FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

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

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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.

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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.

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Adaptive Expectations Model

• Key issue How are expectations formed?
• Prior to the 1960s, most economists assumed that
  market participants formed adaptive expectations.
  
• Their expectations about a variable were based on
  past values of that variable, and changed slowly
  over time.
• There were, however, a couple of problems with
  this adaptive model of expectations
• 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).
• Expectations can change very quickly if the
  environment also experiences sudden, substantial
  changes.

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Abrupt Change in 1970s/1980s Environment
Affecting Expectations
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The New Environment for Bonds
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Rational Expectations Model

• As a result of the issues surrounding the
  adaptive expectations model, a more realistic
  model of expectations, called rational
  expectations, was introduced
• According to this model, expectations are formed
  using all available information.
• Rational expectations results in the market
  making its best forecast (optimal forecast)
  given available information.
• However and this is important -- it is still a
  forecast, it could be wrong, and will be wrong if
  expectations about the future turn out to be
  incorrect.

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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.

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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 an interview with Fama see
  http//www.dfaus.com/library/reprints/interview_fa
  ma_tanous/
• Efficient market theory Stocks are always
  correctly priced since everything that is
  publicly known about a stock is reflected in its
  market price.
• Random walk theory 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).

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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

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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?

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Famas Illustration of Markets Reaction to
Unanticipated Events
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Famas Illustration of Markets Reaction to
Anticipated Events
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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?

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Krispy Kreme Monday, November 22, 2004 Reaction
to Unexpected Event
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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.

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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).

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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.

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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.

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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.
  

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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.

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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.

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Appendix 1 Impacts of Unexpected Events on Asset
Prices

• The following are examples of unanticipated
  events and their impacts on various asset prices.

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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.

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Appendix 2 Over-Reaction Effect

• Case Study Nike and the Over Reaction Effect

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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.

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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.

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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.

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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.

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Appendix 4 A More Detailed Look at the
Efficient Market Hypothesis
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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.

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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

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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.

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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).

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Efficient Market Hypothesis, Deviation from
Equilibrium RegtR

• 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.

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Efficient Market Hypothesis, Deviation from
Equilibrium ReltR

• 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.

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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.