econ 331 money and credit: part ii financial markets
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More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Last lecture
Risk structure: Bonds with same maturity have differentinterest rates: default risk, liquidity, tax treatment
Term structure: Bonds with same risk structure but differentmaturities have different interest rates
FACTS:
1. Short and long term interest rates comove2. Low rate interest rates yield curve slopes up. If yield curve is
inverted, it happens when interest rates are high.3. Most of the time, yield curve has a positive slope
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Last lecture
Expectations Theory:
Bonds are perfect substitutesLong term rate is an average of short term rates
Segmented Market Theory:
Bonds are not substitutes, most agents prefer short termInterest rates determined in individual (segmented) market
Liquidity Premium (Preferred Habitat) Theory:Short term preference gives rise to a liquidity (or term)premium.Long term rate is an average of short term rates plus liquiditypremium.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Current Slope of the Yield Curve
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Current Slope of the Yield Curve
The current yield curve is flat/inverted/U-shaped.
Theory predicts that agents are expecting lower interest ratesin the future.
Interest rates fall during contractions (see Chapter 6).
Is the US heading for a recession?
The yield curve inverted eight times during the past halfcentury, and the U.S. economy ended up in recession seventimes.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Current Slope of the Yield CurveMany economists do not think US is approaching a recession.Medium and long term interest rates have declined around theworld because of globalization.
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More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Current Slope of the Yield Curve
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More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
One Explanation for the Bond Yield Conundrum
Bond markets are increasingly affected by global factors.
The global savings glut shifts long term bond demand to theright in developed countries.
1. High oil prices2. Income growth in high-saving East Asia3. Excess Reserves of East Asian Central Banks4. Reduced fiscal deficits in Latin America
Global integration of financial markets channels developingcountries’ savings to developed countries bond markets.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Monetary Policy Implications
A country’s interest rates (in particular, the medium- tolong-term maturities) will be determined more by globalinfluences and less by domestic factors
Central banks ability to affect long-term rates may bediminishing.
Globalization calls for greater cooperation and coordination ofpolicy worldwide.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
CHAPTER 7The Stock Market
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
So far we have looked at loans and debt securities, which arefixed income securities.
Short run debt instruments (< 1 year) are traded in themoney market.e.g. T-bills, commercial paper, certificates of deposit, federalfunds
Long run debt instruments (> 1 year) are traded in thecapital market.e.g. T-notes and T-bonds, municipal bonds, corporate bonds,commercial loans, mortgages, consumer loans
The other major component of the capital market is equitycapital.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Aggregate US Household Portfolio Allocation
equities, 33.00%
US governement securities, 2.00%
corporate bonds, 2.00%
tax exempt securities, 1.00%
pension funds, 26.00%
life insurance reserves, 2.00%
checkable deposits and currency, 1.00%
savings and time deposits, 10.00%
money market funds, 5.00%
bond and equity funds, 10.00%
mortgages, 1.00%
other, 7.00%
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Equities are shares of ownership, with no stated maturities.
1. Common stock: entitles the shareholder to vote atshareholders meetings, e.g. for electing board of directorsCommon stock shareholders are residual claimants on theincome and net worth of a corporation.
2. Preferred stock: no voting rights but first claim on residualvalue of the firm in case of bankruptcy.
Most equities offer dividends as payments out of net earningsof the firm.
The stockholder’s liability in case of bankruptcy is limited tothe value of the stock.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Stocks are traded on
1. Stock Exchanges,
Orders are delivered to the trading floor (often electronically)Trades occur face-to-face in trading areas in auctionseg. NYSE (since 1792, 2750 listed companies)Indices: Dow Jones Industrial Average, NYSE Composite,NYSE US 100, S&P’s 500.
2. Decentralized Over-the-Counter (OTC) markets,stocks are traded electronically via a network of dealers,
e.g. NASDAQ (since 1971, 3200 listed companies)Indices: NASDAQ Composite, NASDAQ 100
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
One-Period Valuation Model
To value a stock, calculate the present discounted value offuture cash flows.
Discount using the required return on equity investment,rather than the interest rate.
If you hold the stock for one year, the current price is:
P0 =D1
1 + ke+
P1
1 + ke
P0 = Current stock priceD1 = Dividend paid at the end of year 1ke = Required return on equity investmentP1 = Price at the end of year 1
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
One-Period Valuation Model
Example:
Suppose you want to earn a return of 12% on Intel stock.Intel promises to pay $0.16 dividend.You think next year’s price of Intel Stock is $60.
P0 =$0.16
1 + 0.12+
$60
1 + 0.12= $53.71
Your valuation of the stock is $53.71Market price might be different.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Generalized Dividend Valuation Model
Extend to n periods.
The value of a stock is the present value of all future cashflows:
P0 =D1
1 + ke+
D2
(1 + ke)2+ ... +
Dn
(1 + ke)n+
Pn
(1 + ke)n
For n far in the future (n→∞)
P0 =∞∑
t=1
Dt
(1 + ke)t
The stock value is the present value of the dividend streamfrom now into the infinite future.
Why do stocks of firms that do not pay dividends have value?
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Gordon Growth Model
Present value calculation is very complicated.
Many firms strive to increase dividends at a yearly constantrate g .
Under this assumption:
P0 =D0 × (1 + g)
1 + ke+
D0 × (1 + g)2
(1 + ke)2+ ... +
D0 × (1 + g)∞
(1 + ke)∞
D0 = Most recent dividend paidg = Expected dividend growth rate
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
The Gordon Growth Model
If g < ke , this formula simplifies to
P0 =D0 × (1 + g)
ke − g=
D1
ke − g
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
How the Market Sets Prices
Auctions on the trading floor.
