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FNCE 3020 Financial Markets and Institutions

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Title: FNCE 3020 Financial Markets and Institutions


1
FNCE 3020Financial Markets and Institutions
  • Lecture 6 Part 1
  • Expectations and Financial Markets
  • (The Efficient Market Hypothesis)

2
Objectives for This Lecture Series
  • (1) To discuss the role of expectations in
    financial markets.
  • How do expectations influence asset prices and
    decisions of investors and borrowers in the
    financial markets.
  • (2) To introduce you to the concept of market
    efficiency and the Efficient Market Hypothesis.
  • (3) To introduce you to the controversy
    surrounding the Efficient Market Hypothesis.
  • (4) Create a foundation and understanding for
    possible forecasting techniques.
  • Lecture 6 Part 2

3
The Role of Expectations
  • Expectations play a critical role in financial
    markets. Here are some examples
  • Expectations about inflation affect
  • Interest rates in the bond market.
  • Central Bank actions.
  • Expectations about interest rates affect
  • The term structure of interest rates, i.e. the
    slope of the yield curve
  • The movement stock and bond prices and foreign
    exchange rates.
  • Expectations about future economic activity
    affect
  • Bond and stock prices.

4
Adaptive Expectations Model
  • Key issue How are expectations formed?
  • Prior to the 1960s, most economists assumed that
    market participants formed adaptive expectations
    about the future.
  • Their expectations about a variable were based on
    past values of that variable, and changed slowly
    over time.
  • There were, however, potential problems with
    this adaptive model of expectations
  • (1) A particular variable may be affected by many
    other variables, so people will likely use all
    relevant data in forming an expectation about a
    variable (not just the variable itself).
  • (2) Expectations can change very quickly if the
    environment also experiences sudden, substantial
    changes.

5
Abrupt Change in 1970s/1980s Environment
Affecting Expectations
6
The New Environment for Bonds
7
Rational Expectations Model
  • As a result of the potential problems surrounding
    the adaptive expectations model, another model of
    expectations, called rational expectations, was
    introduced
  • According to this model, market participants form
    expectations using all available information.
  • New information is constantly being introduced to
    the market.
  • Rational expectations results in the market
    making its best forecast (optimal forecast)
    given all available information.
  • However and this is important at any point in
    time , this is still a forecast, it could be
    wrong, and will be wrong if expectations about
    the future turn out to be incorrect.

8
Rational Expectations and Efficient Financial
Markets
  • Applying the theory of rational expectations to
    financial markets produces the efficient markets
    theory.
  • The efficient markets theory assumes that asset
    prices reflect all available information (events)
    that directly impact on the future cash flow of a
    security (financial asset)
  • This includes
  • Past events,
  • Current events and
  • Expected future events.
  • Based upon all available information, the market
    forms its expectations and then sets prices
    accordingly.

9
Efficient Market Theory (Hypothesis) and Stock
Prices
  • Application of Efficient Market Theory to common
    stocks can be traced to the work of Eugene Fama
    (1965, Financial Analyst Journal)
  • For a published interview with Fama see
    http//www.dfaus.com/library/reprints/interview_fa
    ma_tanous/
  • (1) Efficient market theory Stocks are always
    correctly priced given that everything that is
    publicly known about a stock is reflected in its
    market price.
  • (2) Random walk theory Since new information is
    random, all future price changes are independent
    from previous price changes thus, future stock
    prices cannot be predicted.
  • See A Random Walk Down Wall Street, by Burton
    Malkiel (Norton Publishing 1973).

10
The Efficient Market Hypothesis (EMH) According
to Eugene Fama
  • Quoting Eugene Fama
  • In an efficient market, competition among the
    many intelligent participants leads to a
    situation where, at any point in time, the actual
    prices of securities already reflects the effects
    of information based on events that have
  • (1) already occurred and on events,
  • (2) as of now, and events
  • (3) the market expects to take place in the
    future.
  • Eugene F. Fama, "Random Walks in Stock Market
    Prices," Financial Analysts Journal,
    September/October 1965

11
Role of Unexpected Events
  • According to Eugene Famas definition of
    efficient markets, financial asset prices reflect
    the best knowledge of the past, the present and
    predictions of the future.
  • Key issues
  • What happens when something unexpected occurs?
  • How does the market react if the market is
    efficient?
  • How does the market react if the market is
    inefficient?
  • How quickly do asset prices adjust?
  • How does an efficient market react to anticipated
    events?
  • How does an inefficient market react to
    anticipated events?
  • Next two slides illustrating addressing these
    questions from Nikolai Chuvakhin, Efficient
    Market Hypothesis and Behavioral Finance Is a
    Compromise in Sight?

