Financial Markets MSFI535 Week #4 1Financial Markets Week 4 Lecture Slides

Financial Markets

MSFI535 Week #4

1Financial Markets Week 4 Lecture Slides

Financial MarketsLecture Outline

– Markets & Time Preference – Bonds– Stocks– Foreign exchange (uncovered interest

parity_– Efficient-Markets Hypothesis (EMH)

– Degrees of efficiency– Empirical evidence– Model weakness– Behavior school


Financial MarketsFinancial Markets

– Financial markets tend to be forward-looking, and the link between the present and the future is reflected in the concept of arbitrage, which says that the price of a stock today must be equal to the present discounted value of the sum of all expected dividends and the expected future price of the stock.

When prices are in equilibrium, financial investors are equally willing to buy or sell an asset.

But if prices are not in equilibrium, there is an opportunity for arbitrage, that is, people will buy or sell assets to take advantage of the resulting profit opportunity.

As they do, prices adjust until no further arbitrage opportunity exists. Through this process, an equilibrium is always eventually established.


Financial MarketsTime Preference

– A simple rational trade-off model based on time preference of market participants can help to discover the price of time or interest rate.

For example, a rational agent can consume III + IV at Period 1 (or present).

As a trade off, the agent can postpone one’s consumption (or invest) and consume in Period 2.

However, the agent’s preference is to consume in Period 1. This is represented by Slope = 1 + i < 1.

To make the agent indifferent (or provide the necessary incentive to invest) then the market has to offer a positive interest or r and the slope of time trade off line or 1 + r > 1.

Hence, if r is reduced then more consumption will take place in Period 1.


Financial MarketsBonds

– In the bond market, the relationship between the yields of government bonds with different maturities is called the term structure of interest rate or the yield curve.

Since long-term rates are generally higher than short-term rates, the yield curve is usually upward-sloping.

The expectations theory of the term structure states that the long-term interest rate equals the average of current and future short-term interest rates plus a term premium to compensate investors for the risk associated with the higher price volatility of long-term bonds.

According to this theory, the yield curve is upward-sloping (downward-sloping) if financial investors believe that interest rates will increase (decrease) in the future.

Therefore, the yield curve often serves as a forecasting tool. For example, a downward-sloping yield curve is often interpreted as a sign of an imminent recession.


Financial MarketsBonds

– Note that bond prices (b) are inversely related to interest rates (i). This is because the price of the bond can be calculated as the sum of all discounted present values of coupon payments (c) plus the present value of the face value (FV). In other words, nb = NPV = ct/(1 + i)t + FV/(1 + i)t. t=1 Since the interest rate is in the denominator of this formula, any increase in the interest rate will decrease the net present value (price) of the bond.

The longer the maturity of the bond, the larger the influence an interest rate change has on its price.

This implies that prices of long-term bonds tend to be much more volatile than prices of short-term bonds with respect to interest rates changes.

To compensate for this interest rate risk, long-term bonds often promise a risk premium to make them more attractive.


Financial MarketsStocks

– Future stock prices can be described by the following formula,

Pt + 1 = a + Pt + є

From this we see that

∆P = a + є

This implies that apart from the very small component “a,” representing the expected return from holding stock, changes in stock prices are unpredictable, that is, determined by the random change є.

Stock prices do not have a tendency to return to a normal level and the behavior of stock prices is most accurately described as a random walk.

In other words, future stock prices cannot be accurately predicted from looking at past behavior. Even if stocks did well last month, there is no guarantee that they will do equally well this month. A random walk is a sign of market efficiency. (More on this later.)


Financial MarketsForeign Exchange

– In the mid-run (usually 1 to 12 month period) changes in exchange rates depend on international differences in interest rates.

This uncovered interest parity (UIP) can be expressed by the equation:

(et+1 - et)/et = i - i*

where e = foreign / domestic currencies

and that is, interest rate differentials in different countries are reflected in exchange rate changes.

