Economics 134a

1
Economics 134a

• Lecture notes

2
Big ideas in finance ...

• NPV
• Portfolio theory/CAPM
• EFFICIENT CAPITAL MARKETS 3 lectures
• Capital Structure/Miller-Modigliani
• Options

3
Efficient capital markets

• Focuses on how much information people have.
• Only information that other agents dont have can
  be used to trade profitably
• How hard is it to acquire such information?
• ECM very hard

4
An Example

• Toys-R-Us Stock
• Suppose that its dividend pattern is 1,2,1,2,,
  starting a year from now.
• Discount factor is 10

5
What is its price?

• The sum of a perpetuity with payoff 1,1,1,
• This is 1/.10 10
• Plus the value of a perpetuity that pays 1 every
  2 years
• This is 1/(1.12-1) 1/.21 4.76
• So the price of the stock is 14.76 this year.

6
How about next year?

• Its the present value of (2,1,2,1,)15.24, by a
  similar calculation.
• So Toys-R-Us stock price alternates between 14.77
  and 15.24.
• Note the return over any year is 10
• Recall definition of return (dividend yield plus
  capital gain)

7
Another Way to do this

• Define p1 to be the price of 1,2,1,2,
• Define p2 to be the price of 2,1,2,1,
• These prices obey

8

• This assumes that the information that Toys-R-Us
  earnings are cyclical is fully incorporated in
  asset prices.
• As a result, you cant make money trading
  Toys-R-Us stock based on the information that
  their earnings and dividends are cyclical.
• Where make money means earn more than a normal
  return of 10

9
What about uncertainty?

• You cant trade to earn a higher return without
  incurring greater risk

10
Capital Market Efficiency Focus on information

• In CAPM we didnt think much about information
  we just assumed everyone had the same information
• Efficient capital markets does everyone have
  the same information?
• Is it (1) relatively easy, (2) difficult or (3)
  virtually impossible to get better information
  than the market?

11
Efficient markets

• Most generally, the idea of efficient capital
  markets is that you are always betting your
  information against the information of others who
  have similar motivation as you
• Or, at least, you are considering doing so.

12
Efficient Markets

• Markets are efficient, if at all, only with
  respect to a certain set of information.
• That information is fully reflected in securities
  prices
• In efficient markets, you cannot earn extranormal
  profits unless you have information beyond whats
  reflected in asset prices.

13
Efficient Markets

• Under the prices computed above, THE INFORMATION
  THAT TOYS-R-US EARNINGS ARE CYCLICAL IS FULLY
  REFLECTED IN ITS STOCK PRICE. YOU CANT MAKE
  MONEY TRADING BASED ON THAT INFORMATION.
• MARKETS ARE EFFICIENT RELATIVE TO THAT
  INFORMATION.

14
CAPM

• An efficient markets model information about
  means, variances, covariances is fully reflected
  in prices
• No one has information beyond what everyone has
• Also -- equally relevant -- no one thinks he/she
  has such information

15
Inefficient markets

• Markets are inefficient with respect to certain
  information if
• That information is NOT reflected in asset prices
• OR is reflected incorrectly (markets overreact or
  underreact)
• In either case there exist profitable
  information-based trading rules.

16
Toys-R-Us ...

• Suppose investors didnt know that Toys-R-Uss
  earnings and dividends are cyclical -- that is,
  that information isnt already reflected in their
  stock price.
• For concreteness, suppose that investors only
  know current earnings -- they immediately forget
  the past.
• So they assume earnings will be constant at the
  current level

17

• In that case, from the perpetuity formula, the
  price of the stock would be 10, 20, 10, 20,,
  (assuming a 10 discount rate).
• Still efficient!
• but relative to a smaller information set -- one
  that doesnt include past earnings, so investors
  cant perceive the cyclical pattern.

18
Trading rule

• buy at 10, sell at 20. Hugely profitable.
• IN THIS CASE THE INFORMATION THAT TOYS-R-US
  EARNINGS ARE CYCLICAL IS NOT REFLECTED IN ITS
  STOCK PRICE. THEREFORE YOU CAN MAKE MONEY
  TRADING BASED ON THAT INFORMATION.
• MARKETS ARE INEFFICIENT RELATIVE TO THAT
  INFORMATION.

19
Efficient Capital Markets

• In making an investment decision, you need to
  bear in mind that the only relevant information
  in identifying mispriced securities is that which
  isnt already fully reflected in asset prices.
• Unless you think you have information thats not
  already reflected in asset prices, you should
  conclude that assets are priced right. In that
  case you have no basis to make a choice.

20
CAPM reasoning

• Buy some of each and get some diversification.
• In fact, youll buy each stock only insofar as it
  appears in the market portfolio.

21
Earnings surprises

• In an efficient market, prices only react to
  surprises -- the difference between what is
  reported and what the market expected (i.e., what
  was already incorporated in asset prices).
• Even a big increase (drop) in earnings can lead
  to a drop (increase) in security prices,
  depending on what was expected.

22
Implications

• You need to decide whether you have access to
  information thats not fully reflected in asset
  prices.
• If you do (if the market is inefficient relative
  to the information you have) you should use it.
• For most of us, we dont!
• In that case, if we disagree with the market
  price, thats because the market has more
  information than we do.
• Cant trade profitably in that case.

23
How do you interpret differences of opinion?

• If you think capital markets are efficient
• with respect to an information set that includes
  all the information that you have
• and your information leads to a guess that a
  stock is mispriced
• YOU INTERPRET THIS AS REFLECTING THE INADEQUACY
  OF YOUR INFORMATION
• And you DONT trade on the difference of opinion

24
Toys-R-Us

• Suppose the market knows that Toys-R-Us dividends
  were cyclical, but I dont
• I wouldnt understand why its priced as it is.
• Based on my information, Toys--Us is overpriced
  at 14.77 (shouldnt it be 10?) and underpriced at
  15.25 (shouldnt it be 20?).
• But if I assumed the market was efficient with
  respect to information that includes the
  information I have, I wouldnt trade based on my
  information
• I would know I cant do so profitably.

25
Ivan Boesky

• If Ivan Boesky (a 1980s arbitrageur who was
  notorious for trading on inside information)
  wants to buy your stock, what do you conclude?
• He must know something I dont. Ill hang onto
  it.

26

• If you think capital markets are NOT efficient,
  and your information leads to a guess that a
  stock is mispriced
• YOU INTERPRET THIS AS REFLECTING THE INADEQUACY
  OF OTHER INVESTORS INFORMATION (the markets
  information)
• And you DO trade on the difference of opinion

27
The question of market efficiency comes up all
the time in business

• Lets postpone our financing interest rates
  are dropping well do better in 6 months
• Internet stocks are hot -- lets load up.
• Internet stocks are hot lets get out while we
  can
• Buy beachfront property theres no new supply,
  so prices are sure to go up.