12
Famas Illustration of Markets Reaction to
Unanticipated Events
13
Famas Illustration of Markets Reaction to
Anticipated Events
14
Example Krispy Kreme and the Efficient Market
Theory
  • Founded in 1937 (in Winston-Salem, NC) , the
    company went public (IPO) on April 5, 2000 and
    traded on NASDAQ.
  • The company listed on the NYSE on May 17, 2001.
  • The company was selling over 7.5 million
    doughnuts a day.
  • Earnings announcement Monday, November 22, 2004
    (prior to the opening on the NYSE) for the three
    months ending October 31, 2004.
  • Analysts had expected Krispy Kreme to earn 13
    cents per share,
  • Instead, the company announced its first
    quarterly loss since going public in 2000.
  • Losses for the three months ending Oct. 31 were
    3 million, or 5 cents per share, down from a
    profit of 14.5 million, or 23 cents per share, a
    year earlier.
  • Announced earnings (loss) were not in line with
    market expectations. So, what happened to the
    stock?

15
Krispy Kreme Monday, November 22, 2004 Reaction
to Unexpected Event
16
Example Stock Market Reacts to Fed Surprise
  • On Tuesday, September 18, 2007, the Federal
    Reserve surprised financial markets by lowering
    the fed funds rate 50 basis points to 4.75 (the
    markets had been anticipating a reduction of 25
    basis points). The announcement took place at
    215EST.

17
Testing the Efficient Market Hypothesis
  • The EMH provided the theoretical basis for much
    of the financial market research during the 1970s
    and 1980s.
  • During that time, most of the evidence seems to
    have been consistent with the EMH.
  • Prices were seen to follow a random walk model
    and the predictable variations in equity returns,
    if any, were found to be statistically
    insignificant.
  • So, most of the studies in the 1970s focused on
    the inability to predict prices from past prices.
  • However, beginning in the 1980s, the EMH became
    somewhat controversial, especially after the
    detection of certain anomalies in the capital
    markets (i.e., situations which provided
    abnormal returns).

18
Testing for Financial Market Anomalies
  • Some of the main financial market anomalies that
    have been identified are as follows
  • 1. The January Effect Rozeff and Kinney (1976)
    were the first to document evidence of higher
    mean stock returns in January as compared to
    other months.
  • The January effect has also been documented for
    bonds by Chang and Pinegar (1986).
  • Maxwell (1998) showed that the bond market effect
    is strong for non-investment grade bonds, but not
    for investment grade bonds.

19
The Weekend (or Monday) Effect
  • 2. The Weekend Effect (or Monday Effect) French
    (1980) analyzed daily returns of U.S. stocks for
    the period 1953-1977 and found that there was a
    tendency for returns to be negative on Mondays
    whereas they were positive on the other days of
    the week.
  • Agrawal and Tandon (1994) found significantly
    negative returns on Monday in nine countries and
    on Tuesday in eight countries, yet large and
    positive returns on Friday in 17 of the 18
    countries studied.
  • Steeley (2001) found that the weekend effect in
    the UK disappeared in the 1990s.

20
Seasonal Effects
  • 3. Seasonal Effects Holiday and turn of the
    month effects have been documented over time and
    across countries.
  • Lakonishok and Smidt (1988) showed that U.S.
    stock returns were significantly higher at the
    turn of the month, defined as the last and first
    three trading days of the month.
  • Ziemba (1991) found evidence of a turn of month
    effect for Japan when turn of month was defined
    as the last five and first two trading days of
    the month.
  • Cadsby and Ratner (1992) provided evidence to
    show that returns were, on average, higher the
    day before a holiday, than on other trading days.

21
Small Firm Effects
  • 4. Small Firm Effect
  • Banz (1981) published one of the earliest
    articles on the 'small-firm effect' which is also
    known as the 'size-effect'.
  • His analysis of the 1936-1975 period in the U.S.
    revealed that excess returns would have been
    earned by holding stocks of low capitalization
    companies.

22
Over/Under Reaction Effect
  • 5. Over/Under Reaction of Stock Prices to
    Earnings Announcements DeBondt and Thaler (1985,
    1987) presented evidence that is consistent with
    stock prices overreacting to current changes in
    earnings.
  • They reported positive (negative) estimated
    abnormal stock returns for portfolios that
    previously generated inferior (superior) stock
    price and earning performance.
  • This was construed as the prior period stock
    price behavior overreacting to earnings
    announcements.

