FNCE 3020 Lecture 8

							FNCE 4070
Financial
Markets
and Institutions
 Lecture 6
 The Role of Expectations in Financial Markets
       (Including The Efficient Market Hypothesis)
Two Objectives for This Lecture

   (1) To discuss the role of expectations in
    financial markets.
       How are expectations formed and how do
        expectations influence asset prices?
   (2) To introduce you to the concept of financial
    market efficiency and the Efficient Market
    Hypothesis.
       What does it mean if financial markets are efficient (or
        inefficient)? How do financial asset prices respond if
        markets are efficient (or inefficient)?
The Role of Expectations
   Expectations play a critical role in financial markets.
    Here are some examples:
   Markets’ expectations about future inflation affects
       Market interest rates (and thus, bond prices)
       Central bank (especially those that target inflation) actions
        relating to their short term benchmark interest rate.
   Markets’ expectations about future (forward) interest
    rates affects
       Spot interest rates (expectations and liquidity premium theories).
       The term structure of interest rates, i.e. the shape and slope of
        the yield curve.
       Bond prices, stock prices and foreign exchange rates.
   Markets’ expectations about future economic activity
    affects
       Stock prices.
       Commodity prices (e.g., oil)
How are Market “Expectations”
Formed?
   Prior to the 1960s, most economists (and thus economic
    models) assumed that market participants formed
    adaptive expectations about the future, or that:
       Market expectations about a variable were based primarily on
        past values of that variable, and
       These expectations changed slowly over time.
       This approach undoubtedly reflected the environment at that
        time.
   There were, however, potential problems with this
    adaptive model of expectations:
       (1) A particular variable could easily be affected by many other
        variables (not just the variable itself), so markets are likely use all
        relevant data in forming an expectation about a variable.
       (2) In the 1970s we saw that expectations could change very
        quickly if the environment also experienced sudden and
        substantial changes.
Post War Inflation Environment
Post War Interest Rate Environment
Post War Exchange Rate Environment
Post War Exchange Rate Environment
Abrupt Change in 1970s/1980s in the
Environment Affecting Expectations
Inflation Environment in the 1970s
The 1970s -80s: A New Problem
   In the 1970’s, global               Inflation in Industrial
    inflation became the major
    economic issue for                  Countries, % per year
    industrial countries.
       Two distinct inflation peaks:
        1973/74 and 1980/81.
   The inflation of this period
    was attributed to cost push
    “supply shocks” to the
    global economy.
       Especially oil.
   As a result, many central
    banks turned their attention
    to inflation and some to the
    use of inflation targets as a
    macro economic goal.
       Beginning with New Zealand
        in March 1980.
The Result of the Changing
Environment on U.S. Interest Rates
Volatility of Short Term Interest Rates
in the Late 1970s Though the 1980s
Changing Exchange Rate Environment;
The Japanese Yen in the 1970 and 1980s
Changing Exchange Rate Environment;
The British Pound in the 1970 and 1980s
Rational Expectations Model
   Given the problems surrounding the adaptive
    expectations model, a second approach to
    expectations, called rational expectations, was
    developed:
       According to the rational expectations model, market
        participants form expectations using all available
        information (not just past information and not just the
        variable itself).
           Model also assumes that new information constantly being
            introduced to the market.
   The rational expectations, in turn, is a bridge to
    “efficient markets theory (hypothesis).”
       The efficient markets theory assumes that asset prices
        reflect all available information (events) that directly impact
        on the future cash flow of a security (i.e., a financial asset).
Eugene Fama and The Efficient Market
Hypothesis
   According to Eugene Fama (see Appendix 1), who
    many see as the “father of the efficient market
    hypothesis:”
    “In an efficient market, competition among many
    intelligent participants leads to a situation where, at
    any point in time, the actual prices of securities
    already reflects the effects of information based on
    events that have:
   (1) already occurred [i.e., in the past], and events,
   (2) as of now [i.e., in the present], and events
   (3) the market expects to take place in the future. [i.e.,
    what it anticipates]”
       From: Eugene F. Fama, "Random Walks in Stock Market Prices,"
        Financial Analysts Journal, September/October 1965
       For an interesting interview with Fama see:
           http://www.dfaus.com/library/reprints/interview_fama_tanous/
The Role of Expectation
   Thus, according to Fama in an efficient market, financial
    asset prices reflect the best knowledge of the past, the
    present and predictions (anticipations) of the future.
   Key issues:
       What happens when something unanticipated occurs and how
        quickly do asset prices adjust?
           (1) How does the market react if the market is efficient?
           (2) How does the market react if the market is inefficient?
       What happens when something anticipated occurs?
           (1) How does an efficient market react to anticipated events?
           (2) How does an inefficient market react to anticipated events?
   Next two slides illustrate possible answers to these
    questions.
       Illustrations from Nikolai Chuvakhin, “Efficient Market Hypothesis
        and Behavioral Finance – Is a Compromise in Sight?”
Unanticipated “Favorable” Event
Efficient Market: Prices   Inefficient Market: Prices
would adjust up very       would drift upward for
quickly                    some time following the
                           event
Anticipated “Favorable” Event
Efficient Market: Prices    Inefficient Market: Prices
would drift up for some     would drift up for some
time before the event and   time before the event and
then stabilize              continue up after
Krispy Kreme and
the Efficient Market Theory
   Founded in 1937 (in Winston-Salem, NC) , the company went
    public on April 5, 2000 and traded on NASDAQ (eventually listing
    on the NYSE on May 17, 2001).
   By 2004, the company was selling over 7.5 million doughnuts a
    day.
   Earnings announcement on Monday, November 22, 2004 for the
    three months ending October 31, 2004 (Announcement prior to
    the opening on the NYSE).
     Stock had closed at $11.50 the previous Friday.

