Week-6 Stock Market, Rational Expectations and Financial Structure Money and Banking Econ 311 Tuesdays 7 - 9:45 Instructor: Thomas L. Thomas

o Common Stock is the principal way that corporations raise equity capital o Stockholders those who own stock – own an interest in the corporation proportional to the shares they own. o The most important rights are the right to vote and to be a residual claimant of al the funds flowing into the firm (cash flows). (What do we mean by residual) o Dividends are payments made periodically (usually quarterly to the stockholders (shareholders). Stock

One Period Valuation

The Generalized Dividend Valuation Model

The Gordon Growth Model

The Required Return (k)  Depends on  the risk-free rate (r f ),  the return on the market (r m ), and  the stock's beta.

Relationship Between Risk and Required Return k=3.5% +(10% - 3.5%)ß B A Required Return (%) Risk ß

Substitution of Cash Flow for Earnings and Dividends  Emphasis on firm ’ s ability to generate cash  May be applied when firm does not pay a dividend

How the Market Sets Prices The price is set by the buyer willing to pay the highest price The market price will be set by the buyer who can take best advantage of the asset Superior information about an asset can increase its value by reducing its perceived risk Information is important for individuals to value each asset. When new information is released about a firm, expectations and prices change. Market participants constantly receive information and revise their expectations, so stock prices change frequently

Application: The Global Financial Crisis and the Stock Market Financial crisis that started in August 2007 led to one of the worst bear markets in 50 years. Downward revision of growth prospects: ↓g. Increased uncertainty: ↑k e Gordon model predicts a drop in stock prices. Explain why the formula suggests a drop in prices?

The Theory of Rational Expectations Adaptive expectations: Expectations are formed from past experience only. Changes in expectations will occur slowly over time as data changes. However, people use more than just past data to form their expectations and sometimes change their expectations quickly. Expectations will be identical to optimal forecasts using all available information Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate 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 This is due to What???????

Formal Statement of the Theory

Rationale Behind the Theory The incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets, people with better forecasts of the future get rich. The application of the theory of rational expectations to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful

Implications of the Theory 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 Changes in the conduct of monetary policy (e.g. target the federal funds rate) The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.

The Efficient Market Hypothesis: Rational Expectations in Financial Markets

The Holding Period Return (HPR)  The percentage earned on an investment during a period of time  HPR = P 1 + D - P 0 P 0

The Efficient Market Hypothesis: Rational Expectations in Financial Markets (cont’d) At the beginning of the period, we know P t and C. P t+1 is unknown and we must form an expectation of it. The expected return then is Expectations of future prices are equal to optimal forecasts using all currently available information so Supply and Demand analysis states R e will equal the equilibrium return R*, so R of = R*

How Valuable are Published Reports by Investment Advisors? Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices So acting on this information will not yield abnormally high returns, on average The empirical evidence for the most part confirms that recommendations from investment advisers cannot help us outperform the general market

Efficient Market Prescription for the Investor 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

Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient Some financial economists believe all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) and so financial markets are efficient However, prices in markets like the stock market are unpredictable- This casts serious doubt on the stronger view that financial markets are efficient

The Efficient Market Hypothesis  Hard to beat the market on a risk-adjusted basis consistently  Earning a higher return is not necessarily outperforming the market.  Considering risk is also important.

Assumptions Concerning Efficient Markets  Large number of competing participants  Information is readily available.  Transaction costs are small.

Random Walk  Another term for efficient markets  Does not imply security prices are randomly determined.  Implies day-to-day price changes are random

Random Walk  Successive prices changes are independent.  Today's price does not forecast tomorrow's price.  Current price embodies all known information.

Random Walk  New information must be random IF NOT  An opportunity to earn an excess return would exist

Undervaluation and Overvaluation Undervaluation  drives prices up  returns decline Overvaluation  drives prices down  returns increase

Rationale Behind the Hypothesis

Undervaluation and Overvaluation

Random Walk  Prices change quickly to new information.  By the time most investors know the information, the price change has already occurred.

Degree of Market Efficiency  The forms of the efficient market hypothesis:  the weak form  the semi-strong form  the strong form

The Weak Form  Studying past price and volume data will not lead to superior investment results.  While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns.

The Semi-Strong Form  Studying economic and accounting data will not lead to superior investment returns.  Studying inside information may lead to superior returns.

The Strong Form  Using inside information will not lead to superior investment returns.

Anomalies  Empirical results generally support:  the weak form, and  the semi-strong form.  Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist.

Anomalies and Returns  Empirical evidence of the existence of an anomaly does not mean the individual can take advantage of the anomaly.  The anomaly can still exist and the market be effectively efficient from the individual investor's perspective.

Implications of Efficient Markets  Security prices embody known information.  The playing field is level.  Specifying financial goals may be more important than seeking undervalued stocks.

Implications of Efficient Markets  Other markets may not be efficient.  Importance of reducing transactions costs: the argument for a buy-and-hold strategy

Implications of Efficient Markets  Security prices embody known information.  The playing field is level.  Specifying financial goals may be more important than seeking undervalued stocks.

Implications of Efficient Markets  Other markets may not be efficient.  Importance of reducing transactions costs: the argument for a buy-and-hold strategy

Behavioral Finance 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