Mishkin Ppt06

2/25/15
Expectations
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Asset Demand: Returns, Risk, Liquidity

In2lation: Bond Prices, Interest Rates
Risk Structure: Default Risk
Term Structure: Future ST Rates
EFFICIENT MARKET HYPOTHESIS / THEORY OF

EFFICIENT CAPITAL MARKETS
- states that prices of securities in financial markets fully
reflect all available information.
Financial Markets and Institutions
6-1
Pearson Prentice Hall
Ef2icient Market Hypothesis

- states that prices of securities in financial markets fully
reflect all available information.
Rate of Return [from holding a security]

- equals the sum of the capital gain on the security
(the change in the price) plus any cash payments,
divided by the initial purchase price of the security:

P - P + C Pt+1 = Price, end of HP
t+1
Pt
Pt
C
= Price, beg of HP
= Cash Payment
(Coupon or Dividend)

6-2
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Expected Rate of Return
- Current Price (Pt) and Cash Payments (C) are known at
the beginning, the only variable uncertain is the price
next period (Pe t + 1)
f
Pe t+1 - Pt + C C
Pe
Pt
Pt
= Cash Payt (Coupon or Dividend)
t + 1 = Expected Price, end of HP
= Price, beg of HP
The ecient market hypothesis views expectations as equal to

optimal forecasts using all available information.
Pe t + 1 = Pof t + 1

Optimal forecast: best guess of the

future; not perfectly accurate
6-3

Expected Rate of Return
e and e
Theorists states that
t + 1 cannot be
observed, so the equations cannot be used to tell
how the nancial markets behave.

Measuring value of e have important implications
for how prices of securities change in the nancial
market.
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However, demand & supply shows the expected

return on a security (interest rate) will have a
tendency to head toward the equilibrium return that
equates the quantity demanded to the quantity
supplied. So using the equilibrium condition:
e
The expected return on a security equals the

equilibrium return.

6-5
Deriving an equation to describe pricing behavior

using the equilibrium condition:
of
The current prices in a financial market will be set so

that the optimal forecast of a securitys return using all
available information equals the securitys equilibrium
return.
Financial economists state it: A securitys price fully
reects all available information in an ecient market
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Application: Predicting Opening Prices, Pt
Suppose that a share of Microsoft had a closing price yesterday of $90,
but new information was announced after the market closed that caused
a revision in the forecast of the price for next year to go to $120. If the
annual equilibrium return on Microsoft is 15%, what does the efficient
market hypothesis indicate the price will go to today when the market
opens? (Assume that Microsoft pays no dividends.)
f of
Rof = optimal forecast of return = 15%

* R* = equilibrium return = 15%
Poft+1 = optimal forecast Price = $120
Poft+1 - Pt + C
Pt
Solve: Pt
=0
6-7

Application: Predicting Opening Prices, Pt
of
Rof = optimal forecast of return = 15%

* R*

= equilibrium return = 15%
of
P t+1 = optimal forecast Price = $120
Poft+1 - Pt + C
Pt
Solve: Pt
0.15 = $120 Pt
=0
Pt
Pt x 0.15 = $120 - Pt
Pt x 1.15 = $120
Pt = $104.35
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Rationale Behind the Hypothesis
Arbitrage: market participants eliminate unexploited profit
opportunities (UPO), returns on a security that are larger
than what is justied by the characteristics of that security
2 Types of Arbitrage:
a. Pure elimination of UPO involves NO RISKS
b. Arbitrageur takes on SOME RISK when eliminating UPO
Efficient Market condition:
Rof
R* " Pth "Rof
of
*
Rof
R* " Pti "Rof
until R
6-9

Efficient Market condition:
Rof
Rof
R* " Pth "Rof

R* " Pti "Rof
until Rof
R*
In an efficient market, all unexploited profit opportunities

will be eliminated.
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An extremely important factor in this reasoning is that
NOT everyone in a financial market must be well
informed about a security for its price to be driven to
the point at which the efficient market condition holds
SMART MONEY: the few market participants that keep

their eyes open for UPO; they will eliminate the UPO
because in so doing, they make a profit
6 - 11

Stronger Version of the Ef2icient Market Hypothesis
Efficient market conditions:
a. Expectations are optimal using all available information
b. prices reflect the market fundamentals - intrinsic value of
the securities

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Stronger Version of the Ef2icient Market Hypothesis
Implications on the Security Price:
a. One investment is as good as any other because the
securities prices are correct

b. Reects all available info about the intrinsic value of the
security
c. Security prices can be used by managers to assess their
cost of capital accurately and hence can be used to help
them make the correct decisions about the worth of
making a specic investment

