FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 7
• Topics
• Expectations and Financial Markets
• Forecasting Financial Asset Prices
• The Efficient Market Hypothesis

2
Objectives for This Lecture Series

• To discuss the role of expectations in financial
  markets.
• Affecting asset prices and decisions of people in
  the financial markets.
• To introduce you to the concept of market
  efficiency (the Efficient Market Hypothesis).
• To introduce you to two basic approaches to
  forecasting financial asset prices.
• Fundamental analysis
• Technical analysis

3
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, such as the FOMC's vote on
  a federal funds rate target
• 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.
• Expectations about future profitability affect
• Stock prices

4
Adaptive Expectations Model

• Prior to the 1960s, most economists assumed that
  economic participants formed adaptive
  expectations.
• That is, their expectations about a variable were
  based on past values of that variable, and they
  changed slowly over time.
• However, there were a couple of problems with
  this model of expectations
• A variable may be affected by many other
  variables, so people will likely use all relevant
  data in forming an expectation about a variable.
• Expectations can change very quickly if the
  environment also experiences sudden, large
  changes.

5
Rational Expectations Model

• A more realistic model of expectations, called
  rational expectations, replaced adaptive
  expectations.
• Rational expectations are formed using all
  available information to make the best forecast
  possible (known as the optimal forecast).
• However, since it is still a forecast, it could
  be wrong, and will be if expectations are turn
  out to be incorrect.
• 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.
• Based upon available information, the market
  forms its expectations and sets prices
  accordingly.

6
Efficient Market

• The efficient markets theory states that security
  prices are a reflection of the market
  fundamentals.
• The fundamentals are variables that directly
  impact the future cash flow of a security and
  include information about the company, its
  product, and economic conditions.
• One key implication of the efficient markets
  theory is that over time it will be almost
  impossible to "beat the market."
• This means that we should not see any one group
  or person earning returns in a financial market
  that are consistently above average stock returns
  (the market return). Since prices already reflect
  all available information, using this information
  to predict asset prices will be worthless.
• Thus it is impossible to predict asset prices,
  since it is impossible to predict unanticipated
  information.

7
Impact of Unanticipated Information

• Unanticipated Good Information 25.00
• EMH Asset Price 20.00
• Unanticipated Bad Information 15.00
• Issue How does one predict unanticipated
  information.
• Answer You cant thus you cant beat the EMH
  market.

8
Krispy Kreme and the Efficient Market Hypothesis?

• Founded in 1937, 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 sells over 7.5 million doughnuts a
  day.
• Monday, November 22, 2004
• Krispy Kreme announced its quarterly earnings for
  the three months ending October 31.
• 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.

9
Krispy Kreme Monday, November 22, 2004 Reaction
to Bad Information
10
Evidence Against Efficient Markets

• Starting in the 1970s, researchers discovered
  some return patterns in the stock market that are
  inconsistent with efficiency.
• Essentially researchers tested for abnormal
  returns (i.e., higher/lower than what one would
  expect)
• These return inconsistencies are referred to as
  anomalies, and provide some evidence that the
  stock market is not perfectly efficient.
• These anomalies include
• Small firm effect
• January effect
• Over-reaction effect
• Market volatility

11
Small Firm Effect

• The small-firm effect literature has found that
  small firm stocks have earned higher returns over
  long periods of time, even when adjusted for
  risk.
• Many explanations for this have been offered, but
  none are truly satisfactory.
• These included the possibility of an
  inappropriate risk measurement for small firms.
• This size effect has become smaller over time,
  but if markets are efficient, it should have
  disappeared very quickly as investors tried to
  profit from this information.

12
January Effect

• The January effect is the tendency for stocks to
  post large returns in January (over December) and
  to have done this over long periods of time.
• Since the effect has been predictable, it is
  inconsistent with the efficient market
  hypothesis.
• While the January can be explained by sell-offs
  in December for tax reasons, this effect should
  have disappeared as tax-exempt institutions (like
  pension funds) tried to profit from this anomaly.
• This effect has gotten smaller over time, but it
  has persisted too long to be consistent with
  efficient prices.

13
Excess Market Volatility

• Another anomaly is the occurs when stock prices
  fluctuate much more than the fundamentals behind
  them fluctuate.
• On October 19, 1987, the stock market plunged
  with what was the largest one-day point loss in
  history for the Dow Jones Industrial Average
  (507.99 points, or 22.6 of the index value).
• Could such a large one-day loss be reconciled
  with efficient markets?
• 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 decline.
• Most economists conclude that this episode is
  evidence that investor psychology plays a role in
  stock prices along with the fundamentals.

