ECON 351: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

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1 ECON 351: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis Alejandro Riaño Penn State University June 8, 2008 Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 1 / 23 M

2 Objectives We ve talked a lot about fixed income/debt securities (i.e. bonds) Now we ll start studying Equity (stocks) The main question that we want to address is, how to determine the value of stocks? We ll study the implications of Rational Expectations in financial markets, which lead to the Efficient Market Hypothesis This material is based on Chapter 7 Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 2 / 23 M

3 Equity Equity securities represent an ownership interest in a corporation Holders of equity are entitled to the earnings of the corporation when those earnings are distributed in form of dividends. They are also entitled to a share of the remaining equity in case of liquidation Dividends are payments made periodically, usually every quarter, to stockholders. The board of directors of the firm sets the level of dividend, based on the recommendation of the management Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 3 / 23 M

4 Sources of External Funds for Non-Financial Businesses Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 4 / 23 M

5 Debt vs. Equity Debt: Fixed claim High priority on cash flows Tax-deductible payments Fixed maturity Equity: Lowest priority on cash flows Non-tax-deductible Infinite life Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 5 / 23 M

6 Debt: Pros and Cons Pros: Doesn t dilute ownership of the company Is faster to issue than equity Its easier to match to funding requirements Cons: Many debt issuers cannot issue equity Interest rate risk Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 6 / 23 M

7 Equity: Pros and Cons Pros: Cons: It can be used to raise capital that doesn t need to be repaid Dividends can be varied depending on the company s needs Ownership and control are split (source of Moral Hazard) Initial cost of issuing equity is very high Constant fluctuation of prices can have negative effects on the company Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 7 / 23 M

8 Primary Markets When financial securities are newly issued, they are traded in the primary market In the process of issuing a new security, investment bankers perform one or more of the following: 1 Advising the issuer on terms and timing of the offering 2 Buying the securities from the issuer (underwriting) 3 Distributing the issue to the public The fee that investment banks earn from underwriting a security is called the gross spread, it is the difference between the price paid to the issuer and the price at which the investment bank re-offers the security to the public. It averages 6.5% for issues listed at NYSE and 7% for issues listed in NASDAQ Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 8 / 23 M

9 Secondary Markets The secondary market is where already issued financial assets are traded In the secondary market the issuer of the asset doesn t receive funds from the buyer The periodic trading reveals the consensus price of an asset in the open market The secondary market allows agents to reverse investments by converting securities into cash at low transaction costs Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 9 / 23 M

10 Stock Valuation The value of a stock today is the present value of all future cash flows p t = s=t+1 D s (1 + k e ) s t (1) where p t is the price of the stock at time t, D s is the dividend payment in period s, and k e is the required return on investments in equity This formula is very similar to the one used for YTM. What are the differences? Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 10 / 23 M

11 Example: One-period holding Assume the price of a share of Intel today is $50. This share pays $0.16 per year in dividends. If you want to earn a return of 12% on the investment, should you buy the share if you expect the stock sells for $60 one year from now? Practically, you just need to discount the cash-flow that you ll get one year from now at a discount rate of 12%.Let s call P 0 the NPV of the stock. If P 0 > p t then you should buy the stock: P 0 = $ = $53.71 If the price of the stock is actually $60 one year from now, your realized return is: R = p t+1 p t + D t $60 $50 + $0.16 = = 20.32% p t $50 Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 11 / 23 M

12 Dividends Dividends are usually not constant (say as coupon payments for a bond) The amount of dividends depends on a firm s life-cycle Gordon Growth Model: Assumes that dividends grow at a constant rate g. It also assumes that g < k e P 0 = D 0(1 + g) 1 + k e + D 0(1 + g) 2 (1 + k e ) 2 + D 0(1 + g) 3 (1 + k e ) 3 + (2) Then we have: P 0 = D 0(1 + g) k e g = D 1 k e g (3) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 12 / 23 M

13 Examples of Product Life-Cycle Source: Klepper & Simons (1997) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 13 / 23 M

14 Financing and the Product Life-Cycle Source: Damodaran (2000) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 14 / 23 M

15 Price Setting in the Stock Market 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 risk Crucially, the price of a stock today will depend on people s expectations of future prices Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 15 / 23 M

16 Expectations of Future Economic Variables Definition Economic agents have Adaptive Expectations if they only use past information to form their expectation about the future. In particular, for an economic variable X, we have X e t+1 = (1 λ) j=0 λj X t j, λ (0, 1) Definition Economic agents have Rational Expectations if they form their expectations as optimal forecasts using all available information. That is, X e t+1 E[X t+1 I t ], where I t denotes all the information available up to time t Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 16 / 23 M

17 Efficient Markets Hypothesis (EMH) Definition The Efficient Markets Hypothesis, (Fama, 1970) defines an efficient financial market as one in which security prices always fully reflect all the available information In other words, an average investor cannot hope to consistently beat the market....there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis, Michael Jensen (1978) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 17 / 23 M

18 Efficient Markets Hypothesis (EMH) The EMH assumes that investors are rational, and hence value securities rationally (based on their fundamentals) When investors learn something new about fundamental values of securities, they quickly bid up prices when the news is good and bid them down when the news is bad As a consequence, security prices incorporate all available information almost immediately and prices adjust to new levels corresponding to the NPV of cash flows Samuelson (1965) showed that when markets are competitive and investors are risk-neutral, returns are unpredictable. In other words, security prices follow random walks Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 18 / 23 M

19 Does active money management pay off? Source: Lakonishok, Shleifer and Vishny (1992) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 19 / 23 M

20 Does active money management pay off? performance over time Source: Lakonishok, Shleifer and Vishny (1992) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 20 / 23 M

21 Adjustment of Prices to new information Keown and Pinkerton (1981) look at cumulative excess returns (returns above the market portfolio) for acquired firms around the time of the first public announcement of planned merger Source: Keown & Pinkerton (1981) Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 21 / 23 M

22 Random Walks Let the price of a security p t be described by the following statistical model, called an Auto-regressive (AR) process p t = ϕp t 1 + ε t, ϕ [0, 1], ε t N (0, σ 2 ) (4) When ϕ = 1, we say that p t follows a Random Walk. It implies that the change in prices p t p t p t 1 is just random noise. p t = ε t (5) And, using a backward recursion, we can see that the price today is just a cumulation of purely random changes: p t = t ε i (6) i=1 Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 22 / 23 M

23 Evidence against EMH Researchers has uncovered several anomalies that contradict the EMH Small-firm effect January effect Market over-reaction Excessive volatility Mean reversion Alejandro Riaño (Penn State University) ECON 351: The Stock Market, the Theory of Rational Expectations, June 8, 2008 and the Efficient 23 / 23 M

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