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ECN 310-- Stock Market and Financial Market Efficiency

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Yuanyuan Chen

on 8 October 2012

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Transcript of ECN 310-- Stock Market and Financial Market Efficiency

Dr. Chen The Stock Market, Information, and Financial Market Efficiency Stock Market and Efficient Market Stocks are sometimes referred to as equities. Stock and the Stock Market Adaptive Expectations versus Rational Expectations Rational Expectations and Efficient Markets Pricing Anomalies Actual Efficiency in Financial Markets Structure of this Chapter Rational Expectations and Efficient Markets Behavioral
Finance Stock Prices Add Efficiency in Financial Markets Stock and Stock Market (cc) image by nuonsolarteam on Flickr Investing in Stock for One Year How Stock Prices are Determined Behavioral Finance A stockholder, sometimes called a shareholder, has a legal claim on the firm’s profits and on its equity, which is the difference between the value of the firm’s assets and the value of its liabilities. A sole proprietor, who is the sole owner of a firm, or someone who owns a firm with partners, has unlimited liability for the firm’s debts. An investor who owns stock in a firm organized as a corporation is protected by limited liability. Preferred stockholders receive a fixed dividend that is set when the corporation issues the stock.
Common stockholders receive a dividend that fluctuates as the profitability of the corporation varies over time. Common Stock Versus Preferred Stock Corporation A legal form of business that provides owners with protection from losing more than their investment if the business fails.
Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm. Definitions Dividend A payment that a corporation makes to stockholders, typically on a quarterly basis. The total market value of a firm’s common and preferred stock is called the firm’s market capitalization. How and Where Stocks Are Bought and Sold Publicly traded company A corporation that sells stock in the U.S. stock market; only 5,100 of the 5 million U.S. corporations are publicly traded companies. Stock exchange A physical location where stocks are bought and sold face-to-face on a trading floor. Over-the-counter market A market in which financial securities are bought and sold by dealers linked by computer. Measuring the Performance of Stock Market Stock market index An average of stock prices that is used to measure the overall performance of the stock market. Does the Performance of the Stock Market Matter to the Economy? Fluctuations in stock prices can affect the economy by affecting the spending of households and firms. The stock market is an important source of funds for corporations. Stocks also make up a significant portion of household wealth.Households spend more when their wealth increases and less when their wealth decreases. Stock market fluctuations can heighten uncertainty and lead households and firms to postpone their spending. The price of a financial asset is equal to the present value of the payments to be received from owning it. Required return on equities, r , The expected return necessary to compensate for the risk of investing in stocks. E From the viewpoint of firms, this is the rate of return they need to pay to attract investors, so it is called the equity cost of capital. The equity premium is the additional return investors must receive in order to invest in stocks (equities) rather than Treasury bills. Equity Premium The equity premium for an individual stock has two components: systematic risk, or the risk from price fluctuations in the stock market that affect all stocks, and
unsystematic, or idiosyncratic, risk that results from movements in the price of that particular stock. Suppose you expect that Microsoft will pay a dividend of $0.60. The expected price of the stock at the end of the year is $32, and the return you require in order to invest is 10%. Then present value: For investors as a group, the price of a stock today, Pt, equals the sum of the present values of the dividend expected to be paid at the end of the year, 𝑒, and the expected price of the stock at the end of the year, 𝑃 , discounted by the market’s required return on equities, rE, or The Rate of Return on a One-Year Investment in a Stock Dividend yield The expected annual dividend divided by the current price of a stock. The expected rate of return from investing in a stock equals the dividend yield plus the expected rate of capital gain: Consider the fundamental value of a share of stock equal to the present value of all the dividends expected to be received into the indefinite future: The Fundamental Value of Stock The Gordon Growth Model Gordon growth model A model that uses the current dividend paid, the expected growth rate (g) of dividends, and the required return on equities to calculate the price of a stock. The model assumes that investors receive the first dividend during the current period.
The model assumes that the growth rate of dividends is constant. This may be unrealistic, but it is a useful approximation in analyzing stock prices.
The required rate of return must be greater than the dividend growth rate.
Investors’ expectations of the future profitability of firms and, therefore, their future dividends, are crucial in determining the prices of stocks. Examples Adaptive expectations The assumption that people make forecasts of future values of a variable using only past values of the variable. Rational expectations The assumption that people make forecasts of future values of a variable using all available information; formally, the assumption that expectations equal optimal forecasts, using all available information. No one can accurately forecast the size of an error is caused by new information that is not available when the forecast is made. More formally: The Efficient Markets Hypothesis Efficient markets hypothesis The application of rational expectations to financial markets; the hypothesis that the equilibrium price of a security is equal to its fundamental value. An Example of the Efficient Markets Hypothesis 10:14 Monday morning: Price of Microsoft stock is $17.80 per shareDividend of $0.50 per share and expected to grow at a rate of 7%
