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FNCE 3020 Financial Markets and Institutions PowerPoint PPT Presentation

FNCE 3020 Financial Markets and Institutions Lecture 7 Topics: Expectations and Financial Markets Forecasting Financial Asset Prices The Efficient Market Hypothesis Objectives for This Lecture Series To discuss the role of expectations in financial markets.

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FNCE 3020 Financial Markets and Institutions

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FNCE 3020Financial Markets and Institutions

Lecture 7

Topics:

Expectations and Financial Markets

Forecasting Financial Asset Prices

The Efficient Market Hypothesis


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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


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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


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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.


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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.


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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.


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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 can’t; thus you can’t beat the EMH market.


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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.


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Krispy Kreme: Monday, November 22, 2004; Reaction to Bad Information


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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


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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.


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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.


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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.


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Over Reaction Effect

  • A final anomalyis theover-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.


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Nike and the Overreaction Effect

  • Thursday, November 18, 2004 

  • Near the close of the market (just before 4:00) 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.


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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.

Movement of Nike Stock


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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.


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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 company’s performance

        • Warning flags (litigation, change in management, product recalls).


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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 stock’s future price.

      • Analysis will estimate future earnings (per share) and then attach a P/E ratio to that estimate.


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Price Earnings Formula

  • This fundamental approach assumes that the future value (price) of a firm’s 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) company’s 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


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Technical Analysis

  • Technical Analysis of Common Stock

    • This approach is NOT interested in a company’s 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.


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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.


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Moving Average: DJIA Over the Last 6 Months


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Moving Average: Google Over the Last 6 Months


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Overbought or Oversold Market: The DJIA with Trading Bands


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Overbought or Oversold Market: Google with Trading Bands


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Source of Technical Charts

  • Data for individual stocks:

    • http://finance.yahoo.com/q?s=goog

  • For charts of individual stocks and the market:

    • http://finance.yahoo.com/q/bc?s=goog&t=1d

  • For interactive charts of individual stocks and the market:

    • http://finance.yahoo.com/charts#chart1:symbol=goog;range=1d;indicator=volume;charttype=line;crosshair=on;logscale=off;source=

  • Data for U.S. market and overseas markets

    • http://finance.yahoo.com/intlindices?u


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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.


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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.


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FNCE 3020Financial Markets and Institutons

Lecture 7 (Appendix)

The Efficient Market Hypothesis


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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.


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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


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Can we Measure the Expected Return?

  • However, a security’s 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.


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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 security’s equilibrium return is determined by the security’s 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 security’s equilibrium return (R*).


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Efficient Market Hypothesis, Deviation from Equilibrium : Re>R*

  • 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:


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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.


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Efficient Market Hypothesis, Deviation from Equilibrium : Re<R*

  • 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:


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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.


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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 can’t 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 doesn’t have, you can’t take advantage of this market move.


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