Money, Banking, and Financial Markets

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• Money, Banking, and Financial Markets

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• Lecture 16

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• Chapter 7
• The Stock Market,
• The Theory of Rational Expectations,
• and the
• Efficient Markets Hypothesis

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The Stock Market

• A stock market is a place where stocks are traded
• It is the most closely followed market in Canada
• Many people invest in the stock market
• Fluctuations in the prices of stocks affects the
  ability of people to retire comfortably
• During the past three decades the market has
  experienced most volatile stock prices
• Stock prices are measured by the SP/TSX
  Composite Index

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Toronto Stock Exchange (TSX)

• Most Active by Trading Volume
• BCE Inc.
• Nortel Network Corp
• Telus Corporation
• Equinox Mineral
• Talis Energy
• Gold Corp Inc.
• Kinross Gold Corp
• Sunlar Energy
• Berna Gold Corp
• Sun Life Financial Inc.

Sectoral Composition of TSX Mining Oil and
Gas Life Science Technology Exchange trade
funds Income trusts Structured Products
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Price Computation of Common Stock

• The principal way used by Corporations to raise
  equity capital is Common Stock
• Stockholder of common stock own an interest in
  the corporation consistent with the percentage of
  shares owned
• The ownership of stock gives Stockholders a
  bundle of rights
• Right to vote
• To be residual claimant of all the cash flows
• Get dividends periodically
• Right to sell the stock
• The value of common stock is calculated in terms
  of present value of all the future cash flows
• The cash flows to a stockholder include
  dividends, the sale price, or both

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The One-Period Valuation Model

• Lets start with the most simple scenario
  the One Period Valuation Model
• Assume you have some extra money that you want to
  invest for just one year
• Where would you invest your money?
• To find out the best option you need to find the
  present discounted value of the expected cash
  flows (future payments)
• The cash flows consists of one dividend payment
  plus a final sales price
• You know the formula to calculate the present
  value

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Computing the Price of Common Stock

• Basic Principle of Finance
• Value of Investment Present Value of Future
  Cash Flows
• One-Period Valuation Model

(1)
where P0 the current price of stock Div1
the dividend paid at the end of year 1 ke
the required return on investment in equity P1
the price at the end of the first period,
the assumed sale price of stock
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Computing the Price of Common Stock

• An Example
• Current price, P0 50
• the dividend paid at the end of year, Div1
  0.16
• Predicted future price, P1 60
• Lets assume that you desire to earn at least 12
  return
• on your investment (i.e. ke 0.12)
• P0 0.16/(10.12) 60/(10.12)
• .14 53.57 53.71
• The present value from all the cash flows is
  greater than the current price (50), you would
  choose to buy it

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Generalized Dividend Valuation Model

• In order to find the present value we must have
  value for Pn, However, Pn could be far in future
  thus it will not affect P0
• Hence current value of a share can be calculated
  as simply the present value of the future
  dividend stream
• Since last term of the equation is small, the
  equation is written as

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Generalized Dividend Valuation Model

• Issues with the Model
• The model says that the price of stock is
  determined only by the present value of the
  dividends, many stocks do not pay dividends how
  is it that they have value?
• The model requires that we compute the present
  value of a infinite stream of dividends a very
  difficult task
• Therefore, simplified models have been developed
• One such model is Gordon Growth Model

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Gordon Growth Model

• This model assumes constant dividend growth
• where D0 the most recent dividend paid
• g the expected constant growth rate in
  dividends
• Ke the required return on an investment in
  equity

• The above equation can be simplified and written
  as

• The model is useful for finding the value of
  stock, given following assumption
• Dividends are assumed to continue to grow at a
  constant rate for ever
• The growth rate is assumed to be less than the
  required return on equity

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How the Market Sets Security Prices

• The price is set by the buyer willing to pay the
  highest price
• The price is not necessarily the highest price
  that the asset could fetch
• But it is incrementally greater than what any
  buyer is willing to pay
• The market price will be set by the buyer who can
  take best advantage of the asset
• Information plays the most important role,
  superior information about the asset can add to
  its value by reducing risk or fear of unknown
• The buyer who has the best information about the
  cash flows will discount them at a lower interest
  rate than a buyer who is very uncertain
• When new information is released about the firm
  expectations change and with them prices change

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Monetary Policy and Stock Prices

