Transcript NUK-Money and Banking

The Economics of Money,
Banking, and Financial Markets
Mishkin, 7th ed.
Chapter 7
The stock market, rational
expectations, efficient markets,
and random walks
Common stock
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Common stock - primary source of equity
capital
Owners have voting rights and are residual
claimants (they receive whatever is left after all
other claims are satisfied)
Dividends are payments to stockholders,
typically paid on a quarterly basis (if at all).
Computing the Price of Common
Stock
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Basic Principle of Finance
Value of Investment = Present Value of
Future Cash Flows
One-Period Valuation Model
P0 =
D iv 1
(1 +  e )
+
P1
(1 +  e )
(1)
Generalized dividend valuation
model
General dividend Valuation
model (long-term holding)
Gordon growth model
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Assumes constant dividend growth:
Simplifying: Assuming the dividend growth rate is less
than the required return on equity
Assumptions of the Gordon
growth model
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Constant dividend growth
Growth rate of dividends is less than the
required return on equity
Stock price determinants
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Uncertainty plays an important role.
An increase in risk results in a higher expected
return on equity (lowering current stock prices)
Adaptive and rational expectations
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Adaptive expectations - based only on current
and past realizations for the series being forecast
Rational expectations - unbiased forecasts based
on all available relevant information
Arguments against rational expectations:
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effort needed to construct optimal forecasts may be
too costly.
people may be unaware of relevant information (the
cost of acquiring the information may be too high).
Theory of Rational Expectations
Rational expectation (RE) = expectation that is optimal forecast
(best prediction of future) using all available information: i.e., RE
e
of
 X =X
2 reasons expectation may not be rational
1. Not best prediction
2. Not using available information
Rational expectation, although optimal prediction, may not be accurate
Rational expectations makes sense because it is costly not to have optimal
forecast
Implications:
1. Change in way variable moves, way expectations are formed changes
2. Forecast errors on average = 0 and are not predictable
Efficient markets hypothesis
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Decisions concerning financial markets are
based on rational expectations.
Expected value of a variable equals the optimal
forecast of the variable.
It is argued that rational expectations are used in
financial markets due to the strong financial
incentive to have optimal forecasts.
Implications of the efficient
markets hypothesis
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A change in the way a variable behaves will
change the way in which expectations are
formed
Expected value of forecast error will be zero.
Efficient markets hypothesis Implications
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The expected return on a security will equal the
optimal forecast of the return.
Current prices are set so that optimal forecast of a
security’s return = security’s equilibrium return.
Efficient Markets Hypothesis
RET 
Pt  1  Pt  C
Pt  1  Pt  C
e
,
RET 
e
Pt
Rational Expectations implies:
e
of
Pet+1 = Poft+1  RET = RET
Market equilibrium
RETe = RET*
Put (1) and (2) together: Efficient Markets Hypothesis
of
RET = RET*
Pt
(1)
(2)
Why the Efficient Markets Hypothesis makes sense
of
of
If RET > RET*  Pt , RET 
of
of
If RET < RET*  Pt , RET 
of
until RET = RET*
1. All unexploited profit opportunities eliminated
2. Efficient Market holds even if are uninformed, irrational participants in market
Further implications
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In an efficient market, prices reflect the
intrinsic value of a security (based on
market fundamentals)
Security prices reflect all available
information concerning the equilibrium
value of the security.
Security prices reflect the cost of financial
capital.
Evidence supporting efficient
markets hypothesis
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Performance of investment analysts and mutual funds
(e.g., “dartboard index”)
 Past performance is not a predictor of future
performance for analysts and mutual funds
Timing of new information releases and stock prices
Random walk behavior of stock prices
Technical analysis - technical analysts do not perform
better than other analysts.
Evidence against the efficient
markets hypothesis
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Small-firm effect – higher return for small firms, adjusting for
risk.
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Possibly due to high information costs? Nonlinear risk-return functions?
January effect - price rise December-January
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Tax issues - selling to realize capital losses (but why does it persist?)
Market overreaction - initial overshooting of price when
announcements are made
Excessive volatility - fluctuations in stock prices are greater than
would be expected based on changes in fundamental value
Mean reversion - not a random walk?
New information is not always immediately incorporated into
stock prices
Implications for Investing
1.
2.
3.
4.
Published reports of financial analysts not very valuable
Should be skeptical of hot tips
Stock prices may fall on good news
Prescription for investor
1. Shouldn’t try to outguess market
2. Therefore, buy and hold
3. Diversify with no-load mutual fund
Evidence on Rational Expectations in Other Markets
1. Bond markets appear efficient
2. Evidence with survey data is mixed; Skepticism about quality of data
3. Following implication is supported: change in way variable moves, way
expectations are formed changes
Evidence in other markets
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Evidence in other financial markets (i.e., Bond)
supports the efficient markets hypothesis
Evidence with survey data is mixed; Skepticism
about quality of data (such as inflation forecasts)
There is evidence that a change in the way a
variable moves will change the method of
forecast formation
Speculative bubbles
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Rational bubble – prices differ from
fundamental market value because people
expect other people to pay more in the
future.