# mishkin ppt06

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Powerpoint slides on Mishkin Ch 6TRANSCRIPT

2/25/15

1

Pearson Prentice Hall Financial Markets and Institutions 6 - 1

Expectations - Asset Demand: Returns, Risk, Liquidity - In2lation: Bond Prices, Interest Rates - Risk Structure: Default Risk - Term Structure: Future ST Rates EFFICIENT MARKET HYPOTHESIS / THEORY OF EFFICIENT CAPITAL MARKETS

- states that prices of securities in financial markets fully reflect all available information.

Pearson Prentice Hall Financial Markets and Institutions 6 - 2

Ef2icient Market Hypothesis

- states that prices of securities in financial markets fully reflect all available information.

Rate of Return [from holding a security]- equals the sum of the capital gain on the security

(the change in the price) plus any cash payments, divided by the initial purchase price of the security:

Pt+1 = Price, end of HP Pt = Price, beg of HP C = Cash Payment

(Coupon or Dividend)

Pt+1 - Pt + C Pt

2/25/15

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Pearson Prentice Hall Financial Markets and Institutions 6 - 3

Ef2icient Market Hypothesis

Expected Rate of Return- Current Price (Pt) and Cash Payments (C) are known at the beginning, the only variable uncertain is the price next period (Pe t + 1)

C = Cash Payt (Coupon or Dividend) Pe t + 1 = Expected Price, end of HP Pt = Price, beg of HP

The ecient market hypothesis views expectations as equal to optimal forecasts using all available information. Pe t + 1 = Pof t + 1 Optimal forecast: best guess of the future; not perfectly accurate

e Pet+1 - Pt + C

Pt f

Pearson Prentice Hall Financial Markets and Institutions 6 - 4

Ef2icient Market Hypothesis

Expected Rate of Return Theorists states that e and et + 1 cannot be

observed, so the equations cannot be used to tell how the nancial markets behave.

Measuring value of e have important implications

for how prices of securities change in the nancial market.

2/25/15

3

Pearson Prentice Hall Financial Markets and Institutions 6 - 5

Ef2icient Market Hypothesis

However, demand & supply shows the expected return on a security (interest rate) will have a tendency to head toward the equilibrium return that equates the quantity demanded to the quantity supplied. So using the equilibrium condition:

e *

The expected return on a security equals the equilibrium return.

Pearson Prentice Hall Financial Markets and Institutions 6 - 6

Ef2icient Market Hypothesis

Deriving an equation to describe pricing behavior using the equilibrium condition:

of *

The current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return.

Financial economists state it: A securitys price fully reects all available information in an ecient market

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4

Pearson Prentice Hall Financial Markets and Institutions 6 - 7

Ef2icient Market Hypothesis

Application: Predicting Opening Prices, PtSuppose that a share of Microsoft had a closing price yesterday of $90, but new information was announced after the market closed that caused a revision in the forecast of the price for next year to go to $120. If the annual equilibrium return on Microsoft is 15%, what does the efficient market hypothesis indicate the price will go to today when the market opens? (Assume that Microsoft pays no dividends.)

Rof = optimal forecast of return = 15% R* = equilibrium return = 15% Poft+1 = optimal forecast Price = $120 Solve: Pt C = 0

of *Poft+1 - Pt + C

Pt f

Pearson Prentice Hall Financial Markets and Institutions 6 - 8

Ef2icient Market Hypothesis

Application: Predicting Opening Prices, Pt Rof = optimal forecast of return = 15% R* = equilibrium return = 15% Poft+1 = optimal forecast Price = $120 Solve: Pt C = 0

0.15 = $120 Pt Pt

Pt x 0.15 = $120 - PtPt x 1.15 = $120

Pt = $104.35

of *Poft+1 - Pt + C

Pt

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5

Pearson Prentice Hall Financial Markets and Institutions 6 - 9

Ef2icient Market Hypothesis

Rationale Behind the Hypothesis Arbitrage: market participants eliminate unexploited profit

opportunities (UPO), returns on a security that are larger than what is justied by the characteristics of that security

2 Types of Arbitrage: a. Pure elimination of UPO involves NO RISKS b. Arbitrageur takes on SOME RISK when eliminating UPO

