econ 331 money and credit: part ii financial markets

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


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.


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.


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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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.


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.


CHAPTER 7The Stock Market

http://www.people.cornell.edu/pages/km426/Teaching/ECON331.html


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.


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%


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.


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


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


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.


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?


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


The Gordon Growth Model

If g < ke , this formula simplifies to

P0 =D0 × (1 + g)

ke − g=

D1

ke − g


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.


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).


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 .


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


Formal Statement of the Theory


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


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)


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?


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∗


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.


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.


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


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.


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.

econ 331 money and credit: part ii financial markets

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