But this equation can also be written as

i = i* + (et+1 - et)/et

which indicates that a financial investor will only invest in a foreign bond if the return (i) on a foreign bond in terms of the domestic currency is equal to the yield of the foreign bond (i*) plus whatever is earned (or lost) from the expected appreciation (depreciation) of the foreign currency.

Hence, if i > i* + (et+1 - et)/et then traders and short the domestic currency (e.g. sell for foreign) since under the UIP framework, the domestic exchange rate is expected to depreciate relative to the foreign to restore the parity.


Financial Markets The Efficient-Markets Hypothesis (EMH)

– Eugene Fama put forward the EMH hypothesis that the price of an financial asset reflects all available information that is relevant to its value.

The EMH’s underlying assumption is that financial markets would price financial - bond, stock currency – assets broadly correctly.

– By the process of arbitrage, any deviation in asset equilibrium prices could not last for long.

Hence under the EMH, financial bubbles could not form – or, at any rate, could not be last. Some wise investor would spot them and pop them.

– With the confidence in EMH and its complex mathematics that describe it, financial markets invented so called engineered asset products such as derivatives.



– The weak form EMH stipulates that current asset prices already reflect past price and volume information.

The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security.

It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows".

Yet, there are still numbers of financial researchers who are studying the past stock price series and trading volume data in attempt to generate profit. This technique is so called technical analysis that is asserted by EMH as useless for predicting future price changes.


THE BEHAVIOR OF STOCK-MARKET PRICESEUGENE F. FAMA (1965)

For many years the following question has been a source of continuing controversy in both academic and business circles: To what extent can the past history of a common stock's price be used to make meaningful predictions concerning the future price of the stock …


– The semi strong form EMH states that all publicly available information is similarly already incorporated into asset prices.

In another word, all publicly available information is fully reflected in a security's current market price. The public information stated not only past prices but also data reported in a company's financial statements, company's announcement, economic factors and others.

It also implies that no one should be able to outperform the market using something that "everybody else knows". This indicates that a company's financial statements are of no help in forecasting future price movements and securing high investment returns.


The tests of EMH often start with the following equation:

r1 = r0 +u1

where• r0 is the risk-adjusted expected return from a pricing model (e.g. CAPM and APT)

• u1 is the residual term.

EMH says that the residual term u1 must be:

• zero on average• unpredictable based on current information (at time 0)

Under EMH of above forms, asset returns are unpredictable.


– The strong form EMH stipulates that private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits.

Thus, all information, whether public or private, is fully reflected in a security's current market price. That's mean, even the company's management (insider) are not able to make gains from inside information they hold. They are not able to take the advantages to profit from information such as take over decision which has been made ten minutes ago.

The rationale behind to support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders.

The random walk model of asset prices is an extension of the EMH, as are the notions that the market cannot be consistently beaten, arbitrage is impossible, and "free lunches" are generally unavailable.


Returns on Two Successive Days for Weyerhaeuser (1963-1993)

T. Crack and O. Ledoit, “Robust Structure without Predictability: The‘Compass Rose’ Pattern of the Stock Market.” Journal of Finance

(1996).


– Empirically, the weak and semi-strong EMHs are supported by real market data.

Note that given r1 = r0 +u1 , u1 or the residual term, is estimated to be close to zero – as postulated by the EMH.

Under the above EMH form, its implication is that asset returns are unpredictable.

And, asset prices reflect all available information. This means that financial transactions at market prices are zero net present value activities (or no arbitrage opportunities for any party involved).


Serial Correlation of Daily Returns on Nine Stock MarketsSource: B. Solnik, “A Note on the Validity of the Random

Walk for European Stock Prices.” Journal of Finance (December 1973).

u0 of leading stock markets is estimated to be:

USA 0.03 UK 0.08France -0.01 Italy -0.02Germany 0.08 Holland 0.03Belgium -0.02 Switzerland 0.01Sweden 0.06


– Suppose that a company announces a merger agreement that was not expected in the market. How should the share price of the company respond to this new development?

