Transcript The Theory of Capital Markets

The Theory of Capital Markets
Rational Expectations and Efficient
Markets
Adaptive Expectations
• Adaptive Expectations
– Expectations depend on past experience only.
• Expectations are a weighted average of past
experiences.
• Expectations change slowly over time.
Rational Expectations
• The theory of rational expectations states
that expectations will not differ from
optimal forecasts using all available
information.
– It is reasonable to assume that people act
rationally because it is is costly not to have the
best forecast of the future.
Rational Expectations
• Rational expectations mean that
expectations will be identical to optimal
forecasts (the best guess of the future) using
all available information, but…..
– It should be noted that even though a rational
expectation equals the optimal forecast using
all available information, a prediction based
on it may not always be perfectly accurate.
“Irrational” Expectations?
• There are two reasons why an expectation
may fail to be rational:
– People might be aware of all available
information but find it takes too much effort
to make their expectation the best guess
possible.
– People might be unaware of some available
relevant information so their best guess of the
future will not be accurate.
Rational Expectations:
Implications
• If there is a change in the way a variable
moves, there will be a change in the way
expectations of this variable are formed.
• Therefore, the forecast errors of
expectations will on average be zero and
cannot be predicted ahead of time.
Rational Expectations and
Monetary Policy
Policy Ineffectiveness
Proposition
• According to the rational expectations
hypothesis, macroeconomic policy actions
that individuals and firms anticipate have no
effects on real variables such as output and
employment.
• Only unanticipated policy actions that
people cannot predict in advance can
influence real GDP and employment.
Rational Expectations Hypothesis
• Let people’s expectation of the price level,
Pexp, depend in part on their expectation of
how the government will change the money
supply, government spending, and taxes.
• Also assume that people can anticipate
government policy with a great deal of
accuracy.
Rational Expectations Hypothesis
• Expansionary monetary policy actions
cause an increase in aggregate demand.
• If people correctly forecast those policy
actions, then they fully anticipate the
change in the price level that the actions
will induce.
• As price expectations change, people’s
wage demands change, causing an
offsetting change in aggregate supply.
Rational Expectations Hypothesis
AS2 AS1
P
Rational expectations cause
offsetting changes in AS given
a change in AD.
P2
P1
0
2
P rises but Y remains constant.
1
Y1
AD2
AD1
Y
Anticipated Policy Changes
Unanticipated Policy Changes
• If people do not correctly forecast the
government’s policy actions, then they do
not correctly forecast the change in the price
level induced by the policy change.
• In this case, as the price level rises output
increases along the aggregate supply curve.
Unanticipated Policy Changes
AS
P
Only unanticipated policy
changes result in a change
in output.
2
P2
P1
0
1
Y1 Y2
AD2
AD1
Y
Unanticipated Policy Changes
Rational Expectations:
Conclusions
• The development of rational expectations
ignited a major controversy among
economists because the model yielded an
implication of policy ineffectiveness that
directly challenged the mainstream view
that active fiscal and monetary policies are
needed to moderate the inherent instability
of a market economy.
Rational Expectations:
Conclusions
• The research on expectations that followed the
introduction of rational expectations
increasingly supported the rapid expectations
adjustment implied by rational expectations
over the sluggish adjustment of adaptive
expectations.
• This suggested that misperceptions would
disappear so quickly that there was no time for
countercyclical policies to be implemented.
Rational Expectations:
Conclusions
• Ultimately, a consensus was reached that the
key issue is not how expectations are formed,
but whether changing expectations are really
the only important source of output
fluctuations.
• A series of statistical studies showed that the
rational expectations model of the business
cycle could not account for the observed
slower responses of real world economies.
Conclusions: Summary
• Although early rational expectations models
seemed to suggest that active fiscal and
monetary policies were not effective.
• Further research demonstrated that the rational
expectation models could not explain the slow
response of real world economies to shocks.
• New approaches rely on underlying sources of
friction in the market clearing process to explain
business cycles.
Efficient Markets Hypothesis
Efficient Markets
• The efficient markets hypothesis states that
securities are typically in equilibrium or that
they are fairly priced.
– Current security prices fully reflect all available
information because in an efficient market all
unexploited profit opportunities are eliminated.
Efficient Markets Theory
• Weak Version
– All information contained in past price
movements is fully reflected in current market
prices.
• In this case, information about recent trends in stock
prices would be of no use in selecting stocks.
• “Tape watchers” and “chartists” are wasting their
time.
Efficient Markets Theory
• Semi- Strong Version
– Current market prices reflect all publicly
available information.
• In this case, it does no good to pore over annual
reports or other published data because market prices
will have adjusted to any good or bad news contained
in those reports as soon as they came out.
• Insiders, however, can make abnormal returns on their
own companies’ stocks.
Efficient Markets Theory
• Strong Version
– Current market prices reflect all pertinent
information, whether publicly available or
privately held.
• In an efficient capital market, a security’s price
reflects all available information about the intrinsic
value of the security.
• Security prices can be used by managers of both
financial and non-financial firms to assess their cost of
capital accurately.
Efficient Markets: Strong Version
• Security prices can be used to help make correct
decisions about whether a specific investment is
worth making.
