THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS, AND THE EFFICIENT MARKET HYPOTHESIS

Transcription

1 Mishkin/SerleBs The Economics of Money, Banking, and Financial Markets Sixth Canadian EdiBon Chapter 7 THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS, AND THE EFFICIENT MARKET HYPOTHESIS Copyright 2017 Pearson Canada Inc.

2 Learning ObjecBves 1. Calculate the price of common stock and recognize the impact of new informa9on on stock prices 2. Dis9nguish adap9ve and ra9onal expecta9ons 3. Explain why arbitrage opportuni9es imply the efficient market hypothesis holds 4. Iden9fy and explain the implica9ons of the efficient market hypothesis for financial markets Copyright 2017 Pearson Canada Inc. 7-2

3 Common Stock Common stock is the principal way that corpora9ons raise equity capital Stockholders have the right to vote and be the residual claimants of all funds flowing to the firm Receives whatever remains a/er all other claims against the firm s assets have been sa6sfied Dividends are payments made periodically, usually every quarter, to stockholders Set by board of directors Copyright 2017 Pearson Canada Inc. 7-3

4 One- Period ValuaBon Model P O = the current price of the stock DIV 1 = the dividend paid at the end of year 1 k e = the required return on investment in equity P 1 = the sale price of the stock at the end of the first period Copyright 2017 Pearson Canada Inc. 7-4

5 Generalized Dividend ValuaBon Model The value of stock today is the present value of all future cash flows If P n is far in the future, it will not affect P 0 The price of the stock is determined only by the present value of the future dividend stream Copyright 2017 Pearson Canada Inc. 7-5

6 Gordon Growth Model D 0 = the most recent dividend paid g = the expected constant growth rate in dividends k e = the required return on an investment in equity Dividends are assumed to con9nue growing at a constant rate forever The growth rate is assumed to be less than required return on equity Copyright 2017 Pearson Canada Inc. 7-6

7 How the Market Sets Prices Price is set by the buyer with highest willingness to pay Typically the buyer who can take best advantage of the asset The role of informabon Superior informa6on about an asset can increase its value by reducing its perceived risk When new informa6on is released about a firm, expecta6ons and prices change Market par6cipants constantly receive informa6on and revise their expecta6ons, so stock prices change frequently Copyright 2017 Pearson Canada Inc. 7-7

8 ApplicaBon: 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 Copyright 2017 Pearson Canada Inc. 7-8

9 The Theory of RaBonal ExpectaBons AdapBve ExpectaBons: expecta6ons are formed from past experience only expecta6ons change slowly over 6me as data changes However, people use more than just past data to form their expecta9ons and some9mes change their expecta9ons quickly Copyright 2017 Pearson Canada Inc. 7-9

10 The Theory of RaBonal ExpectaBons (cont d) RaBonal ExpectaBons: Expecta6ons will be iden6cal to op6mal forecasts using all available informa6on Even though a ra9onal expecta9on equals the op9mal forecast using all available informa9on, a predic9on based on it may not always be perfectly accurate Copyright 2017 Pearson Canada Inc. 7-10

11 Formal Statement of the Theory Copyright 2017 Pearson Canada Inc. 7-11

12 RaBonale Behind the Theory The incen9ves for equa9ng expecta9ons with op9mal forecasts are strong in financial markets In these markets people with bezer forecasts of the future get rich The applica9on of the theory of ra9onal expecta9ons to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus par9cularly useful Copyright 2017 Pearson Canada Inc. 7-12

13 ImplicaBons of the Theory Ra9onal expecta9ons theory leads to two implica9ons: 1. If there is a change in the way a variable moves, the way in which expecta9ons of the variable are formed will change as well i.e., changes in the conduct of monetary policy 2. The forecast errors of expecta9ons will, on average, be zero and cannot be predicted ahead of 9me Forecast error is X - X e Copyright 2017 Pearson Canada Inc. 7-13

14 The Efficient Market Hypothesis: RaBonal ExpectaBons in Financial Markets Recall: The rate of return from holding a security equals the sum of the capital gain on the security plus any cash payments divided by the ini9al purchase price of the security R = the rate of return on the security P t+1 = price at 9me t+1 (end of the holding period) P t = C = price at 9me t (beginning of the holding period) cash payment (coupon or dividend) made during the holding period Copyright 2017 Pearson Canada Inc. 7-14

15 The Efficient Market Hypothesis: RaBonal ExpectaBons 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 expecta9on of it The expected return then is Expecta9ons of future prices are equal to op9mal forecasts using all currently available informa9on so Supply and demand analysis states R e will equal the equilibrium return R* so R of = R* Copyright 2017 Pearson Canada Inc. 7-15

16 The Efficient Market Hypothesis: RaBonal ExpectaBons in Financial Markets (cont d) Current prices in a financial market will be set so that the op9mal forecast of a security s return using all available informa9on equals the security s equilibrium return In an efficient market, a security s price fully reflects all available informa9on Copyright 2017 Pearson Canada Inc. 7-16

17 RaBonale Behind the Hypothesis un9l R of = R* In an efficient market all unexploited profit opportuni9es will be eliminated by arbitrage Not everyone in a financial market must be well informed or have ra6onal expecta6ons for its price to be driven to the point at which the efficient market condi6on holds Copyright 2017 Pearson Canada Inc. 7-17

18 Random- Walk Behaviour of Stock Prices Random Walk: the movements of a variable whose future values cannot be predicted Given today s value, the value of the variable is just as likely to fall as it is to rise Important implica9on of the efficient market hypothesis is that stock prices should approximate a random walk Future changes in stock prices should, for all prac6cal purposes, be unpredictable Copyright 2017 Pearson Canada Inc. 7-18

19 How Valuable are Published Reports by Investment Advisors? Informa9on in newspapers and in the published reports of investment advisers is already reflected in market prices Ac9ng on this informa9on will not yield abnormally high returns The empirical evidence confirms that recommenda9ons from investment advisers cannot help us outperform the general market Copyright 2017 Pearson Canada Inc. 7-19

20 Efficient Market PrescripBon for the Investor Recommenda9ons from investment advisors cannot help us outperform the market A hot 9p is probably informa9on already contained in the price of the stock Stock prices respond to announcements only when the informa9on is new and unexpected A buy and hold strategy is the most sensible strategy for the small investor Copyright 2017 Pearson Canada Inc. 7-20

21 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 and so financial markets are efficient One investment is as good as any other Prices reflect all informa6on about intrinsic value of security Prices can be used to assess cost financing real investments The efficient market hypothesis may be misname, however. Only implies prices are unpredictable, not that they are efficient. Copyright 2017 Pearson Canada Inc. 7-21