FNCE 3020 Financial Markets and Institutions

1. FNCE 3020Financial Markets and Institutions Lecture 6; Part 1 The Role of Expectations in Financial Markets (Including The Efficient Market Hypothesis)

2. Three 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? (3) Ultimately to create a foundation for forecasting. Lecture 6; Part 2

3. 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)

4. 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. 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.

5. Abrupt Change in 1970s/1980s Environment Affecting Expectations

6. The Result of the Changing Environment on Interest Rates

7. 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).

8. 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/

9. 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?”

10. Unanticipated “Favorable” Event Efficient Market: Prices would adjust up very quickly Inefficient Market: Prices would drift upward for some time following the event

11. Anticipated “Favorable” Event Efficient Market: Prices would drift up for some time before the event and then stabilize Inefficient Market: Prices would drift up for some time before the event and continue up after

12. 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?

13. KrispyKreme: November 22, 2004; Reaction to Unanticipated “Unfavorable” Event

14. 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.

15. 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.

16. 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.

17. 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.

18. 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

19. 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.

20. Appendix 1 Eugene Fama, the Efficient Market Hypothesis and Stock Prices

21. 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=20093&person_id=12824813568

22. 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).

23. Appendix 2 Testing the Efficient Market Hypothesis

24. 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”).

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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

34. 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.”

35. 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.

36. 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.

37. Appendix 3: Over-Reaction Effect Case Study: Nike and the Over Reaction Effect

38. 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.

39. 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.

40. Appendix 4: Three Forms of Market Efficiency The following slide discusses the three forms of market efficiency

41. 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.

42. Appendix 5: A More Detailed Look at the Efficient Market Hypothesis This is one approach to understanding the Efficient Market Hypothesis as Presented in the Text Book

43. Efficient Market Hypothesis According 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.

44. 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

45. 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.

46. 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*).

47. 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:

48. 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.

49. 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:

50. 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.