6 - 13

Evidence on the Ef2icient Market Hypothesis
In Favor of Market Efficiency:
a. Performance of Investment Analysts & Mutual Funds
b. Stock Prices Reect Publicly Available Information
c. Random-Walk Behavior of Stock Prices
d. Technical Analysis
6 - 14
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Evidence on the Ef2icient Market Hypothesis
Against Market Efficiency
a. Small-Firm Eect
b. January Eect
c. Market Overreaction
d. Excessive Volatility
e. Mean Reversion
f. New Information Is Not Always Immediately
Incorporated into Stock Prices
6 - 15

Evidence In Favor of Market Ef2iciency
a. Performance of Investment Analysts & Mutual Funds
It is impossible to beat the market
Buy & sell recommendations from a group of advisers
or mutual funds and compare the performance of the
resulting selection of stocks with the market as a whole
Having performed well in the past does not indicate
that an investment adviser or a mutual fund will

perform well in the future
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b. Stock Prices Reect Publicly Available Information
Positive announcement about a company will not, on

average, raise the price of its stock because this
information is already reected in the stock price
c. Random-Walk Behavior of Stock Prices
Random Walk: future changes in stock prices should,

for all practical purposes, be unpredictable

6 - 17

d. Technical Analysis
Study past STOCK PRICE DATA and search for patterns

such as trends and regular cycles.
Rules for when to buy and sell stocks are then
established on the basis of the patterns that emerge.
Conclusion: Technical analysts fare no better than
other nancial analysts. On average, they do not
outperform the market, and successful past forecasting
does not imply that their forecasts will outperform the
market in the future.
6 - 18
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Evidence Against Market Ef2iciency
a. Small-Firm Eect
b. January Eect
e. Mean Reversion
f. New Information Is Not Always Immediately
Incorporated into Stock Prices
6 - 19

a. Small-Firm Eect
Many empirical studies have shown that small rms have

earned abnormally high returns over long periods of time,
even when the greater risk for these rms has been taken into
account.
Various theories have been developed to explain the small-rm
eect, suggesting that it may be due to rebalancing of
portfolios by institutional investors, tax issues, low liquidity of
small-rm stocks, large information costs in evaluating small
rms, or an inappropriate measurement of risk for small-rm
stocks.
6 - 20
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b. January Eect
Over long periods of time, stock prices have tended to

experience an abnormal price rise from December to January
that is predictable and hence inconsistent with random-walk
behavior.
Some nancial economists argue that the January eect is due
to tax issues. Although this explanation seems sensible, it
does not explain why institutional investors such as private
pension funds, which are not subject to income taxes, do not
take advantage of the abnormal returns.
6 - 21

Corporate announcements of major change in earnings,

say, a large decline, the stock price may overshoot, and
after an initial large decline, it may rise back to more
normal levels over a period of several weeks.
This violates the ecient market hypothesis because an
investor could earn abnormally high returns, on average,
by buying a stock immediately after a poor earnings
announcement and then selling it after a couple of weeks
when it has risen back to normal levels.
6 - 22
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Fluctuations in stock prices may be much greater than is

warranted by uctuations in their fundamental value.
Robert Shiller of Yale University found that uctuations in the
S&P 500 stock index could not be justied by the subsequent
uctuations in the dividends of the stocks making up this
index.
Consensus that stock market prices appear to be driven by
factors other than fundamentals; e.g. Black Monday Crash of
1987 & Tech Crash of 2000
6 - 23

e. Mean Reversion
Stocks with low returns today tend to have high returns in

the future, and vice versa.
Hence stocks that have done poorly in the past are more
likely to do well in the future because mean reversion
indicates that there will be a predictable positive change
in the future price, suggesting that stock prices are not a
random walk.
6 - 24
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f.
New Information Is Not Always Immediately Incorporated

into Stock Prices
Generally, stock prices adjust rapidly to new information.
Recent evidence suggests that, inconsistent with the ecient
market hypothesis, stock prices do not instantaneously adjust
to prot announcements.
Instead, on average stock prices continue to rise for some
time after the announcement of unexpectedly high prots,
and they continue to fall after surprisingly low prot
announcements.
6 - 25

Conclusion on Market Ef2iciency
Debate on the ecient market hypothesis is far from over

Evidence seems to suggest that the ecient market
hypothesis may be a reasonable starting point for
evaluating behavior in nancial markets.
Ecient market hypothesis may not be the whole story
and so may not be generalizable to all behavior in
nancial markets.
6 - 26
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Investing Lessons:
On publicly available info: hot tips, investment advisers

published recommendations, & technical analysis
No one can outperform the general market, as empirical
evidence conrms, even with recommendations from
investment advisers; anecdotal evidence is not reliable.
A person who has done well regularly in the past cannot
guarantee that he or she will do well in the future.
Be skeptical of Hot Tips
Stock Prices DO NOT always rise when there is good news

