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 Rates CH5 Behavior of Interest Rates CH6 Risk and Term Structure of Interest Rates CH7 The Stock Market

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence CHAPTER 7 The Stock Market 2000 450 1800 400 Real S&P 500 Stock Price Index Real S&P Composite Earnings 1600 350 1400 300 1200 250 1000 200 800 150 600 100 400 200 50 0 0 1870 1890 1910 1930 1950 1970 1990 2010 Year

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence So far we have looked at loans and debt securities, which are fixed income securities. Short run debt instruments (< 1 year) are traded in the money market. e.g. T-bills, commercial paper, certificates of deposit, federal funds Long run debt instruments (> 1 year) are traded in the capital 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 equity capital.

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence Aggregate US Household Portfolio Allocation other, 7.00% mortgages, 1.00% bond and equity funds, 10.00% equities, 33.00% money market funds, 5.00% savings and time deposits, 10.00% checkable deposits and US governement currency, 1.00% securities, 2.00% life insurance reserves, corporate bonds, 2.00% 2.00% tax exempt securities, 1.00% pension funds, 26.00%

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Equities are shares of ownership, with no stated maturities. 1. Common stock: entitles the shareholder to vote at shareholders meetings, e.g. for electing board of directors Common stock shareholders are residual claimants on the income and net worth of a corporation. 2. Preferred stock: no voting rights but first claim on residual value of the firm in case of bankruptcy. Most equities offer dividends as payments out of net earnings of the firm. The stockholder’s liability in case of bankruptcy is limited to the value of the stock.

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence 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 auctions eg. 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

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence One-Period Valuation Model To value a stock, calculate the present discounted value of future 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: D1 P1 P0 = + 1 + ke 1 + ke P0 = Current stock price D1 = Dividend paid at the end of year 1 k e = Required return on equity investment P1 = Price at the end of year 1

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence 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. $0.16 $60 P0 = + = $53.71 1 + 0.12 1 + 0.12 Your valuation of the stock is $53.71 Market price might be diﬀerent.

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Generalized Dividend Valuation Model Extend to n periods. The value of a stock is the present value of all future cash flows: D1 D2 Dn Pn P0 = + + ... + + 1 + ke (1 + k e )2 (1 + k e )n (1 + k e )n For n far in the future (n → ∞) ∞ Dt P0 = (1 + k e )t t=1 The stock value is the present value of the dividend stream from now into the infinite future. Why do stocks of firms that do not pay dividends have value?

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence The Gordon Growth Model Present value calculation is very complicated. Many ﬁrms strive to increase dividends at a yearly constant rate g . Under this assumption: D0 × (1 + g ) D0 × (1 + g )2 D0 × (1 + g )∞ P0 = + + ... + 1 + ke (1 + k e )2 (1 + k e )∞ D0 = Most recent dividend paid g = Expected dividend growth rate

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence The Gordon Growth Model If g < k e , this formula simpliﬁes to D0 × (1 + g ) D1 P0 = e −g = e k k −g

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence 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 leads to a better valuation. Anytime new information is released, expectations change, and the price will change. Stock prices respond continuously to new pieces of information. Sales and profitability figures, new product releases,... Oil prices, political events,... Monetary Policy.

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Monetary Policy and Stock Prices Monetary Policy affects stock prices in two ways: 1. Through k e : e.g. lower interest rates, bond returns decline, stock market investors are willing to accept lower equity returns → higher P0 2. Through g : lower interest rates, economy expands, profitability and dividends increase. → higher P0 Stock market investors hang on every word of the Fed Chairman and Committee Members. (Fed watching).

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence Formation of Expectations Expectations are crucial, but how are they formed? Xte denotes the expected value of X in period t Xt denotes the actual value of X in period t Extrapolative Expectations Xte = Xt−1 + α (Xt−1 − Xt−2 ) Adaptive Expectations: Xte = Xt−1 + α Xt−1 − Xt−1 e Regressive Expectations: ¯ Xte = Xt−1 + α X − Xt−1 ¯ X is long run equilibrium value.

