Ch 7 The Stock Market the Theory of Rational Expectations and the Efficient Market Hypothesis October 11 2012 Stock Market Background Amsterdam Stock Exchange was the first stock exchange o Export driven economy needed to find a way to help finance those industries NY Stock Market is the largest in the world and most influential formed in 1792 o NASDAQ smaller companies OTC Healthy stock market is characteristic of developed economy Highly volatile market 1920s stock bubble began to grow assets priced at higher than fundamental value burst in 1929 Stock holder residual claimant in a firm o Last in line to get paid if company goes bankrupt o May or may not receive dividends Purpose of stock raise financial capital The Gordon Growth Model g the expected constant growth rate in dividends ke the required return on an investment in equity Similar to i but added component of personal willingness to accept risk Most realistic model D0 most recent dividend paid The higher the growth rate the lower the K willing to accept More risk averse the higher K Dividends are assumed to continue growing at a constant rate forever The growth is assumed to be less than the required return on equity 1 October 18 2012 How the Market Sets Prices The 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 asset Superior information about an asset can increase its value by reducing its perceived risk 2 o As K decreases P increases Information is important for individuals to value each asset When new information is released about a firm expectations and prices change Market participants constantly receive information and revise their expectations so stock prices change frequently o Stocks are volatile on an intraday basis Application The Global Financial Crisis and the Stock Market Downward revision of growth prospects decreasing g Gordon model predicts a drop in stock prices Increased uncertainty increasing k The Theory of Rational Expectations Financial crisis that started in Aug 2007 led to one of the worst bear markets in 50 years Adaptive expectations expectations are formed from past experience only Changes in expectations will occur slowly over time as data changes However people use more than just past data to form their expectations and sometimes Rational expectations expectations will be identical to optimal forecasts using all available change their expectations quickly information o Even though a rational expectation equals the optimal forecast using all available data a prediction based on it may not always be perfectly accurate Optimal forecast the best guess of the future using all available information Best guesses will not be accurate because predictor is unaware of some relevant It takes too much effort to make the expectation the best guess possible information Must adapt to new information Formal Statement of the Theory of Rational Expectations Expectation optimal forecast o Optimal but not always accurate over forecast and negative forecast are likely to average to zero The Efficient Market Hypothesis Rational Expectations in Financial Markets Very similar to rate of change formula Very difficult to predict Pt 1 in stock market Current 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 reform o Very difficult for anyone to make a killing in the stock market including insiders 3 If you know it someone else has to know it and has already acted on it In an efficient market a security s price fully reflects all available information In an efficient market all unexploited profit opportunities will be eliminated o Rof Re Rof optimal forecast return Re expected return How 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 everyone Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices Acting on this information will not yield abnormally high returns on average The empirical evidence for the most part confirms that recommendations from investment advisors cannot help us outperform the general market Efficient Market Prescription for the Investor Recommendations from investment advisors cannot help us outperform the market A hot tip is probably information already contained in the price of the stock A buy and hold strategy is the most sensible strategy for the small investor Overall stocks outperform bonds Stock prices respond to announcements only when the information is new and unexpected Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient Some 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 efficient However prices in markets like the stock market are unpredictable This casts serious doubt on the stronger view that financial markets are efficient 4 Behavioral 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 How to make money by short selling Stock market bubbles may be explained by overconfidence and social contagion o 1 Borrow shares of stock while the market is still high o 2 Sell shares at currently high price and then wait for price to fall very risky bc the prices may not fall o 3 Buy shares at now lower price and return them to broker 5 Ch 10 Banking and Management of Financial Institutions October 23 2012 The Bank Balance Sheet Liabilities Source of funds o Checkable deposits o Nontransaction deposits o Borrowings o Bank Capital Assets Use of funds o Reserves Total Revenues Required Reserves Excess Reserves RR 10 of deposits When a bank gains deposits it gains reserves o Cash items in process of collection Float of checks expensive bc need to borrow money to cover that float The bank receives your check but cannot spend it until it is collected o Deposits at other banks Most commercial banks keep checking accounts at other banks correspondent Invest in bonds i e US govn t bonds you know you will be repaid accounts o Securities o Loans o Other assets