• How does monetary policy affect stock prices?
• It can affect stock prices in two ways Gordon
  growth model
• When Bank of Canada lowers interest rate, the
  return on bonds (an alternative asset to stocks)
  declines
• The investors are willing to accept a lower rate
  of return on an investment in equity (ke)
• The resulting decline in ke would lower the
  denominator which will raise the value of P0
  the stock price
• Secondly, lowering of interest rate will have
  positive impact on the economic growth, so that
  the growth in dividends, g, is likely to be
  higher
• This rise in g will also lead to higher P0 and a
  rise in stock prices
• The impact of monetary policy on stock prices is
  one of the key ways in which monetary policy
  affects economy

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Exogenous Factors and Stock Prices

• A sudden unanticipated event can instantly affect
  stock prices
• For instance, a massive terrorist attack could
  paralyze the country
• This would lead to downward revision of the
  growth prospects for companies, thus lowering the
  dividend growth rate (g)
• This would result in decline of P0 and hence the
  stock price will fall
• Similarly, increased uncertainty about the
  economy would also raise the required return on
  investment in equity (ke)
• This rise in ke will also lead to a decline in P0
  and a general fall in stock prices

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Exogenous Factors and Stock Prices

• The US stock market fell by 10 immediately after
  the 9/11
• Subsequently, the absence of further threats
  reduced market fears and uncertainty, causing g
  to recover and ke to fall leading to recovery
  in P0 and a rebound in the stock market
• Unearthing of scandals, like Enron where
  companies make false claims and overstate their
  earning cause many investors to doubt the rosy
  forecast resultantly g and ke thus P0 falls
• As a result of that the recovery aborted and
  downward slide started

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The Theory of Rational Expectation

• Expectations play a crucial role in almost every
  sector of the economy (and even in human life)
• Analysis of the stock price evaluation also
  depends on peoples expectations especially of
  the cash flows
• Therefore it is important to know how
  expectations are formed
• We will use the most widely used theory the
  theory of rational expectation - to describe the
  formation of business and consumer expectations
• The theory developed by John Muth says that
  Expectations will be identical to optimal
  forecasts (the best guess of the future) using
  all available information Xe Xof

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The Theory of Rational Expectation

• What exactly does that mean?
• Expectation based on best knowledge about the
  possible outcome
• Even though a rational expectation equals the
  optimal forecast using all available information,
  a prediction based on it may not be perfectly
  accurate
• There are two reasons why an expectation may fail
  to be rational
• People might be aware of all available
  information but did not bothered to pay attention
  to it
• People might be unaware of some available
  information, so their best guess of the future
  will not be accurate
• The important thing is that if an additional
  factor is important but information about it is
  not available, an expectation that does not take
  account of it can still be rational

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Implications of The Theory

• The incentives for equating expectations with
  optimal forecasts are especially strong in
  financial markets
• In these markets people with better forecast of
  the future get rich
• The application of the theory of rational
  expectations to financial markets is thus
  particularly useful
• In financial markets the theory of rational
  expectation is known as efficient market
  hypothesis or the theory of efficient capital
  market
• Rational expectations theory has two commonsense
  implications in the analysis of the aggregate
  economy
• If there is a change in the way the variable
  moves, the way in which the expectation are
  formed will change as well
• The forecast errors of expectations will on
  average be zero and cannot be predicted ahead of
  time outcome

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Efficient Market Hypothesis

• Efficient Market Hypothesis is nothing but an
  application of rational expectation theory to the
  pricing of securities
• This hypothesis is based on the assumption that
  prices of securities in financial markets fully
  reflect all available information
• You may recall that the rate of return from
  holding a security equals the sum of the capital
  gain on the security (change in the price), plus
  any cash payments, divided by the initial
  purchase price of the security

Pt1 Pt C RET Pt
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Efficient Market Hypothesis

• The efficient market hypothesis also views
  expectations of future prices as equal to optimal
  forecasts using all the available information
• Therefore, Rational Expectations implies
• Pet1 Poft1
• Which in turn implies that the expected return on
  the security will equal the optimal forecast of
  the return
• RETe RETof
• Unfortunately, we cannot observe either RETe or
  Pet1
• Thus the rational expectations equations by
  themselves do not tell us much about how the
  financial market behaves

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Efficient Market Hypothesis

• Can we do anything about it? Device some way to
  measure the value of RETe
• If yes, than these equations will have important
  implications for how prices of securities change
  in financial markets
• The supply and demand analysis of the bond market
  shows that the interest rate will have a tendency
  to head towards the equilibrium
• RETe RET
• Therefore, for our purposes it is sufficient to
  know that we can determine the equilibrium return
  and thus can determine the expected return with
  the equilibrium condition RETof RETe
• This relationship will tell us that current
  prices will be set so that the optimal forecast
  of a return equals the securitys equilibrium
  return