10:15 same morning: Microsoft releases new sales information that sales of latest version of Windows is higher than expected.
You and other investors revise upward your forecast of the growth rate from 7% to 8%.Present value of future dividend rises from $17.80 to $27. You and other investors buy shares of Microsoft. Increased demand causes the price of Microsoft’s shares to rise until they reach $27—the new fundamental value of the stock. self-interested actions of informed traders cause available information to be incorporated into the market prices Financial arbitrage The process of buying and selling securities to profit from price changes over a brief period of time. The profits made from financial arbitrage are called arbitrage profits. "Inside Information" Inside information Relevant information about a security that is not publicly available. A strong version of the efficient markets hypothesis holds that even inside information is incorporated into stock prices.
Trading on inside information—known as insider trading—is illegal.
Employees of a firm may not buy and sell the firm’s stocks and bonds on the basis of information that is not publicly available. Are Stock Prices Predictable? A key implication of the efficient markets hypothesis is that stock prices are not predictable. The price today reflects all available information. Random walk The unpredictable movements of the price of a security. Portfolio Allocation Efficient Markets and Investment Strategies News that may unfavorably affect the price of one stock can be offset by news that will favorably affect the price of another stock.
Because we can’t know ahead of time what will happen, it makes sense to hold a diversified portfolio of stocks and other assets. Trading Investors should not move funds repeatedly from one stock to another, or churn a portfolio. It is better to buy and hold a diversified portfolio over a long period of time. Financial Analysts and Hot Tips The efficient markets hypothesis indicates that the stocks that financial analysts recommend are unlikely to outperform the market.
The stock of a more profitable firm will not be a better investment than the stock of a less profitable firm. Some analysts believe they have identified stock trading strategies that can result in above-average returns.
The small firm effect refers to the fact that over the long run, investment in small firms has yielded a higher return than has investment in large firms.
The January effect refers to the fact that during some years, rates of return on stocks have been abnormally high during January. Pricing Anomalies Data mining. It is always possible to search through the data and construct trading strategies that would have earned above-average returns—if only we had thought of them at the time!
Risk, liquidity, and information costs. Higher returns on investments in small firm stocks actually are just compensation for investors accepting higher risk, lower liquidity, and higher information costs.
Trading costs and taxes. Taking into account trading costs and taxes eliminates the above-average returns supposedly earned using many trading strategies. Mean Reversion Mean reversion is the tendency for stocks that have recently been earning high returns to experience low returns in the future and for stocks that have recently been earning low returns to earn high returns in the future. Momentum investing is almost the opposite of mean reversion. Momentum investing is based on the idea that there can be persistence in stock movements, so that a stock that is increasing in price is somewhat more likely to rise than to fall, and a stock that is decreasing in price is somewhat more likely to fall than to rise. Excess Volatility Robert Shiller of Yale University has found that the actual fluctuations in the prices of some stocks have been much greater than the fluctuations in their fundamental values. This finding could be used to earn above-average returns by, for instance, selling stocks when they are above their fundamental values and buying them when they are below their fundamental values. In practice, though, attempts to use this trading strategy have not been consistently able to produce above-average returns. Behavioral economics is the study of situations in which people make choices that do not appear to be economically rational. Behavioral finance The application of concepts from behavioral economics to understand how people make choices in financial markets. People may not realize that their actions are inconsistent with their goals.
Some investors believe they see useful patterns in plots of past stock prices even if the prices are actually following a random walk, as indicated by the efficient markets hypothesis.
Investors also show a reluctance to admit mistakes by selling their losing investments. Noise Trading and Bubbles When asked to estimate their investment returns, many investors report a number that is far above the returns they have actually earned. One consequence of overconfidence can be noise trading, which involves investors overreacting to good or bad news.
Noise trading can also lead to herd behavior. With herd behavior, relatively uninformed investors imitate the behavior of other investors rather than attempting to trade on the basis of fundamental values. Investors imitating each other can help to fuel a speculative bubble. Bubble A situation in which the price of an asset rises well above the asset’s fundamental value. How Great a Challenge is Behavioral Finance to the Efficient Markets Hypothesis? After the wide swings in stock prices during the financial crisis, skepticism among economists concerning the accuracy of the efficient markets hypothesis has grown.
Although fewer economists now believe that asset prices can be relied on to continually reflect fundamental values, many economists still believe that it is unlikely that investors can hope to earn above-average profits in the long run by following trading strategies.
Ongoing research in behavioral finance continues to attempt to reconcile the actual behavior of investors with the rational behavior economists have traditionally assumed prevails in financial markets.
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