• In this case, even insiders would find it impossible
to earn abnormal returns in the market.
– Scandals involving insiders who profited handsomely
from insider trading helped to disprove this version of the
efficient markets hypothesis.
Efficient Markets Theory:
Example
• Assume you own a stock that has an
equilibrium return of 10%.
• Also assume that the price of this stock has
fallen such that the return currently is 50%.
– Demand for this stock would rise, pushing its
price up, and yield down.
• Demand and price would rise until RETof = RETeq
Efficient Markets: Theory
• RETof > RET* Price rises RETof falls to RET*
• RETof < RET* Price falls RETof rises to RET*
• In an efficient market, all unexploited profit
opportunities are eliminated.
Rational Expectations: Demand and
Supply
Price
S
Yield
0
P*
i*
P1
iof
D1
0
S
Yield
0
P1
iof
P*
i*
D1
D2
D2
Stock
RETof > RET*
Price
0
Stock
RETof < RET*
Efficient Markets: Example
Let the initial price and the expected price of stock A be $100.
Also, let the dividend paid equal $15, thereby providing an initial
return of 15%. Assume that 15% is the equilibrium return.
Let higher profit expectations cause the expected price of
stock A to rise to $115 and solve for the new price.
RET = (Pt+1 – Pt + D)/Pt
0.15 = ($115 – Pt + $15)/Pt
0.15 = ($130 – Pt)/Pt
0.15Pt = $130 – Pt
0.15Pt + Pt = $130
Pt(1.15) = $130
Pt = $130/1.15 = $113.04
Price rises to $113.04, where given the expected price of $115,
the expected return is at equilibrium and equal to 15%.
Stock Market Equilibrium
• Evidence suggests that stocks, especially
those of large companies, adjust rapidly to
disequilibrium situations.
– Equilibrium ordinarily exists for any given
stock.
• Required and expected returns are equal.
Stock Market Equilibrium
• Stock prices do change and sometimes
violently and rapidly.
– This reflects changing conditions and
expectations.
• Occasionally, stock prices react for several
months to developments.
– This is not a long adjustment period, but rather
the market responding to new information.
Efficient Markets Hypothesis:
Summary
• The efficient markets hypothesis is a theory
of the financial markets that argues that
security prices tend to:
– Fluctuate randomly around their intrinsic values
– Return quickly to equilibrium
– Fully reflect the latest information available
The Crash of 1987
• The stock market crash of 1987 convinced
many financial economists that the stronger
version of the efficient markets theory is not
correct.
– It appears that factors other than market
fundamentals may have had an effect on stock
prices.
• This means that asset prices did not reflect their true
fundamental values.
The Crash of 1987
• But, the crash has not convinced these
financial economists that rational
expectations was incorrect.
– Rational Bubbles
• A bubble exists when the price of an asset differs
from its fundamental market value.
– In a rational bubble, investors can have rational
expectations that a bubble is occurring, but continue to
hold the asset anyway.
Efficient Markets: Evidence
• Pro:
– Performance of Investment Analysts and
Mutual Funds
• Generally, investment advisors and mutual funds do
not “beat the market” just as the efficient markets
theory would predict.
– The theory of efficient markets argues that abnormally
high returns are not possible.
Efficient Markets: Evidence
• Pro:
– Random Walk
• Future changes in stock prices should be
unpredictable.
– Examination of stock market records to see if changes in
stock prices are systematically related to past changes and
hence could have been predicted indicates that there is no
relationship.
– Studies to determine if other publicly available
information could have been used to predict stock prices
also indicate that stock prices are not predictable.
Efficient Markets: Evidence
• Pro:
– Technical Analysis
• The theory of efficient markets suggests that
technical analysis cannot work if past stock prices
cannot predict future stock prices.
– Technical analysts predict no better than other analysts.
– Technical rules applied to new data do not result in
consistent profits.
Efficient Markets: Evidence
• Con:
– Small Firm Effect
• Many empirical studies show that small firms have
earned abnormally high returns over long periods.
– January Effect
• Over a long period, stock prices have tended to
experience an abnormal price rise from December to
January that is predictable.
Efficient Markets: Evidence
• Con:
– Market Overreaction
• Recent research indicates that stock prices may
overreact to news announcements and that the
pricing errors are corrected only slowly.
– Excessive Volatility
• Stock prices appear to exhibit fluctuations that are
greater than what is warranted by fluctuations in
their fundamental values.
Efficient Markets: Evidence
• Con:
– Mean Reversion
• Stocks with low values today tend to have high
values in the future.
• Stocks with high values today tend to have low
values in the future.
– The implication is that stock prices are predictable and,
therefore, not a random walk.
Efficient Markets Theory:
Implications
• Hot tips cannot help an investor outperform
the market.
– The information is already priced into the stock.
• Hot tip is helpful only if you are the first to get the
information.
• Stock prices respond to announcements
only when the information being announced
is new and unexpected.
Conclusions:
• The evidence on efficient markets theory is
mixed, but the theory suggests that hot tips,
investment advisers’ published
recommendations, and technical analysis
cannot help an investor outperform the
market.
• The 1987 crash convinced many economists
that the strong version of the efficient
markets hypothesis was not correct.