The Stock Market and Stock Prices

1
The Stock Market and Stock Prices

• Reading Siklos Chapter 14

2
Overview

• Basics of Stock Markets
• Explaining Stock Price Behaviour
• Efficient Markets Fundamentalists
• Stock Market Volatility
• The Home-bias in Stock Purchases
• International Stock Price Linkages

3
Notation
Note that many stocks do not pay dividends.
Buyers of the stock expect that the firm will pay
dividends some day.
4
Computing the Price of Common Stock

• Basic Principle of Finance
• Value of Investment Present Value of Future
  Cash Flows
• One-Period Valuation Model

(1)
5
Exercise 1

• Intel Share Price
• 12 return is required on equity
• 16 cent dividend to be paid next year.
• 10 share price forecasted for next year

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Generalized Dividend Valuation Model

• Since last term of the equation is small,
  Equation 2 can be written as

(2)
(3)
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Theory of Rational Expectations

• Rational expectation (RE) expectation that is
  optimal forecast (best prediction of future)
  using all available information i.e., RE ?
• Xe Xof
• 2 reasons an expectation may not be rational
• 1. Not best prediction
• 2. Not using available information

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• Rational expectation, although optimal
  prediction, may not be accurate
• Rational expectations makes sense because it is
  costly not to have optimal forecast
• Implications
• 1. Change in way variable moves, changes the way
  expectations are formed
• 2. Forecast errors on average 0 and are not
  predictable (i.e. forecasters do not make
  persistent mistakes and they learn from previous
  mistakes immediately)

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Theories of Stock Price Determination

• Efficient Markets Hypothesis an application of
  rational expectations theory.
• Expectations about stock prices will be identical
  to optimal forecast using all available
  information.
• Three forms (vary based on definition of all
  available information)
• weak form, semi-strong form, strong form

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Notation
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Efficient Markets HypothesisWeak form
Investors have an information set on which
expectations of future stock prices are formed
E(Pt1 Pt, Pt-1,)Pt
If the past history of stock prices is known then
E(Pt1) Pt so that Pt1PtUt giving rise to
the random walk of stock prices
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The Random Walk of Stock Prices
13
The Random Walk of Stock Prices
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Efficient Markets Hypothesis (contd)

• Semi-strong form expands the Information set to
  include other fundamental macroeconomic variables
  such as interest rates, inflation, money
  growth,.)
• The strong form would incorporate private or
  insider information. This would most severely
  limit the profitable opportunities from changes
  in stock price behaviour

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Interest Rates and Stock Prices
R
R
LF1
LFs
R? P?
LF0
LF 2
Stock Price
LF
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Efficient Markets Hypothesis

• Pt1 Pt C
• RET
• Pt
• Pet1 Pt C
• RETe
• Pt
• Rational Expectations implies
• Pet1 Poft1 ? RETe RETof (1)
• Market equilibrium
• RETe RET (2)
• Put (1) and (2) together Efficient Markets
  Hypothesis
• RETof RET

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• Why the Efficient Markets Hypothesis makes sense
• If RETof gt RET ? Pt ?, RETof ?
• If RETof lt RET ? Pt ?, RETof ?
• until RETof RET
• 1. All unexploited profit opportunities
  eliminated
• 2. Efficient Market holds even if there are
  uninformed, irrational participants in the market

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Evidence on Efficient Markets Hypothesis

• Favorable Evidence
• 1. Investment analysts and mutual funds dont
  beat the market
• 2. Stock prices reflect publicly available
  information anticipated announcements dont
  affect stock price
• 3. Stock prices and exchange rates close to
  random walk
• 4. Technical analysis does not outperform market

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• Unfavorable Evidence
• 1. Small-firm effect small firms have abnormally
  high returns
• 2. January effect high returns in January
• 3. Market overreaction
• 4. Excessive volatility
• 5. Mean reversion
• 6. New information is not always immediately
  incorporated into stock prices
• Overview
• Reasonable starting point but not whole story

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Implications for Investing

• 1. Published reports of financial analysts not
  very valuable
• 2. Should be skeptical of hot tips
• 3. Stock prices may fall on good news
• 4. Prescription for investor
• 1. Shouldnt try to outguess market
• 2. Therefore, buy and hold
• 3. Diversify with no-load mutual fund

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A Different but Compatible ViewThe
Fundamentalist Approach

• Related to Gordon Growth Model
• Stock prices should reflect expectations about
  the flow of future dividends
• Assume that dividends reflect profits of the firm
• Assume a constant opportunity cost of holding
  money, R.
• Assume a constant growth rate of dividends, g
• Assume that dividends paid out forever

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Gordon Growth Model

• Assuming dividend growth is constant, Equation 3
  can be written as
• Assuming the growth rate is less than the
  required return on equity, Equation 4 can be
  written as

(4)
(5)
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Exercise 2

• Intel Share Price
• 12 return is required on equity
• 16 cent was last dividend paid.
• 10 dividend growth rate expected.

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The Fundamentalist Approach

• Assumption the required return on equity, ke,
  is equal to the market interest rate, R.
• Rewriting equation (5),

(6)
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Anomalies and Other features of stock price
behaviour

• Volatility and its Measurement
• Price-Earnings Ratio
• January other calendar effects
• Bubbles (South Sea, Mississippi, Tulipmania)
• International Linkages

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What Causes Noise in Stock Markets

Case 1 Market dominated by Informed Traders
Noisy Traders
? LOW VOLATILITY
Inf. Traders
Noisy Traders
Informed Traders
Case 2 Market dominated by Uninformed traders
?HIGH VOLATILITY
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Stock Market Volume
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International Stock Price Behaviour
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Summary

• Stock market behaviour is governed by the
  efficient markets hypothesis which comes in the
  weak, semi-strong and strong forms
• The Fundamentalist approach explains the
  determination of stock prices according to the
  flow of dividends generated by a stock
• Stock price behaviour is also subject to a number
  of anomalies and there are a number of other
  interesting aspects about stock prices