Title: FNCE 3020 Financial Markets and Institutions
1FNCE 3020Financial Markets and Institutions
- Lecture 6 Part 1
- Expectations and Financial Markets
- (The Efficient Market Hypothesis)
-
-
2Objectives 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
3The 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.
4Adaptive 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.
5Abrupt Change in 1970s/1980s Environment
Affecting Expectations
6The New Environment for Bonds
7Rational 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.
8Rational 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.
9Efficient 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).
10The 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
11Role 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?
12Famas Illustration of Markets Reaction to
Unanticipated Events
13Famas Illustration of Markets Reaction to
Anticipated Events
14Example 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?
15Krispy Kreme Monday, November 22, 2004 Reaction
to Unexpected Event
16Example 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.
17Testing 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).
18Testing 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.
19The 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.
20Seasonal 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.
21Small 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.
22Over/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.
23Standard 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.
24Weather 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.
25Volatility 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.
26Volatility 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
27Human 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.
28Behavioral 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.
29Conclusions 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. -
30Appendix 1 Impacts of Unexpected Events on Asset
Prices
- The following are examples of unanticipated
events and their impacts on various asset prices.
31Nike 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.
32Stock 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.
33Foreign 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.
34Appendix 2 Over-Reaction Effect
- Case Study Nike and the Over Reaction Effect
35Nike 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.
36Overreaction 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.
37Appendix 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.
38Three 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.
39Appendix 4 A More Detailed Look at the
Efficient Market Hypothesis
40Efficient 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.
41How 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
42Can 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.
43Conceptualizing 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).
44Efficient 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
45Restoring 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.
46Efficient 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 47Restoring 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.
48Unexploited 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.