     Analysts anticipated earnings of 13 cents per share

     Instead, the company announced its first quarterly loss (of 5
       cents a share) since going public in 2000.
   Since announced earnings were not in line with market
    expectations, what do you think happened to Krispy Kreme stock
    and how quickly did it react?
 Krispy Kreme: November 22, 2004; Reaction
to Unanticipated “Unfavorable” Event
Nike Reacts to an Unanticipated
“Unfavorable” Event
   On Thursday, November 18, 2004, near the close of the market (just
    before 4:00) the company announced that the company’s co-founder
    Philip H. Knight was stepping down as president and chief executive
    officer of the company.
The Stock Market Reacts to an
Unanticipated “Favorable” Event
   On Tuesday, September 18, 2007, the Federal Reserve surprised
    financial markets by lowering the fed funds rate 50 basis points to
    4.75% (the markets had been anticipating a reduction of 25 basis
    points). The announcement took place at 2:15EST.
Conclusions from the Efficient
Market Hypothesis
   If markets are efficient, anticipated events have
    already been discounted in asset prices.
   If markets are efficient, financial asset prices will
    adjust quickly to new and unanticipated events
    (including data, news).
       Any unexploited profits will quickly disappear as
        market participants adjust prices in accordance with
        the new event.
       Thus, it is impossible to beat the market with respect
        to any financial asset.
           Essentially your return will be no better than what the market,
            or a particular, security returns.
Issues Surrounding the Efficient
Market Hypothesis
   How efficient are financial markets in terms or
    assimilating new information into asset prices?
       Industrial country financial markets (especially the
        large financial markets) appear to be very efficient.
           Developing country financial market prices react more slowly
            to information.
       Even in industrial country markets, are there situations
        when a market acts inefficiently?
           See Appendix 2.
   If markets are efficient, is it possible to forecast
    future asset prices?
       Topic for Lecture 6, Part 2.
How Efficient are Foreign
Exchange and Bond Markets?
   Foreign Exchange (Dollar/Mark) Markets:
       Ederington and Lee (1993, 1995):
           Found that exchange rates reacted after about 10 seconds of
            scheduled macroeconomic news releases and are complete after
            another 30 seconds. If the market over-reacts, it is corrected
            within 2 minutes after the release.
   Interest Rate (Treasury Bond) Markets:
       Ederington and Lee (1993, 1995)
           Same results as found for the foreign exchange market.
   Conclusion: Foreign exchange and interest rate markets
    (e.g., Treasury markets) react very quickly to information.
   See: Louis H. Ederington and Jae Ha Lee, “The Short-Run
    Dynamics of the Price Adjustment to New Information,” The
    Journal of Financial and Quantitative Analysis, Vol. 30, No.
    1 (Mar., 1995), pp. 117-134
How Efficient are Equity Markets?
   Equity Markets:
       Dann, Mayers, and Raab (1977), Patell and Wolfson (1984),
        Jennings and Starks (1985):
           Prices adjusted within 1 to 15 minutes upon receiving
            information.
       Brooks, Patel and Su (2003)
           Price reaction to announcements of unanticipated negative
            events took over 20 minutes and tended to reverse over the
            following two hours (because of over reaction to the bad news).
   Conclusion: Most researchers generally agree that equity
    markets are reasonably efficient, however, debate is kept
    alive by the search for and discovery of market anomalies
    (see Appendix 2)
   See: Raymond Brooks, Ajay Patel and Tie Su, “How the
    Equity Market Responds to Unanticipated Events,” Journal
    of Business, 2003, vol. 76, no, 1, pp. 109-133.
Appendix 1