23
Standard and Poors Effect
  • 6. Standard Poors (SP) Index effect Harris
    and Gurel (1986) and Shleifer (1986) found an
    increase in share prices (up to 3 percent) on the
    announcement of a stock's inclusion into the SP
    500 index.
  • Since in an efficient market only new information
    should change prices, the positive stock price
    reaction appears to be contrary to the EMH
    because there is no new information about the
    firm other than its inclusion in the index.

24
Weather Effect
  • 7. The Weather Saunders (1993) showed that the
    New York Stock Exchange index tended to fall when
    it was cloudy.
  • Hirshleifer and Shumway (2001) analyzed data for
    26 countries from 1982-1997 and found that stock
    market returns were positively correlated with
    sunshine in almost all of the countries studied.

25
Volatility Effect
  • 8. Volatility Effect These tests are designed to
    test for rationality of market behavior by
    examining the volatility of share prices relative
    to the volatility of the fundamental variables
    that affect share prices.
  • Shiller (1981) and LeRoy and Porter (1981) showed
    that fluctuations in actual prices (for both
    stocks and bonds) were greater than those implied
    by changes in fundamental variables during
    volatile periods.
  • Schwert (1989) found increased volatility in
    financial asset returns during recessions.
  • The empirical evidence provided by volatility
    tests suggests that movements in stock prices
    cannot be attributed merely to the rational
    expectations of investors, but also involve an
    irrational component.

26
Volatility Effect October 19, 1987
  • On October 19, 1987, the stock market plunged
    with what, on that day, was the largest one-day
    point loss in the history of the Dow Jones
    Industrial Average (507.99 points, or 22.6).
  • Issue Could such a large one-day loss be
    reconciled with efficient markets and the data at
    that time?
  • The were several factors justifying lower stock
    prices at the time widening federal budget,
    trade deficits, legislation against corporate
    takeovers, rising inflation, and a falling
    dollar.
  • However, none of these fundamentals experienced
    such a dramatic one-day change as to precipitate
    the 22.6 decline.
  • Many economists concluded that this episode is
    evidence that investor psychology plays a role in
    setting stock prices (along with the
    fundamentals).
  • Lead to the study of Behavioral Finance

27
Human Behavior in Markets
  • If we assume that markets are not totally
    rational (i.e., they dont react as a rational
    expectations model would suggest), it might be
    possible to explain some of the anomaly findings
    on the basis of human and social psychology.
  • John Maynard Keynes once described the stock
    market as a "casino" guided by "animal spirit"
    (1939).
  • Shiller (2000) describes the rise in the U.S.
    stock market in the late 1990s as the result of
    psychological contagion leading to irrational
    exuberance.

28
Behavioral Finance and Asset Pricing
  • Suggests that real people
  • Have limited information processing capabilities
  • Exhibit systematic bias in processing information
  • Are prone to making mistakes
  • Tend to rely on the opinion of others (fads)
    referred to as a bandwagon effect.

29
Conclusions from EMH Tests
  • The studies based on EMH have made an invaluable
    contribution to our understanding of financial
    market.
  • The role of information (especially new
    information) in asset pricing.
  • However, for some there seems to be growing
    discontentment with the theorys rational
    expectations focus.
  • However, for an excellent paper in support of the
    EMH read The Efficient Market Hypothesis and
    its Critics, by Burton Malkiel, Princeton
    University, Working Paper 91, April 2003.

30
Appendix 1 Impacts of Unexpected Events on Asset
Prices
  • The following are examples of unanticipated
    events and their impacts on various asset prices.

31
Nike Reacts to Surprise Announcement
  • Thursday, November 18, 2004 
  • Near the close of the market (just before 400)
    the company announced that Philip H. Knight,
    co-founder of Nike (NYSE NKE) Inc., was stepping
    down as president and chief executive officer of
    the company.

32
Stock Market Reacts to Fed Surprise
  • On Tuesday, September 18, 2007, the US Federal
    Reserve surprised financial markets by lowering
    the fed funds rate 50 basis points to 4.75 (the
    markets had been anticipating a reduction of 25
    basis points). The Fed announcement took place at
    215EST.

33
Foreign Exchange Reaction to Fed Surprise
  • On Tuesday, September 18, 2007, the US Federal
    Reserve surprised by financial markets by
    lowering the fed funds rate 50 basis points to
    4.75 (the markets had been anticipating a
    reduction of 25 basis points). The Fed
    announcement took place at 215EST.

34
Appendix 2 Over-Reaction Effect
  • Case Study Nike and the Over Reaction Effect

35
Nike and the Overreaction Effect
  • Thursday, November 18, 2004 
  • Near the close of the market (just before 400)
    the company announced that Philip H. Knight,
    co-founder of Nike (NYSE NKE) Inc., was stepping
    down as president and chief executive officer of
    the company.