The price is set by the buyer willing to pay the highest price,i.e. the buyer with the highest valuation.
Superior information about an asset reduces its risk and leadsto a better valuation.
Anytime new information is released, expectations change,and the price will change.
Stock prices respond continuously to new pieces ofinformation.
Sales and profitability figures, new product releases,...Oil prices, political events,...Monetary Policy.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Monetary Policy and Stock Prices
Monetary Policy affects stock prices in two ways:
1. Through ke : e.g. lower interest rates, bond returns decline,stock market investors are willing to accept lower equityreturns → higher P0
2. Through g : lower interest rates, economy expands, profitabilityand dividends increase. → higher P0
Stock market investors hang on every word of the FedChairman and Committee Members. (Fed watching).
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Last Lecture:
The stock value is the present value of the dividend streamfrom now into the infinite future.
P0 =∞∑
t=1
Dt
(1 + ke)t
Gordon growth model: if dividends grow at a constant rate gand g < ke , this formula simplifies to
P0 =D0 × (1 + g)
ke − g=
D1
ke − g
Valuations are very sensitive to news.
Monetary policy affects P0 through ke and Dt .
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Theory of Rational Expectations
Expectations are crucial, but how are they formed?
Theory of Adaptive Expectations: Expectations are solelybased on the past and adjust slowly (backward looking).
Theory of Rational Expectations: Expectations will beidentical to optimal forecasts using all available information(forward looking).
Even though a rational expectation equals the optimalforecast, it is not always perfectly accurate
In practice, expectations may not be fully rational in the strictsense, because
It takes too much effort to make the expectation the bestguess possibleBest guess will not be accurate because predictor is unaware ofsome relevant information
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Formal Statement of the Theory
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Implications
If there is a change in the way a variable moves, the way inwhich expectations of the variable are formed will change aswell
The forecast errors of expectations will, on average, be zeroand cannot be predicted ahead of time
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Efficient Markets: Application of Rational Expectations
RE in macroeconomics implies the efficient marketshypothesis in finance.
Recall: the rate of return of a security equals cash paymentsplus capital gain/loss divided by the current price:
R =C
Pt+
Pt+1 − Pt
Pt
R = rate of returnC = cash payment (coupon or dividend)Pt = current price of the security (at time t) Pt+1 price ofthe security at the end of the holding period (time t + 1)
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Efficient Markets
At the beginning of the holding period, we know Pt and C .
Pt+1 is unknown and we must form an expectation Pet+1
Expected return is
Re =C
Pt+
Pet+1 − Pt
Pt
Expectations of future prices are equal to optimal forecastsconditional on all available information.
Pet+1 = Pof
t+1 ⇒ Re = Rof
How can we measure the value of Re to understand thebehavior of prices in financial markets?
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Efficient Markets
Supply and demand analysis states Re = R∗ (the equilibriumreturn), so
Rof = R∗
Current prices in a financial market will be set so that theoptimal forecast of a security’s return using all availableinformation equals the security’s equilibrium return.
In an efficient market, a security’s price fully reflects allavailable information.
Suppose Rof > R∗, then Pt ↑⇒ Rof ↓Suppose Rof < R∗, then Pt ↓⇒ Rof ↑Market forces yield Rof = R∗
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Efficient Markets
In an efficient market, all unexploited profit opportunitieswill be eliminated.
This does not mean that every participant in the market mustbe well informed or have rational expectations.
If a few do, prices will be driven to the point where all profitopportunities disappear. (smart money)
Stronger version of efficient markets hypothesis:All necessary information about fundamental value is outthere.Prices are always correct and exactly reflect the marketfundamentals.
Price reflects all available information about intrinsic valueAny investment is as good as the other because the price isalways rightManagers can look at security prices for investment decisions,because they exactly reflect the cost of capital.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Evidence in Favor of Market Efficiency
Pretty convincing.
1. Nobody consistently beats the market.Having performed well in the past does not indicate that aninvestment advisor or a mutual fund will perform well in thefuture.
2. If information is already publicly available, a positiveannouncement does not, on average, cause stock prices to rise.
3. Stock prices follow a random walk and are unpredictable.
4. Technical analysis cannot successfully predict changes in stockprices.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Evidence Against Market Efficiency
Some anomalies:
1. Small-firm effect ⇒ low liquidity, inappropriate riskmeasurement, high information costs
2. Price rise in January Effect ⇒ Tax issues
3. Market Overreaction
4. Excessive Volatility
5. Mean Reversion
6. New information is not always immediately incorporated intostock prices
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
If you want to invest in the stock market,...
put a monkey in charge of your portfolio.
Recommendations from investment advisors cannot help usoutperform the market
A hot tip is probably information already contained in theprice of the stock
Stock prices respond to announcements only when theinformation is new and unexpected
A “buy and hold” strategy is the most sensible strategy forthe small investor
Active traders pay brokerage fees all the time and have lowerpay-offs than passive traders.
More Yield Curve Stock Market Stock Price The Market Price Expectations Efficient Market Hypothesis Evidence
Behavioral Finance
Do smart money traders always eliminate profit opportunities?
If a stock goes above its fundamental value, traders can profit
From borrowing stock from brokers and selling it in the market(short selling).Buying back the stock when the price is lower.
The lack of short selling (causing over-priced stocks) may beexplained by loss aversion.
The large trading volume may be explained by investoroverconfidence
Stock market bubbles may be explained by overconfidence andsocial contagion ⇒ irrational exuberance.
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