The Theory of Capital Markets

1
The Theory of Capital Markets

• Rational Expectations and Efficient Markets

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Adaptive Expectations

• Adaptive Expectations
• Expectations depend on past experience only.
• Expectations are a weighted average of past
  experiences.
• Expectations change slowly over time.

3
Rational Expectations

• The theory of rational expectations states that
  expectations will not differ from optimal
  forecasts using all available information.
• It is reasonable to assume that people act
  rationally because it is is costly not to have
  the best forecast of the future.

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Rational Expectations

• Rational expectations mean that expectations will
  be identical to optimal forecasts (the best guess
  of the future) using all available information,
  but..
• It should be noted that even though a rational
  expectation equals the optimal forecast using all
  available information, a prediction based on it
  may not always be perfectly accurate.

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Non-rational Expectations?

• There are two reasons why an expectation may fail
  to be rational
• People might be aware of all available
  information but find it takes too much effort to
  make their expectation the best guess possible.
• People might be unaware of some available
  relevant information, so their best guess of the
  future will not be accurate.

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Rational Expectations Implications

• If there is a change in the way a variable moves,
  there will be a change in the way expectations of
  this variable are formed.
• The forecast errors of expectations will on
  average be zero and cannot be predicted ahead of
  time.
• The forecast errors of expectations are
  unpredictable.

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Summary Statistics (1926 - 2000)
Arithmetic Annual Return
Risk (StandardDeviation)
Distribution of Annual Returns
Large Company Stocks
13.2
20.3
Small Company Stocks
17.4
33.8
GovtBonds
9.2
5.7
Cash
3.8
3.2
Inflation
3.2
4.5
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Tulipmania

• Holland, 1630s.
• Peter Garber, Famous First Bubbles
• Mosaic virus, random-walk look
• Free press began in Holland then.

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Dot Com Bubble

• Toys.com Had disadvantage relative to bricks
  mortar retailers starting web sites
• Lastminute.com travel agency, sales in fourth
  quarter of 1999 were 650,000, market value in
  IPO ins March 2000 was 1 billion.

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Efficient Markets

• Efficient markets theory is the application of
  rational expectations to the pricing of
  securities in financial markets.
• Current security prices will fully reflect all
  available information because in an efficient
  market all unexploited profit opportunities are
  eliminated.
• The elimination of all unexploited profit
  opportunities does not require that all market
  participants be well informed or have rational
  expectations.

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Definition of Efficient Markets (cont.)

• Professor Eugene Fama, who coined the phrase
  efficient markets, defined market efficiency as
  follows
• "In an efficient market, competition among the
  many intelligent participants leads to a
  situation where, at any point in time, actual
  prices of individual securities already reflect
  the effects of information based both on events
  that have already occurred and on events which,
  as of now, the market expects to take place in
  the future. In other words, in an efficient
  market at any point in time the actual price of a
  security will be a good estimate of its intrinsic
  value."

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The Efficient Markets Hypothesis

• The Efficient Markets Hypothesis (EMH) is made up
  of three progressively stronger forms
• Weak Form
• Semi-strong Form
• Strong Form

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The EMH Graphically
All historical prices and returns

• In this diagram, the circles represent the amount
  of information that each form of the EMH
  includes.
• Note that the weak form covers the least amount
  of information, and the strong form covers all
  information.
• Also note that each successive form includes the
  previous ones.

All public information
All information, public and private
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Efficient Markets Theory Example

• Assume you own a stock that has an equilibrium
  return of 10.
• Also assume that the price of this stock has
  fallen such that the return currently is 50.
• Demand for this stock would rise, pushing its
  price up, and yield down.

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Efficient Markets Theory

• Weak Version
• All information contained in past price movements
  is fully reflected in current market prices.
• In this case, information about recent trends in
  stock prices would be of no use in selecting
  stocks.
• Tape watchers and chartists are wasting their
  time.

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Efficient Markets Theory

• Semi- Strong Version
• Current market prices reflect all publicly
  available information.
• In this case, it does no good to pore over annual
  reports or other published data because market
  prices will have adjusted to any good or bad news
  contained in those reports as soon as they came
  out.
• Insiders, however, can make abnormal returns on
  their own companies stocks.

