The Stock Market

1
Information and Financial Market Efficiency
2
Types of Expectations

• Adaptive expectations market participants change
  expectations gradually over time.
• Rational expectations market participants use
  all information available to them.

3
Characteristics of Markets with Rational
Expectations

• Market price equals the best guess of the present
  value of expected future returns, or the assets
  fundamental value.
• Expectation of the assets price, Pe, equals the
  optimal price forecast, Pf.
• Difference between the actual price and the
  expected price equals a random error.

4
Efficient Markets Hypothesis

• When traders have rational expectations and when
  the cost of trading is low, equilibrium price
  optimal forecast of fundamental value.
• Prices will change in reaction to changes in
  expected future returns, or in risk, liquidity,
  or information costs.

5
Flow of Information in an Efficient Financial
Market
6
Determining an Assets Expected Price
Det1 Pet1

• Pt

1 i

• Where
• Pt price of financial assets at time t
• Det1 expected periodic return on the asset for
  time t 1
• i interest rate, adjusted for the assets risk
• Pet1 expected price of the financial
  instrument at time t 1

7
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8
Iowa Republican Nomination
9
Iowa Pres08 WTA
10
Fed Funds Futures
11
Signals for Savers and Borrowers in an Efficient
Market
12
Investment Strategies

• Investors should hold a diversified portfolio.
• Buying and selling individual assets regularly is
  not a profitable strategy.
• Dont analyze past price trends or use tips in
  financial publications.

13
Actual Efficiency in Financial Markets

• Some analysts have discovered pricing anomalies
  that allow above-normal returns.
• Mean reversion stocks with high (low) returns
  now, get low (high) future returns.
• Stock prices may be more volatile than efficient
  markets hypothesis predicts.

14
Possible Causes of Stock Market Crash of 1987

• Relatively uninformed traders pursued trading
  strategies with no superior information.
• Some stock market assets had prices higher than
  their fundamental values.
• Computer-generated orders to buy or sell many
  stocks at the same time may have played a role.

15
Costs of Inefficiency in Financial Markets

• When price changes do not reflect shifts in
  value, prices contain less information.
• Inefficient markets cause higher information
  costs.
• Inefficiency lowers output since resources arent
  allocated efficiently.