ECON 331 MONEY AND CREDIT: PART II FINANCIAL MARKETS

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ECON 331 MONEY AND CREDIT: PART II FINANCIAL MARKETS

  1. 1. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Last lecture Risk structure: Bonds with same maturity have different interest rates: default risk, liquidity, tax treatment Term structure: Bonds with same risk structure but different maturities have different interest rates FACTS: 1. Short and long term interest rates comove 2. Low rate interest rates yield curve slopes up. If yield curve is inverted, it happens when interest rates are high. 3. Most of the time, yield curve has a positive slope
  2. 2. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Last lecture Expectations Theory: Bonds are perfect substitutes Long term rate is an average of short term rates Segmented Market Theory: Bonds are not substitutes, most agents prefer short term Interest rates determined in individual (segmented) market Liquidity Premium (Preferred Habitat) Theory: Short term preference gives rise to a liquidity (or term) premium. Long term rate is an average of short term rates plus liquidity premium.
  3. 3. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
  4. 4. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence The Current Slope of the Yield Curve
  5. 5. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence The Current Slope of the Yield Curve The current yield curve is flat/inverted/U-shaped. Theory predicts that agents are expecting lower interest rates in the future. Interest rates fall during contractions (see Chapter 6). Is the US heading for a recession? The yield curve inverted eight times during the past half century, and the U.S. economy ended up in recession seven times.
  6. 6. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence The Current Slope of the Yield Curve Many economists do not think US is approaching a recession. Medium and long term interest rates have declined around the world because of globalization.
  7. 7. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence The Current Slope of the Yield Curve
  8. 8. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence One Explanation for the Bond Yield Conundrum Bond markets are increasingly affected by global factors. The global savings glut shifts long term bond demand to the right in developed countries. 1. High oil prices 2. Income growth in high-saving East Asia 3. Excess Reserves of East Asian Central Banks 4. Reduced fiscal deficits in Latin America Global integration of financial markets channels developing countries’ savings to developed countries bond markets.
  9. 9. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Monetary Policy Implications A country’s interest rates (in particular, the medium- to long-term maturities) will be determined more by global influences and less by domestic factors Central banks ability to affect long-term rates may be diminishing. Globalization calls for greater cooperation and coordination of policy worldwide.
  10. 10. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence CHAPTER 7 The Stock Market
  11. 11. More Yield Curve 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.
  12. 12. More Yield Curve 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%
  13. 13. More Yield Curve 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.
  14. 14. More Yield Curve 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
  15. 15. More Yield Curve 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
  16. 16. More Yield Curve 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.
  17. 17. More Yield Curve 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?
  18. 18. More Yield Curve 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
  19. 19. More Yield Curve 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
  20. 20. More Yield Curve 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.
  21. 21. More Yield Curve 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).
  22. 22. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Last Lecture: The stock value is the present value of the dividend stream from now into the infinite future. ∞ Dt P0 = (1 + k e )t t=1 Gordon growth model: if dividends grow at a constant rate g and g < k e , this formula simplifies to D0 × (1 + g ) D1 P0 = e −g = e k k −g Valuations are very sensitive to news. Monetary policy affects P0 through k e and Dt .
  23. 23. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Theory of Rational Expectations Expectations are crucial, but how are they formed? Theory of Adaptive Expectations: Expectations are solely based on the past and adjust slowly (backward looking). Theory of Rational Expectations: Expectations will be identical to optimal forecasts using all available information (forward looking). Even though a rational expectation equals the optimal forecast, it is not always 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 Best guess will not be accurate because predictor is unaware of some relevant information
  24. 24. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Formal Statement of the Theory
  25. 25. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Implications If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time
  26. 26. More Yield Curve 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)
  27. 27. More Yield Curve 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?
  28. 28. More Yield Curve 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 ∗
  29. 29. More Yield Curve 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) 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.
  30. 30. More Yield Curve 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.
  31. 31. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Evidence Against Market Efficiency Some anomalies: 1. Small-firm effect ⇒ low liquidity, inappropriate risk measurement, high information costs 2. Price rise in January Effect ⇒ Tax issues 3. Market Overreaction 4. Excessive Volatility 5. Mean Reversion 6. New information is not always immediately incorporated into stock prices
  32. 32. More Yield Curve 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.
  33. 33. More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence Behavioral Finance Do smart money traders always eliminate profit opportunities? If a stock goes above its fundamental value, traders can profit From borrowing stock from brokers and selling it in the market (short selling). Buying back the stock when the price is lower. The lack of short selling (causing over-priced stocks) may be explained by loss aversion. The large trading volume may be explained by investor overconfidence Stock market bubbles may be explained by overconfidence and social contagion ⇒ irrational exuberance.

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