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October 11, 2012Stock-Market: BackgroundAmsterdam Stock Exchange was the first stock exchangeExport-driven economy, needed to find a way to help finance those industriesNY Stock Market is the largest in the world and most influential, formed in 1792NASDAQ = smaller companies, OTCHealthy stock market is characteristic of developed economyHighly volatile market1920s: stock bubble began to grow (assets priced at higher than fundamental value), burst in 1929Stock holder: residual claimant in a firmLast in line to get paid if company goes bankruptMay or may not receive dividendsPurpose of stock = raise financial capitalThe Gordon Growth ModelMost realistic modelD0 = most recent dividend paidg = the expected constant growth rate in dividendske = the required return on an investment in equitySimilar to i, but added component of personal willingness to accept riskThe higher the growth rate, the lower the K willing to acceptMore risk averse, the higher KDividends are assumed to continue growing at a constant rate foreverThe growth is assumed to be less than the required return on equityOctober 18, 2012How the Market Sets PricesThe price is set by the buyer willing to pay the highest price (like an auction)The market price will be set by the buyer who can best take advantage of the assetSuperior information about an asset can increase its value by reducing its perceived riskAs K decreases, P increasesInformation is important for individuals to value each assetWhen new information is released about a firm, expectations and prices changeMarket participants constantly receive information and revise their expectations, so stock prices change frequentlyStocks are volatile on an intraday basisApplication: The Global Financial Crisis and the Stock MarketFinancial crisis that started in Aug. 2007 led to one of the worst bear markets in 50 yearsDownward revision of growth prospects: decreasing gIncreased uncertainty: increasing kGordon model predicts a drop in stock pricesThe Theory of Rational ExpectationsAdaptive expectations: expectations are formed from past experience onlyChanges in expectations will occur slowly over time as data changesHowever, people use more than just past data to form their expectations and sometimes change their expectations quicklyRational expectations: expectations will be identical to optimal forecasts using all available informationEven though a rational expectation equals the optimal forecast using all available data, a prediction based on it may not always be perfectly accurateOptimal forecast: the best guess of the future using all available informationIt takes too much effort to make the expectation the best guess possibleBest guesses will not be accurate because predictor is unaware of some relevant informationMust adapt to new informationFormal Statement of the Theory of Rational ExpectationsExpectation = optimal forecastOptimal, but not always accurate  over-forecast and negative forecast are likely to average to zeroThe Efficient Market Hypothesis: Rational Expectations in Financial MarketsVery similar to rate of change formulaVery difficult to predict Pt+1 in stock marketCurrent prices in a financial market will be set to the optimal forecast of a security’s return using all available information equals the security’s equilibrium reformVery difficult for anyone to make a killing in the stock market (including insiders)If you know it, someone else has to know it and has already acted on itIn an efficient market, a security’s price fully reflects all available informationIn an efficient market, all unexploited profit opportunities will be eliminatedRof = ReRof = optimal forecast returnRe = expected returnHow Valuable are Published Reports by Investment Advisors?Waste of money for investment advice if the goal of the advising is trying to help you gain a profit bc the market is unpredictable to everyoneInformation in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market pricesActing on this information will not yield abnormally high returns, on averageThe empirical evidence for the most part confirms that recommendations from investment advisors cannot help us outperform the general marketEfficient Market Prescription for the InvestorRecommendations from investment advisors cannot help us outperform the marketA “hot tip” is probably information already contained in the price of the stockStock prices respond to announcements only when the information is new and unexpectedA “buy and hold” strategy is the most sensible strategy for the small investorOverall, stocks outperform bondsWhy the Efficient Market Hypothesis Does Not Imply that Financial Markets are EfficientSome financial economists believe all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) and so financial markets are efficientHowever, prices in markets like the stock market are unpredictable— This casts serious doubt on the stronger view that financial markets are efficientBehavioral FinanceThe lack of short selling (causing over-priced stocks) may be explained by loss aversionThe large trading volume may be explained by investor overconfidenceStock market bubbles may be explained by overconfidence and social contagionHow to make money by short-selling:1) Borrow shares of stock while the market is still high2) Sell shares at currently high price and then wait for price to fall = very risky bc the prices may not fall3) Buy shares at now lower price and return them to brokerOctober 23, 2012The Bank Balance SheetLiabilities (Source of funds)Checkable depositsNontransaction depositsBorrowingsBank CapitalAssets (Use of funds)ReservesTotal Revenues = Required Reserves + Excess Reserves*When a bank gains deposits, it gains reservesRR ~ 10% of depositsCash items in process of collectionFloat of checks — expensive bc need to borrow money to cover that floatThe bank receives your check but cannot spend it until it is collectedDeposits at other banksMost commercial banks keep checking accounts at other banks — correspondent accountsSecuritiesInvest in bonds (i.e. US govn’t bonds  you know you will be repaid)LoansOther assetsBalance Sheet of All Commercial Banks (items as a percentage of the total, June 2011)Most liabilities = small denomination time deposits + savings deposits (money market


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FSU ECO 3223 - Ch. 7 The Stock Market

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