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence 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 are systematically wrong. Muth (1961): The rational expectation of Xt coincides with the prediction of the true underlying mathematical model describing the behavior of Xt .

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence Rational Expectations Rational Expectations: Expectations Xte will be identical to optimal forecasts Xtof using all available information Forward looking, and prediction error is purely random and therefore not forecastable. If there is a change in the way Xt moves, the way in which Xte is formed will change as well Does not mean perfect foresight: Xte is never perfectly accurate In practice, expectations may not be fully rational in the strict sense, because It takes too much eﬀort to make the expectation the best guess possible (rational inattention) Best guess will not be accurate because predictor is unaware of some relevant information

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Efficient Markets: Application of Rational Expectations RE in macroeconomics implies the efficient markets hypothesis in finance. Recall: the rate of return of a security equals cash payments plus capital gain/loss divided by the current price: C Pt+1 − Pt R= + Pt Pt R = rate of return C = cash payment (coupon or dividend) Pt = current price of the security (at time t) Pt+1 price of the security at the end of the holding period (time t + 1)

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Efficient Markets At the beginning of the holding period, we know Pt and C . e Pt+1 is unknown and we must form an expectation Pt+1 Expected return is C P e − Pt Re = + t+1 Pt Pt Expectations of future prices are equal to optimal forecasts conditional on all available information. Pt+1 = Pt+1 ⇒ R e = R of e of How can we measure the value of R e to understand the behavior of prices in financial markets?

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Efficient Markets Supply and demand analysis states R e = R ∗ (the equilibrium return), so R of = R ∗ Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. In an efficient market, a security’s price fully reflects all available information. Suppose R of > R ∗ , then Pt ↑⇒ R of ↓ Suppose R of < R ∗ , then Pt ↓⇒ R of ↑ Market forces yield R of = R ∗

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Efficient Markets In an efficient market, all unexploited profit opportunities will be eliminated. This does not mean that every participant in the market must be well informed or have rational expectations. If a few do, prices will be driven to the point where all profit opportunities disappear. (smart money)

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence 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 market fundamentals Price reflects all available information about intrinsic value Any investment is as good as the other because the price is always right Managers can look at security prices for investment decisions, because they exactly reflect the cost of capital.

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence Evidence in Favor of Market Eﬃciency Pretty convincing. 1. Nobody consistently beats the market. Having performed well in the past does not indicate that an investment advisor or a mutual fund will perform well in the future. 2. If information is already publicly available, a positive announcement 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 stock prices.

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence If you want to invest in the stock market,... put a monkey in charge of your portfolio. Recommendations from investment advisors cannot help us outperform the market A hot tip is probably information already contained in the price of the stock Stock prices respond to announcements only when the information is new and unexpected A “buy and hold” strategy is the most sensible strategy for the small investor Active traders pay brokerage fees all the time and have lower pay-oﬀs than passive traders.

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

Stock Market Stock Price The Market Price Expectations Eﬃcient Market Hypothesis Evidence Equity Premium Puzzle Mehra and Prescott (1985): the average return on equity has far exceeded the average return on short-term virtually default-free debt. 1889-1978 average real annual yield on the S&P 500 Index was 7% average yield on short-term debt was less than 1% Puzzle: can only be explained if agents are implausibly risk averse or risk is much larger than in sample.

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Home Bias Puzzle Both institutional and individual investors tend to hold a disproportionate amount of their portfolios in firms based in their own countries and regions. This may reflect a bias to purchase familiar stocks, or the inside information held by local investors.

Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Behavioral Finance Prospect Theory: the hedonic value of an outcome is determined by whether the outcome is a gain or loss relative to the agent’s reference point → disposition effect Overconfidence in the ability to predict events when information is very poor Tendency for pattern recognition Limited attention/rational inattention Limits to arbitrage: The lack of short selling (causing over-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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