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Efficient Markets Theory

• Strong Version
• Current market prices reflect all pertinent
  information, whether publicly available or
  privately held.
• In an efficient capital market, a securitys
  price reflects all available information about
  the intrinsic value of the security.
• Security prices can be used by managers of both
  financial and non-financial firms to assess their
  cost of capital accurately.

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Efficient Markets Strong Version

• Security prices can be used to help make correct
  decisions about whether a specific investment is
  worth making.
• In this case, even insiders would find it
  impossible to earn abnormal returns in the
  market.
• Scandals involving insiders who profited
  handsomely from insider trading helped to
  disprove this version of the efficient markets
  hypothesis.

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The Crash of 1987

• The stock market crash of 1987 convinced many
  financial economists that the stronger version of
  the efficient markets theory is not correct.
• It appears that factors other than market
  fundamentals may have had an effect on stock
  prices.
• This means that asset prices did not reflect
  their true fundamental values.

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The Crash of 1987

• But, the crash has not convinced these financial
  economists that rational expectations was
  incorrect.
• Rational Bubbles
• A bubble exists when the price of an asset
  differs from its fundamental market value.
• In a rational bubble, investors can have rational
  expectations that a bubble is occurring, but
  continue to hold the asset anyway.
• They think they can get a higher price in the
  future.

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Efficient Markets Evidence

• Pro
• Performance of Investment Analysts and Mutual
  Funds
• Generally, investment advisors and mutual funds
  do not beat the market just as the efficient
  markets theory would predict.
• The theory of efficient markets argues that
  abnormally high returns are not possible.

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Efficient Markets Evidence

• Pro
• Random Walk
• Future changes in stock prices should be
  unpredictable.
• Examination of stock market records to see if
  changes in stock prices are systematically
  related to past changes and hence could have been
  predicted indicates that there is no
  relationship.
• Studies to determine if other publicly available
  information could have been used to predict stock
  prices also indicate that stock prices are not
  predictable.

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Efficient Markets Evidence

• Pro
• Technical Analysis
• The theory of efficient markets suggests that
  technical analysis cannot work if past stock
  prices cannot predict future stock prices.
• Technical analysts predict no better than other
  analysts.
• Technical rules applied to new data do not result
  in consistent profits.

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Efficient Markets Evidence

• Con
• Small Firm Effect
• Many empirical studies show that small firms have
  earned abnormally high returns over long periods.
• January Effect
• Over a long period, stock prices have tended to
  experience an abnormal price rise from December
  to January that is predictable.

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Efficient Markets Evidence

• Con
• Market Overreaction
• Recent research indicates that stock prices may
  overreact to news announcements and that the
  pricing errors are corrected only slowly.
• Excessive Volatility
• Stock prices appear to exhibit fluctuations that
  are greater than what is warranted by
  fluctuations in their fundamental values.

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Efficient Markets Evidence

• Con
• Mean Reversion
• Stocks with low values today tend to have high
  values in the future.
• Stocks with high values today tend to have low
  values in the future.
• The implication is that stock prices are
  predictable and, therefore, not a random walk.

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Efficient Markets Theory Implications

• Hot tips cannot help an investor outperform the
  market.
• The information is already priced into the stock.
• Hot tip is helpful only if you are the first to
  get the information.
• Stock prices respond to announcements only when
  the information being announced is new and
  unexpected.

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Behavioural Finance

• The lack of short selling (causing over-priced
  stocks) may be explained by loss aversion
• The large trading volume may be explained by
  investor overconfidence
• Stock market bubbles may be explained by
  overconfidence and social contagion

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Conclusions

• The theory of rational expectations states that
  expectations will not differ from optimal
  forecasts using all available information.
• Efficient markets theory is the application of
  rational expectations to the pricing of
  securities in financial markets.

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Conclusions

• The evidence on efficient markets theory is
  mixed, but the theory suggests that hot tips,
  investment advisers published recommendations,
  and technical analysis cannot help an investor
  outperform the market.
• The 1987 crash convinced many economists that the
  strong version of the efficient markets
  hypothesis was not correct.

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