Efficient Market condition: Rof R* " Pth "Rof Rof R* " Pti "Rof

until Rof R*

Pearson Prentice Hall Financial Markets and Institutions 6 - 10

Ef2icient Market Hypothesis

Rationale Behind the Hypothesis Efficient Market condition:

Rof R* " Pth "Rof

Rof R* " Pti "Rof

In an efficient market, all unexploited profit opportunities will be eliminated.

until Rof R*

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6

Pearson Prentice Hall Financial Markets and Institutions 6 - 11

Ef2icient Market Hypothesis

Rationale Behind the Hypothesis An extremely important factor in this reasoning is that

NOT everyone in a financial market must be well informed about a security for its price to be driven to the point at which the efficient market condition holds

SMART MONEY: the few market participants that keep their eyes open for UPO; they will eliminate the UPO because in so doing, they make a profit

Pearson Prentice Hall Financial Markets and Institutions 6 - 12

Ef2icient Market Hypothesis

Stronger Version of the Ef2icient Market Hypothesis Efficient market conditions:

a. Expectations are optimal using all available information b. prices reflect the market fundamentals - intrinsic value of

the securities

2/25/15

7

Pearson Prentice Hall Financial Markets and Institutions 6 - 13

Ef2icient Market Hypothesis

Stronger Version of the Ef2icient Market Hypothesis Implications on the Security Price:

a. One investment is as good as any other because the securities prices are correct

b. Reects all available info about the intrinsic value of the security

c. Security prices can be used by managers to assess their cost of capital accurately and hence can be used to help them make the correct decisions about the worth of making a specic investment

Pearson Prentice Hall Financial Markets and Institutions 6 - 14

Ef2icient Market Hypothesis

Evidence on the Ef2icient Market Hypothesis In Favor of Market Efficiency:

a. Performance of Investment Analysts & Mutual Funds b. Stock Prices Reect Publicly Available Information c. Random-Walk Behavior of Stock Prices d. Technical Analysis

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Pearson Prentice Hall Financial Markets and Institutions 6 - 15

Ef2icient Market Hypothesis

Evidence on the Ef2icient Market Hypothesis Against Market Efficiency

a. Small-Firm Eect b. January Eect c. Market Overreaction d. Excessive Volatility e. Mean Reversion f. New Information Is Not Always Immediately

Incorporated into Stock Prices

Pearson Prentice Hall Financial Markets and Institutions 6 - 16

Ef2icient Market Hypothesis

Evidence In Favor of Market Ef2iciency a. Performance of Investment Analysts & Mutual Funds

It is impossible to beat the market Buy & sell recommendations from a group of advisers or mutual funds and compare the performance of the resulting selection of stocks with the market as a whole

Having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future

2/25/15

9

Pearson Prentice Hall Financial Markets and Institutions 6 - 17

Ef2icient Market Hypothesis Evidence In Favor of Market Ef2iciency b. Stock Prices Reect Publicly Available Information

Positive announcement about a company will not, on average, raise the price of its stock because this information is already reected in the stock price

c. Random-Walk Behavior of Stock Prices Random Walk: future changes in stock prices should, for all practical purposes, be unpredictable

Pearson Prentice Hall Financial Markets and Institutions 6 - 18

Ef2icient Market Hypothesis Evidence In Favor of Market Ef2iciency d. Technical Analysis

Study past STOCK PRICE DATA and search for patterns such as trends and regular cycles.

Rules for when to buy and sell stocks are then established on the basis of the patterns that emerge.

Conclusion: Technical analysts fare no better than other nancial analysts. On average, they do not outperform the market, and successful past forecasting does not imply that their forecasts will outperform the market in the future.

2/25/15

10

Pearson Prentice Hall Financial Markets and Institutions 6 - 19

Ef2icient Market Hypothesis Evidence Against Market Ef2iciency a. Small-Firm Eect b. January Eect c. Market Overreaction d. Excessive Volatility e. Mean Reversion f. New Information Is Not Always Immediately

Incorporated into Stock Prices

Pearson Prentice Hall Financial Markets and Institutions 6 - 20

Ef2icient Market Hypothesis Evidence