, or the insideinformation held by local investors.


Behavioral Finance

Prospect Theory: the hedonic value of an outcome isdetermined by whether the outcome is a gain or loss relativeto the agent’s reference point → disposition effect

Overconfidence in the ability to predict events wheninformation is very poor

Tendency for pattern recognition

Limited attention/rational inattention

Limits to arbitrage: The lack of short selling (causingover-priced stocks) may be explained by loss aversion.

Social contagion and herding behavior

econ 331 money and credit: part ii financial markets

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