FNCE 3020 Financial Markets and Institutions - PowerPoint PPT Presentation

1 / 39
About This Presentation
Title:

FNCE 3020 Financial Markets and Institutions

Description:

... in history for the Dow Jones Industrial Average (507.99 points, or 22.6% of the index value) ... Near the close of the market (just before 4:00) the ... – PowerPoint PPT presentation

Number of Views:73
Avg rating:3.0/5.0
Slides: 40
Provided by: palm8
Category:

less

Transcript and Presenter's Notes

Title: 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.
    Write a Comment
    User Comments (0)
    About PowerShow.com