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The Theory of Capital Markets

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The stock market crash of 1987 convinced many financial economists that the ... indicates that stock prices may overreact to news announcements and that ... – PowerPoint PPT presentation

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Title: The Theory of Capital Markets


1
The Theory of Capital Markets
  • Rational Expectations and Efficient Markets

2
Adaptive Expectations
  • Adaptive Expectations
  • Expectations depend on past experience only.
  • Expectations are a weighted average of past
    experiences.
  • Expectations change slowly over time.

3
Rational Expectations
  • The theory of rational expectations states that
    expectations will not differ from optimal
    forecasts using all available information.
  • It is reasonable to assume that people act
    rationally because it is is costly not to have
    the best forecast of the future.

4
Rational Expectations
  • Rational expectations mean that expectations will
    be identical to optimal forecasts (the best guess
    of the future) using all available information,
    but..
  • It should be noted that even though a rational
    expectation equals the optimal forecast using all
    available information, a prediction based on it
    may not always be perfectly accurate.

5
Non-rational Expectations?
  • There are two reasons why an expectation may fail
    to be rational
  • People might be aware of all available
    information but find it takes too much effort to
    make their expectation the best guess possible.
  • People might be unaware of some available
    relevant information, so their best guess of the
    future will not be accurate.

6
Rational Expectations Implications
  • If there is a change in the way a variable moves,
    there will be a change in the way expectations of
    this variable are formed.
  • The forecast errors of expectations will on
    average be zero and cannot be predicted ahead of
    time.
  • The forecast errors of expectations are
    unpredictable.

7
Efficient Markets
  • Efficient markets theory is the application of
    rational expectations to the pricing of
    securities in financial markets.
  • Current security prices will fully reflect all
    available information because in an efficient
    market all unexploited profit opportunities are
    eliminated.
  • The elimination of all unexploited profit
    opportunities does not require that all market
    participants be well informed or have rational
    expectations.

8
Efficient Markets
RET Pt1 Pt C
Pt
RETe Pe t1 Pt C
Pt
Pet1 Poft1 which means RETet1
REToft1
RETe RETof RET eq
Current prices are set so that the optimal
forecast of RET equals the equilibrium RET.
9
Efficient Markets Theory Example
  • Assume you own a stock that has an equilibrium
    return of 10.
  • Also assume that the price of this stock has
    fallen such that the return currently is 50.
  • Demand for this stock would rise, pushing its
    price up, and yield down.

10
Efficient Markets Theory
  • If RETof gt RETeq, demand for the asset rises and
    the current price of the asset rises, causing
    RETof to fall until it equals RETeq.
  • RETeq lt RETof (Poft1 Pt) Pt up RETof
    down

Pt
11
Efficient Markets Theory
  • If RETof lt RETeq, demand for the asset falls and
    the current price of the asset falls, causing
    RETof to rise until it equals RETeq.
  • RETeq gt RETof (Poft1 Pt) Pt down
    RETof up

Pt
12
Efficient Markets Summary
  • RETof gt RETeq Price rises RETof falls
  • RETof lt RETeq Price falls RETof rises
  • In an efficient market, all unexploited profit
    opportunities are eliminated.

13
Efficient Markets Theory
  • Weak Version
  • All information contained in past price movements
    is fully reflected in current market prices.
  • In this case, information about recent trends in
    stock prices would be of no use in selecting
    stocks.
  • Tape watchers and chartists are wasting their
    time.

14
Efficient Markets Theory
  • Semi- Strong Version
  • Current market prices reflect all publicly
    available information.
  • In this case, it does no good to pore over annual
    reports or other published data because market
    prices will have adjusted to any good or bad news
    contained in those reports as soon as they came
    out.
  • Insiders, however, can make abnormal returns on
    their own companies stocks.