14
Over Reaction Effect

• A final anomaly is the over-reaction of stock
  prices to news (good or bad) and that the
  resulting pricing errors are correctly only
  slowly.
• Studies show the stock prices plunge in response
  to bad earnings reports, only to creep back
  upward the following weeks.
• This violates the efficient market as investors
  could earn abnormally high returns from investing
  in companies immediately after a bad earnings
  report.

15
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.

16
Movement 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 second day.

17
Forecasting Asset Prices

• There are essentially two types of methods which
  forecasters used to estimate the future price
  of a financial asset.
• Fundamental Analysis.
• Technical Analysis (Charting).
• Both of these approaches are at odds with the
  Efficient Market Hypothesis assuming that one
  cannot beat the market.

18
Approaches to Forecasting

• Fundamental Analysis
• Uses economic and financial data upon which to
  base the calculation of the appropriate price of
  a financial asset.
• For example, for common stock, the analysis
  would
• Estimate future earnings per share, future
  dividends per share and future stock prices on
  the basis of
• Examining financial statements
• New product developments,
• Competition,
• Relevant macro economic data which may have an
  impact on the companys performance
• Warning flags (litigation, change in management,
  product recalls).

19
Fundamental Analysis

• Fundamental Analysis
• Historically this is the approach most used by
  financial analyst.
• Popularized by Graham and Dodd (1934, Security
  Analysis).
• They argued that investors should buy stocks in
  corporations that have undervalued assets
  relative to their true market value, or
• current assets exceeding current liabilities,
• low price/earnings ratio.
• Popular fundamental approach today is use of
  price earnings (i.e., p/e) ratios in forecasting
  a stocks future price.
• Analysis will estimate future earnings (per
  share) and then attach a P/E ratio to that
  estimate.

20
Price Earnings Formula

• This fundamental approach assumes that the future
  value (price) of a firms stock can be estimated
  by multiplying the firms expected earnings per
  share by some multiplier, which is either the
• (1) average industry P/E or
• (2) companys historical P/E
• Future Price EPS x P/E
• Assume
• Expected future earnings for firm 1.25
• Historical P/E 25
• The calculated appropriate price 1.25 x 25
  31.50

21
Technical Analysis

• Technical Analysis of Common Stock
• This approach is NOT interested in a companys
  financial statement data or in economic data that
  may affect the company.
• Looks at charts of past stock price movements to
  estimate where stock price may move in the
  future.
• Assumes stock prices are not random
• That patterns of prices develop and can be used
  to forecast the future.
• Approach is applied to individual stocks or to
  the market as a whole.
• The approach is also applied to other financial
  assets, such as foreign exchange.

22
Two Types pf Technical Patterns

• Moving Average Analysis
• Where is the individual stock (or market) in
  relation to some moving average of past prices?
• If breaking above, this is a sign of strength.
• If breaking below, this is a sign of weakness.
• Overbought and Oversold Analysis
• Is the individual stock (or market) trading above
  or below its historical range?
• Above its range suggests overbought condition.
• Stock (or market) should move down.
• Below its range suggests oversold condition.
• Stock (or market) should move up.

23
Moving Average DJIA Over the Last 6 Months
24
Moving Average Google Over the Last 6 Months
25
Overbought or Oversold Market The DJIA with
Trading Bands
26
Overbought or Oversold Market Google with
Trading Bands
27
Source of Technical Charts

• Data for individual stocks
• http//finance.yahoo.com/q?sgoog
• For charts of individual stocks and the market
• http//finance.yahoo.com/q/bc?sgoogt1d
• For interactive charts of individual stocks and
  the market
• http//finance.yahoo.com/chartschart1symbolgoog
  range1dindicatorvolumecharttypelinecrosshai
  ronlogscaleoffsource
• Data for U.S. market and overseas markets
• http//finance.yahoo.com/intlindices?u

28
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.

29
Forecasting asset prices within the 3 Types of
Efficient Markets

• Weak form In this type of a market, all past
  data and prices are reflected in the current
  prices.
• Thus, Technical Analysis is not of any use.
• Semi strong form In this type of a market, all
  public information is reflected in the current
  stock prices.
• Thus, here, even Fundamental Analysis is of no
  use (as well as technical analysis)
• Strong form In this type of market, all
  information is reflected in the current stock
  prices.
• Thus, not only is any kind of analysis useless,
  even insider information is useless for
  predicting future stock market prices.

30
FNCE 3020Financial Markets and Institutons

• Lecture 7 (Appendix)
• The Efficient Market Hypothesis

31
Efficient Market Hypothesis

• Accoridn 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.

32
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

33
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.

34
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).

35
Efficient Market Hypothesis, Deviation from
Equilibrium ReR

• 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

36
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.

37
Efficient Market Hypothesis, Deviation from
Equilibrium Re

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

38
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.

39
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.