36
Overreaction of Nike Stock
  • Close Day Before
  • 85.99 (11/17)
  • Close Day Of
  • 85.00 (11/18)
  • change -1.2
  • Close the Day After
  • 82.50 (11/19)
  • change -4.1
  • Close 7 Days After
  • 86.55 (12/1)
  • change 4.9
  • Note change from close day before
    announcement.
  • change from close the day after the
    announcement.

37
Appendix 3 Three Forms of Market Efficiency
  • The following slides discuss the three forms of
    market efficiency and the use of forecasting with
    these three forms.

38
Three Forms of The Efficient Market Hypothesis
  • There are actually three stages of the EMH model
  • Weak Form Current prices reflect all past price
    and past volume information.
  • The fundamental information contained in the past
    sequence of prices of a security is fully
    reflected in the current market price of that
    security.
  • Semi-strong Form Current prices reflect all past
    price and past volume information AND all
    publicly available information.
  • Information such as interest rates, earnings,
    inflation, etc.
  • Strong Form Current prices reflect all past
    price and past volume information, all publicly
    available information publicly available
    information AND all private (e.g., insider)
    information.

39
Appendix 4 A More Detailed Look at the
Efficient Market Hypothesis
40
Efficient Market Hypothesis
  • According to the Efficient Market Hypothesis, the
    prices of securities in financial markets fully
    reflect all available information.
  • The model assumes that the market makes an
    optimal forecast (best guess) of the future
    price using all available information.
  • This is called Rational Expectations.
  • This optimal forecast, in turn, represents the
    expected return on the security.
  • This is what investors expect to receive given
    all the information available to them.

41
How can we Represent the Expected Rate of Return
on a Security?
  • The expected rate of return (expressed as a ) on
    a security equals
  • The capital gain on the security (i.e., change in
    price, or Pet-1 Pt) plus
  • Any cash dividends (C),
  • Divided by the initial purchase price of the
    security, or
  • Where Re is the expected return

42
Can we Measure the Expected Return?
  • However, a securitys expected return cannot be
    observed (i.e., it cannot be calculated).
  • Why is this the so?
  • Because the market does not know what future
    changes in prices or dividends will be.
  • This is dependent upon information which the
    market does not yet have.
  • Thus, we need to devise some way to
    conceptualize the expected return and how it
    moves, or responds to new information.

43
Conceptualizing the Expected Return
  • The EMH assumes that each security has an
    equilibrium return.
  • This is the return which equates the quantity of
    the security demanded with the quantity of the
    security supplied.
  • The securitys equilibrium return is determined
    by the securitys risk characteristics.
  • Higher risk securities carry a higher equilibrium
    return.
  • The EMH assumes that the expected return on a
    security (Re) will move towards the securitys
    equilibrium return (R).

44
Efficient Market Hypothesis, Deviation from
Equilibrium ReR
  • Assume the expected return (Re) on a security is
    suddenly greater than the equilibrium return (R)
    on that security.
  • How could this happen?
  • Any unexpected information which increased the
    cash flow of the security for the given market
    price.
  • We can view this situation in the context of the
    EMH expected rate of return model, or

45
Restoring Equilibrium
  • If the expected return (Re) is suddenly greater
    than the equilibrium return (R), the current
    price (Pt) must adjust to satisfy equilibrium, or
    in this case the current price will rise
  • And will do so, until Re R
  • As the price rises, the expected return will fall.

46
Efficient Market Hypothesis, Deviation from
Equilibrium Re
  • Assume the expected return (Re) on a security is
    suddenly less than the equilibrium return (R) on
    that security.
  • How could this happen?
  • Any unexpected information which decreased the
    cash flow of the security for the given market
    price.
  • We can view this situation in the context of the
    expected rate of return model, or

  • 47
    Restoring Equilibrium
    • If the expected return (Re) is suddenly less than
      the equilibrium return (R), the current price
      (Pt) must adjust must adjust to satisfy
      equilibrium, or in this case the current price
      will fall
    • And will do so, until Re R
    • As the price falls, the expected return will
      rise.

    48
    Unexploited Profits
    • According to the EMH, all unexploited profit
      opportunities (defined as expected returns
      greater than equilibrium returns) will be
      eliminated through price changes.
    • Prices will rise or fall so that expected returns
      will adjust to equilibrium return.
    • Conclusion
    • You cant beat the market.
    • When new information affecting the expected
      return becomes public, prices will adjust.
    • Unless you have expected return information
      that the rest of the market doesnt have, you
      cant take advantage of this market move.
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