15
Efficient Markets Theory
  • Strong Version
  • Current market prices reflect all pertinent
    information, whether publicly available or
    privately held.
  • In an efficient capital market, a securitys
    price reflects all available information about
    the intrinsic value of the security.
  • Security prices can be used by managers of both
    financial and non-financial firms to assess their
    cost of capital accurately.

16
Efficient Markets Strong Version
  • Security prices can be used to help make correct
    decisions about whether a specific investment is
    worth making.
  • In this case, even insiders would find it
    impossible to earn abnormal returns in the
    market.
  • Scandals involving insiders who profited
    handsomely from insider trading helped to
    disprove this version of the efficient markets
    hypothesis.

17
The Crash of 1987
  • The stock market crash of 1987 convinced many
    financial economists that the stronger version of
    the efficient markets theory is not correct.
  • It appears that factors other than market
    fundamentals may have had an effect on stock
    prices.
  • This means that asset prices did not reflect
    their true fundamental values.

18
The Crash of 1987
  • But, the crash has not convinced these financial
    economists that rational expectations was
    incorrect.
  • Rational Bubbles
  • A bubble exists when the price of an asset
    differs from its fundamental market value.
  • In a rational bubble, investors can have rational
    expectations that a bubble is occurring, but
    continue to hold the asset anyway.
  • They think they can get a higher price in the
    future.

19
Efficient Markets Evidence
  • Pro
  • Performance of Investment Analysts and Mutual
    Funds
  • Generally, investment advisors and mutual funds
    do not beat the market just as the efficient
    markets theory would predict.
  • The theory of efficient markets argues that
    abnormally high returns are not possible.

20
Efficient Markets Evidence
  • Pro
  • Random Walk
  • Future changes in stock prices should be
    unpredictable.
  • Examination of stock market records to see if
    changes in stock prices are systematically
    related to past changes and hence could have been
    predicted indicates that there is no
    relationship.
  • Studies to determine if other publicly available
    information could have been used to predict stock
    prices also indicate that stock prices are not
    predictable.

21
Efficient Markets Evidence
  • Pro
  • Technical Analysis
  • The theory of efficient markets suggests that
    technical analysis cannot work if past stock
    prices cannot predict future stock prices.
  • Technical analysts predict no better than other
    analysts.
  • Technical rules applied to new data do not result
    in consistent profits.

22
Efficient Markets Evidence
  • Con
  • Small Firm Effect
  • Many empirical studies show that small firms have
    earned abnormally high returns over long periods.
  • January Effect
  • Over a long period, stock prices have tended to
    experience an abnormal price rise from December
    to January that is predictable.

23
Efficient Markets Evidence
  • Con
  • Market Overreaction
  • Recent research indicates that stock prices may
    overreact to news announcements and that the
    pricing errors are corrected only slowly.
  • Excessive Volatility
  • Stock prices appear to exhibit fluctuations that
    are greater than what is warranted by
    fluctuations in their fundamental values.

24
Efficient Markets Evidence
  • Con
  • Mean Reversion
  • Stocks with low values today tend to have high
    values in the future.
  • Stocks with high values today tend to have low
    values in the future.
  • The implication is that stock prices are
    predictable and, therefore, not a random walk.

25
Efficient Markets Theory Implications
  • Hot tips cannot help an investor outperform the
    market.
  • The information is already priced into the stock.
  • Hot tip is helpful only if you are the first to
    get the information.
  • Stock prices respond to announcements only when
    the information being announced is new and
    unexpected.

26
Conclusions
  • The theory of rational expectations states that
    expectations will not differ from optimal
    forecasts using all available information.
  • Efficient markets theory is the application of
    rational expectations to the pricing of
    securities in financial markets.

27
Conclusions
  • The evidence on efficient markets theory is
    mixed, but the theory suggests that hot tips,
    investment advisers published recommendations,
    and technical analysis cannot help an investor
    outperform the market.
  • The 1987 crash convinced many economists that the
    strong version of the efficient markets
    hypothesis was not correct.
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