  Eugene Fama, the Efficient Market
  Hypothesis and Stock Prices
Short Bio on Eugene Fama
   Eugene Fama (born February 14, 1939),
    an American economist, best known for
    his work on portfolio theory and asset
    pricing, both theoretical and empirical. He
    earned his undergraduate degree in
    French from Tufts University in 1960 and
    his MBA and Ph.D. from the Graduate
    School of Business at the University of
    Chicago in economics and finance.
   Fama is most often thought of as the
    father of the efficient market hypothesis,
    beginning with his Ph.D. thesis (1964)
    which concluded that stock price
    movements are unpredictable and follow
    a random walk.
   In 1963, he joined the faculty at
    University of Chicago Booth School of
    Business.
   For more information on Fama see:
    http://www.chicagobooth.edu/faculty/bio.
    aspx?&min_year=20084&max_year=200
    93&person_id=12824813568
Fama: The Efficient Market
Hypothesis and Stock Prices
   Application of Efficient Market Theory to common
    stocks can be traced to the work of Eugene Fama
    (see: 1965, Financial Analyst Journal).
   There are two critical elements in his work:
   (1) Efficient market theory applied to Stock Prices:
    Stocks are always “correctly priced” given that
    everything that is publicly known about a stock is
    reflected in its market price.
   (2) Random walk theory: Since new information is
    random, all future price changes are independent from
    previous price changes; thus, future stock prices
    cannot be predicted.
       For a more complete discussion see: Burton Malkiel, A
        Random Walk Down Wall Street, (Norton Publishing 1973).
Appendix 2

  Testing the Efficient Market
  Hypothesis
Testing the Efficient Market Hypothesis
   The EMH provided the theoretical basis for much of the
    financial market research during the 1970s and 1980s.
   During that time, most of the evidence seems to have
    been consistent with the EMH.
       Prices were seen to follow a random walk model and the
        predictable variations in equity returns, if any, were found
        to be statistically insignificant.
       So, most of the studies in the 1970s focused on the inability
        to predict prices from past prices.
   However, beginning in the 1980s, the EMH became
    somewhat controversial, especially after the detection of
    certain anomalies in the capital markets (i.e., situations
    which provided “abnormal returns”).
Testing for Financial Market Anomalies
   Some of the main financial market anomalies
    that have been identified are as follows:
       1. The January Effect: Rozeff and Kinney (1976)
        were the first to document evidence of higher
        mean stock returns in January as compared to
        other months.
       The January effect has also been documented for
        bonds by Chang and Pinegar (1986).
       Maxwell (1998) showed that the bond market
        effect is strong for non-investment grade bonds,
        but not for investment grade bonds.
The Weekend (or Monday) Effect
   2. The Weekend Effect (or Monday Effect):
    French (1980) analyzed daily returns of U.S. stocks
    for the period 1953-1977 and found that there was a
    tendency for returns to be negative on Mondays
    whereas they were positive on the other days of the
    week.
   Agrawal and Tandon (1994) found significantly
    negative returns on Monday in nine countries and
    on Tuesday in eight countries, yet large and positive
    returns on Friday in 17 of the 18 countries studied.
   Steeley (2001) found that the weekend effect in the
    UK disappeared in the 1990s.
Seasonal Effects

   3. Seasonal Effects: Holiday and turn of the month
    effects have been documented over time and across
    countries.
   Lakonishok and Smidt (1988) showed that U.S.
    stock returns were significantly higher at the turn of
    the month, defined as the last and first three trading
    days of the month.
   Ziemba (1991) found evidence of a turn of month
    effect for Japan when turn of month was defined as
    the last five and first two trading days of the month.
   Cadsby and Ratner (1992) provided evidence to
    show that returns were, on average, higher the day
    before a holiday, than on other trading days.
Small Firm Effects