Consider three hypothetical paths for stock price adjustments:

1. Increase immediately to a new equilibrium level

2. Increase gradually to the new equilibrium level

3. First over-shoot and then settle back to new equilibrium

– The EMH suggests #1 response.


Cumulative Abnormal Returns (CAR)before and after Takeover Attempts: Target

CompaniesSource: A. Keown and J. Pinkerton, “Merger

Announcements and InsiderTrading Activity.” Journal of Finance (1981).


– The EMH also suggests that money managers can not consistently outperform the market.

Why?



– The EMH also suggests that money managers can not consistently outperform the market.

Note that there tends to be a positive correlation between funds’ Betas and there average return.

Beta or βi in the CAPM (more on CAPM in Week 5):

˜ri − rF = αi + βiM (˜rM − rF)+˜εi where

˜ri = return on investment− rF = risk free return αi = alpha or excess return (adjusted for risk)βiM = beta or systematic risk (relative to M)˜εi = sigma or non-systematic risk

Do you think α > 0 investment opportunities can persist in the market? Why not?


Mutual Fund Performance (Gross of Expenses)Source: M. Jensen, “Risks, the Pricing of Capital

Assets, and the Evaluation ofInvestment Performance.” Journal of Business (April

1969).

Financial Markets


The Efficient-Markets Hypothesis (EMH)

– Screen a set of public companies of your interest (about 10) and note their Betas. If you are using Google Finance then Add (Beta) as a Stock Screener criteria variable.

– Plot your Betas (X) and their 52 week percent price changes (Y). What pattern do you see –if any?

Is there a positive correlation between Betas and Returns?

Financial Markets

The Efficient-Markets Hypothesis (EMH)

– What are its weakness?

Stock Market Crash of 1987 • No apparent exogenous news• Enormous and dis-continuous price drop• Worldwide• No immediate bouncing back.

Smooth dividends but volatile prices (Shiller)


Real S&P Index p versus Ex Post Rational Price p ∗(1871-1979)

Source: R. Shiller, “Do Stock Prices Move Too Much to be Justified by

Subsequent Changes in Dividends?” American Economic Review (Vol. 71,1981).

Financial Markets

Behavioral School

– A second branch of financial economics is far more skeptical about the EMH’s core assumption of markets’ inherent rationality.

Behavioral economics, which applies the insights of psychology to finance, has boomed in the past decade. In particular, behavioral economists have argued that human beings tend to be too confident of their own abilities and tend to extrapolate recent trends into the future, a combination that may contribute to bubbles.

There is also evidence that losses can make investors extremely, irrationally risk-averse—exaggerating price falls when a bubble bursts.

Behavioral economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”.

The title of Mr Shiller’s latest book, “Animal Spirits” (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes’s description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology.


Financial Markets

Behavioral School

Financial markets are fertile territory for anomaly mining. However, we do not think that anomalies are so abundant in finance because the theories are worse than in other areas of economics.

Rather, anomalies are common because the theories are unusually well-specified (so they can be tested) and the data are unusually rich. This combination of well-specified models, good data, and many anomalies makes finance an extremely exciting research area.

The real challenge facing the field is to develop new theories of asset pricing that are consistent with known empirical facts and offer new testable predictions. We are pessimistic about the chances of success for traditional models in which all agents are assumed to be fully rational.

Models in which some agents have nonrational expectations of future cash flows, or have faulty risk perceptions, seem to us to offer greater promise.

However, the current state of these models does not permit them to be carefully tested. When such tests become possible, it may well turn out these models are in as much conflict with the data as is the traditional framework.


A Mean-Reverting Walk Down Wall Street

Werner F. M. De Bondt and Richard H. Thaler Source: The Journal of Economic

Perspectives, Vol. 3, No. 1 (Winter, 1989), pp. 189-202

Documents

Financial Markets MSFI535 Week #4 1Financial Markets Week 4 Lecture Slides