The Stock Market, Rational Expectations, and the Efficient Market Hypothesis
Mishkin Ch. 7
Important Measures
PE ratio
Price to earnings
PE = Price/EPS
Ex:
eBay
(P = 39.61, EPS = .99)
PE =
PE = in 2000
(P = 576.22, EPS = 12.31)
PE =
Market Capitalization
total dollar value of all outstanding shares
Ex:
Google$180 B
Amazon.com$39 B
Barnes & Noble $ B
Computing Stock Prices
One-Period Model
–Notation:
•P0 = today’s price
•P1 = price in 1 year
•DIV1 = dividend paid at the end of the year
•ke = required return on investments in equity
Why ke and not just i?
–i with bonds was interest on an equally risky investment
•ke = irisk free + equity risk premium
–Your equity risk premium depends on how much you know about the corporation
–Must expect to get at least ke or will not purchase the stock
Dell
–Expect a $2.00 dividend payment
–Expect price to be $45.00 in one year
–You require a 15% return on Dell stock
–You would be willing to pay:
Hold for 2 years?
Gordon Growth Model
Assumes dividends will grow at a constant rate = g (estimate)
–D0 = most recent dividend payment (known)
P0 =
Expectations
Adaptive Expectations
–
Ex:
–Will you get “lucky” on your next date?
–Farmers
•Corn or Wheat
Rational Expectations
–Use all available information
Ex:
–Will you get “lucky” on your next date?
Rational Expectations in Financial Markets
Efficient Market Hypothesis
Asset prices full reflect all available information
If not,
By profiting,
Efficient Market Hypothesis
Ex: 2 mkts for apples
Georgetown & RR
PG = $3
PRR = $5
Ex: Stock Returns
RETSTOCK = (DIV1 + Pt+1 – Pt)/ Pt
Expect higher returns in stock market
Evidence in Support of the Efficient Market Hypothesis
Stock prices follow a random walk
–Future stock prices are unpredictable
•Deviations from the expected price should be mean zero
Strong past performance does not predict strong future performance
Evidence Against the Efficient Market Hypothesis
January Effect
–Stock prices increase in January
Market Overreaction
–Investors overreact to news about a company
Small-firm Effect
–Small firms have higher returns over the long-run
If you believe in Efficient Mkts
Investment Advisors offer no help
–Pick an index fund (S&P 500)
–“buy and hold” strategy
Only important information is unexpected, and private information.
What really happened to Long-Term Capital Management?
Hedge Funds
–virtually no regulation
Lowest investment $250,000 - $500,000
Expenses
1% of total fund
20% of profits (25% at LTCM)
Long-Term Capital Management
Robert Merton, of HarvardUniversity
Myron Scholes, of StanfordUniversity
–
–Options Theory
•put a price on risk
How they got in trouble:
–Bet on the spread between interest rates on German and Italian bonds.
–Observed:
Spread between iGerman and iItalian too wide
–Bet that the spread would narrow
expected:
iGerman
iItalian
LTCM
Expect price of bonds
–Buy bonds
Expect price of bonds
–
–
–
Problems
Now must buy the bonds for more than they were sold for = losses
In addition:
–borrowed to buy the Italian bonds (leverage)
–borrowed 50 times its capital
How could this happen?
1. Shit happens
2. Knew shit happens, but did not factor that in
3. Moral Hazard
Solution
Instead of a fire sale
–refinanced, ownership transferred to another group
•Merrill Lynch & Co.
•Bankers Trust
•Chase Manhattan
•Morgan Stanley-Dean Witter
•J.P. Morgan
Refinance of LTCM
Fed brokered the deal
no Federal Reserve funds
no tax money
no forced acceptance of terms
$3.65 billion dollar bailout
Was this needed?
Greenspan:
“could have potentially impaired the economies of many nations, including our own.”
“a fire sale would result in severe, widespread, and prolonged disruptions to financial market activity.”
Consequences of the Bailout
“Too Big to Fail” mentality
–moral hazard
Damage to Fed’s reputation
–other economies need to modernize
•let weak institutions fail