4. Small Firm Effect:
 Banz (1981) published one of the earliest
  articles on the 'small-firm effect' which is also
  known as the 'size-effect'.
     His analysis of the 1936-1975 period in the U.S.
      revealed that excess returns would have been
      earned by holding stocks of low capitalization
      companies.
Over/Under Reaction Effect
   5. Over/Under Reaction of Stock Prices to
    Earnings Announcements: DeBondt and
    Thaler (1985, 1987) presented evidence that
    is consistent with stock prices overreacting to
    current changes in earnings.
       They reported positive (negative) estimated
        abnormal stock returns for portfolios that
        previously generated inferior (superior) stock price
        and earning performance.
       This was construed as the prior period stock price
        behavior overreacting to earnings
        announcements.
Standard and Poor’s Effect
   6. Standard & Poor’s (S&P) Index effect:
    Harris and Gurel (1986) and Shleifer (1986)
    found an increase in share prices (up to 3
    percent) on the announcement of a stock's
    inclusion into the S&P 500 index.
       Since in an efficient market only new information
        should change prices, the positive stock price
        reaction appears to be contrary to the EMH
        because there is no new information about the
        firm other than its inclusion in the index.
Weather Effect

   7. The Weather: Saunders (1993) showed
    that the New York Stock Exchange index
    tended to fall when it was cloudy.
   Hirshleifer and Shumway (2001) analyzed
    data for 26 countries from 1982-1997 and
    found that stock market returns were
    positively correlated with sunshine in almost
    all of the countries studied.
Volatility Effect
   8. Volatility Effect: These tests are designed to test
    for rationality of market behavior by examining the
    volatility of share prices relative to the volatility of the
    fundamental variables that affect share prices.
   Shiller (1981) and LeRoy and Porter (1981) showed
    that fluctuations in actual prices (for both stocks and
    bonds) were greater than those implied by changes
    in fundamental variables during volatile periods.
   Schwert (1989) found increased volatility in financial
    asset returns during recessions.
       The empirical evidence provided by volatility tests suggests
        that movements in stock prices cannot be attributed merely
        to the rational expectations of investors, but also involve an
        irrational component.
Volatility Effect: October 19, 1987
   On October 19, 1987, the stock market plunged with what, on
    that day, was the largest one-day point loss in the history of
    the Dow Jones Industrial Average (507.99 points, or 22.6%).
     Issue: Could such a large one-day loss be reconciled with
       efficient markets and the data at that time?
   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 22.6% decline.
     Many economists concluded that this episode is evidence
       that investor psychology plays a role in setting stock prices
       (along with the fundamentals).
     Lead to the study of Behavioral Finance
Human Behavior in Markets
   If we assume that markets are not totally rational
    (i.e., they don’t react as a rational expectations
    model would suggest), it might be possible to
    explain some of the anomaly findings on the basis of
    human and social psychology.
       John Maynard Keynes once described the stock market as
        a "casino" guided by "animal spirit" (1939).
       Shiller (2000) describes the rise in the U.S. stock market in
        the late 1990s as the result of “psychological contagion
        leading to irrational exuberance.”
Behavioral Finance and Asset Pricing

   Suggests that real people:
       Have limited information processing capabilities
       Exhibit systematic bias in processing information
       Are prone to making mistakes
       Tend to rely on the opinion of others (fads); referred to
        as a “bandwagon” effect.
Conclusions from EMH Tests
   The studies based on EMH have made an
    invaluable contribution to our understanding of
    financial market.
       The role of information (especially new information) in
        asset pricing.
   However, for some there seems to be growing
    discontentment with the theory’s “rational
    expectations” focus.
   However, for an excellent paper in support of the
    EMH read: “The Efficient Market Hypothesis and
    its Critics,” by Burton Malkiel, Princeton
    University, Working Paper #91, April 2003.
Appendix 3: Over-Reaction
Effect
  Case Study: Nike and the Over
  Reaction Effect
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.
Overreaction of Nike Stock
                       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 close the
                        day after the announcement.
Appendix 4: Three Forms
of Market Efficiency

   The following slide discusses the three
   forms of market efficiency
    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.