ECON 351 CHAPTER 7

Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are Efficient

- Some financial economists believe all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities and so financial market are efficient) - however, prices in markets like the stock market are unpredictable. This casts serious doubts on the stronger view that financial markets are efficient

How Valuable are Published Reports by Investment Advisors?

- information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market price - acting on this information will not yield abnormally high returns, on average - the empirical evidence for the most part confirms that recommendations from investment advisers cannot help us outperform the general market

Efficient market prescription for the investor

-Recommendations from investment advisors cannot help us outperform the market -A hot tip is probably information already contained in the price of the stock -Stock prices respond to announcements only when the information is new and unexpected -A "buy and hold" strategy is the most sensible strategy for the small investor

How the Market Sets Stock Prices

1.The price is set by the buyer who is willing to pay the most (not the highest price the asset can fetch) 2.The market price is set by the buyer who can take advantage of the asset the best 3.Superior information about an asset can increase its value by decreasing its risk 4. information is important for individuals to value each asset 5. when new information is released about a firm, expectations and prices change 6. market participants constantly receive information and revise their expectations, so stock prices change frequently

Behavioral Finance

Investigates investor behavior, it's effect on financial markets, how cognitive biases affect anomalies, and if investors are rational; Says investors have an asymmetric preference towards risk the application of psychology to make financial decisions models of financial markets that emphasize potential implications of psychological factors affecting investor behavior - the lack of short selling (causing over-priced stocks) may be explained by loss aversion - the large trading volume may be explained by explained by investor overconfidence - stock market bubbles may be explained by overconfidence and social contagion

adaptive expectations

The assumption that people make forecasts of future values of a variable using only past values of the variable. - expectations are formed from past experience only - changes in expectations will occur slowly over time as data changes - however, people use more than just past data to form their expectations and sometimes change their expectations quickly

Gordon Growth Model

a common name for the constant-growth model that is widely cited in dividend valuation Assumes annual growth rate of dividend is constant; Stock value equals the dividend divided by the difference of the required return and the dividend growth rate An economic model to compute the value of a stock assuming the stock will have constant dividend growth. Gordon Growth Model = D1/(r-g).

Rational Expectations

expectations formed by using all available information about an economic variable the view that individuals and firms make decisions optimally, using all available information the theory that people optimally use all the information they have, including information about government policies, when forecasting the future - expectations will be identical to optimal forecasts using all available information - even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate - it takes too much effort to make their expectation the best guess possible - the best guess will not be accurate because the predictor is unaware of some relevant information - the incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets, people with better forecasts of the future get rich. - The application of theory of rational expectations to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful - if there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well - changes in the conduct of monetary policy (e.g., target the federal funds rate) - the forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time

monetary policy

managing the economy by altering the supply of money and interest rates the setting of the money supply by policymakers in the central bank Government policy that attempts to manage the economy by controlling the money supply and thus interest rates. - can affect stock prices in two ways. 1. when the Fed lowers interest rates, the return on bonds (an alternative asset to stocks) declines, and investors are likely to accept a lower required rate of return on an investment in equity. The resulting decline lowers the denominator in the Gordon growth model and raises stock prices 2. a lowering of interest rates is likley to stimulate the economy, so the growth rate in dividends,g, is likely to be somewhat higher. This rise in g also causes the denominator in Equation 5 to decrease, which also leads to a rise in stock price

Efficient Markets Theory

the price of an item will eventually come to its true value with time. Application of rational expectations to the pricing of securities. Asset prices already reflect all available information, thus it is difficult, if not impossible, to choose stocks that will outperform the market with any degree of consistency, yet people believe they have the edge all the time. Prices will rise or fall in the future only in response to unanticipated events - rate of return from holding a security equals the sum of the capital gain on the security, plus any cash payments divided by the initial purchase price of the security - expectations of future prices are equal to optimal forecasts using all currently available information so - current prices in a financial market will be set so that the optimal forecast of a security's return using all available information equals the security's equilibrium return - in an efficient market, a security's price fully reflects all available information - in an efficient market, all unexploited profit opportunities will be eliminated

Generalized Dividend Valuation Model

the value of stock today is the present value of all future cash flows present value for greater than 1 period the stock price today equals the sum of all future dividends and the final sales price