6 - 27

Ef2icient Markets Prescription for the Investor:
Pursue a buy and hold strategy - purchase stocks and

hold them for long periods of time. This will lead to the
same returns, on average, but the investors net prots
will be higher because fewer brokerage commissions will
have to be paid.
Small investors: buy into a mutual fund. Choose one that
has low management fees.
6 - 28
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Black Monday Crash of 1987 & Tech Crash of 2000
October 19, 1987, dubbed Black Monday, the Dow Jones Industrial
Average declined more than 20%, largest 1-day decline in U.S. history.
NASDAQ index to fall from around 5,000 in March 2000 to around 1,500
in 2001 and 2002, for a decline of well over 60%
Stronger version of the ecient market hypothesis,

which states that asset prices reect the true
fundamental (intrinsic) value of securities, is incorrect.
Stock price determination: attributed to market
psychology & to institutional structure of the
marketplace.
6 - 29

Black Monday Crash of 1987 & Tech Crash of 2000
Rational Bubbles Theory: bubbles - situation in which the

price of an asset diers from its fundamental market value.
Investors hold the asset, because they believe that someone
else will buy the asset for a higher price in the future.
Investors can have optimal forecasts, because the bursting of
the bubble cannot be predicted & so there are no UPO.
However, other economists believe that the crashes suggest
that there may be UPO & that the theory of rational
expectations & the ecient market hypothesis might be
fundamentally awed.
6 - 30
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Behavioral Finance
Applies concepts from other social sciences, such as

anthropology, sociology, and particularly psychology, to
understand the behavior of securities prices
Ecient market hypothesis suggests that smart money SELLS

when a stock price goes up irrationally, with the result that
the stock falls back down to what is justied by fundamentals.
Smart Money helps the market become ecient if they can
dominate ordinary investors. But, they can do this only if they
engage in short sales.
6 - 31

Behavioral Finance
Loss Aversion Theory: Unhappy : Loss > Happy : Gain

Short sales: borrow stock from brokers, then sell it in the
market, with the hope that they earn a prot by buying the
stock back again (covering the short) after it has fallen in
price.
Due to LOSS AVERSION, very little short selling actually takes
place, because short sales can result in losses way in excess of
an investors initial investment if the stock price climbs
sharply above the price at which the short sale is made.

6 - 32
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Behavioral Finance
Overcondence & social contagion provide an explanation for

stock market bubbles
When stock prices go up, investors attribute their prots to
their intelligence and talk up the stock market.
This word-of-mouth enthusiasm and the media then can
produce an environment in which even more investors think
stock prices will rise in the future.
The result is then a so-called positive feedback loop in which
prices continue to rise, producing a speculative bubble, which
nally crashes when prices get too far out of line with
fundamentals.
6 - 33

Questions:
Optimal Forecasts
1.
Forecasters predictions of ination are notoriously
inaccurate, so their expectations of ination cannot be
optimal. Is this statement true, false, or uncertain? Explain
your answer.
2.
Whenever it is snowing when Joe Commuter gets up in the

morning, he misjudges how long it will take him to drive to
work. Otherwise, his expectations of the driving time are
perfectly accurate. Considering that it snows only once every
10 years where Joe lives, Joes expectations are almost always
perfectly accurate. Are Joes expectations optimal? Why or
why not?
6 - 34
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Questions:
Optimal Forecasts
3. If a forecaster spends hours every day studying data to
forecast interest rates, but his expectations are not as
accurate as predicting that tomorrows interest rates will be
identical to todays interest rates, are his expectations
optimal?
4.
If the public expects a corporation to lose $5 a share this

quarter and it actually loses $4, which is still the largest loss in
the history of the company, what does the ecient market
hypothesis say will happen to the price of the stock when the
$4 loss is announced?
6 - 35
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2/25/15

Asset Demand: Returns, Risk, Liquidity

EFFICIENT MARKET HYPOTHESIS / THEORY OF

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Rate of Return [from holding a security]

Pearson Prentice Hall

Ef2icient Market Hypothesis

= Cash Payt (Coupon or Dividend)

t + 1 = Expected Price, end of HP

The ecient market hypothesis views expectations as equal to

Financial Markets and Institutions

Optimal forecast: best guess of the

Pearson Prentice Hall

Ef2icient Market Hypothesis

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

However, demand & supply shows the expected

The expected return on a security equals the

Pearson Prentice Hall

Ef2icient Market Hypothesis

Deriving an equation to describe pricing behavior

The current prices in a financial market will be set so

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Rof = optimal forecast of return = 15%

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Rof = optimal forecast of return = 15%

Pearson Prentice Hall

Ef2icient Market Hypothesis

Financial Markets and Institutions

R* " Pti "Rof

Pearson Prentice Hall

Ef2icient Market Hypothesis

R* " Pth "Rof

In an efficient market, all unexploited profit opportunities

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

SMART MONEY: the few market participants that keep

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

securities prices are correct

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

Incorporated into Stock Prices

Financial Markets and Institutions

Pearson Prentice Hall

Ef2icient Market Hypothesis

that an investment adviser or a mutual fund will

Pearson Prentice Hall