Market Efficiency 51
CHAPTER 9
Market Efficiency
Learning Objectives
· How all prices of financial instruments are related
· How expectations are formed
· The difference between rational expectations and adaptive expectations
· What the efficient market hypothesis is and how it relates all financial prices
· How the sources and uses of funds can integrate financial flows between sectors
Chapter Outline
I. Stocks Rise 32 Percent While Bonds Fall 10 Percent: Can These Price Movements Be Explained?
II. How Expected Rates of Return Affect the Prices of Stocks and Bonds
A. Stocks
B. Bonds
C. The Formation of Price Expectations
D. The Efficient Markets Hypothesis: Rational Expectations Applied to Financial
Markets
E. The Flow of Funds among Sectors
F. Pulling it All Together
Answers to Review Questions
1. Explain why stock and bond prices adjust until investors are indifferent between stocks and bonds, given varying degrees of risk and liquidity.
A portfolio generally contains both stocks and bonds. In deciding whether to hold stocks or bonds, investors compare the expected rates of return on the different types of financial assets, selecting those with the highest expected return consistent with the risk and liquidity the investor prefers. The expected return on holding stock is any dividends plus capital gain that the stock would pay over the holding period. The return on bonds is the coupon rate plus the expected change in the bond prices over the holding period. If the risk adjusted return on stocks is greater than the risk adjusted return on bonds, then investors will purchase stocks, driving their prices up and their return down. Likewise, investors will sell bonds, their prices will fall, and their yield increase. Because of the drive to purchase assets with a higher risk adjusted return, adjustment would continue until the risk-adjusted return between stocks and bonds are equalized. In this case, since they pay the same risk adjusted return, the investor is indifferent between purchasing stocks or bonds.
1. When full adjustment has occurred, what do differences in returns on various financial instruments reflect?
If financial instruments such as stocks and bonds have differences in risk adjusted rates of return, then investors will purchase those instruments with the highest risk adjusted returns and sell those with the lower risk adjusted rates of return. This buying and selling in turn causes financial prices to adjust. When full adjustment has occurred, differences in after-tax returns on various financial instruments reflect varying degrees of risk and liquidity.
3. If current and expected earnings rise, what happens to stock prices?
A growing economy means that sales, production, and incomes increase. As these factors increase, current and expected earning rise. In general, as current and expected earnings rise, stock prices also rise.
4. Interest rates are going up. What happens to the prices of previously issued bonds?
There is an inverse relationship between bond prices and interest rates. Therefore, when interest rates rise, the prices of previously issued bonds fall.
5. How do adaptive expectations differ from rational expectations?
Adaptive expectations are expectations formed by looking back at past values of a variable. In general, more recent past values are given greater weight. Rational expectations are expectations formed by looking at the past as well as all additional available information such as information about expected changes in national income and costs. Rational expectations is looking both backward and forward.
6. Why is the actual value of a financial variable different from the optimal forecast of that variable? Assuming that expectations are rational, what on average will the difference between the actual value and the optimal forecast be?
The actual value of a financial variable can be different from the optimal forecast of that variable because of randomness in financial markets. If expectations are rational, the difference between the actual value and the optimal forecast will on average be zero. In other words, sometimes the actual value will be greater than the optimal forecast and sometimes less, but on average, the differences will cancel each other out. In a given period, it is impossible to know what this forecast error will be.
Actual values may also turn out to be different from the optimal forecast even when expectations are rational if there are key additional factors that are relevant but unknown at the time the forecast is made. This is different from the situation where market participants are unaware of available information or where the available information is too costly to obtain. In this case, forecasts are neither accurate or rational.
7. What is the efficient market hypothesis? How does it differ from the stronger version of the hypothesis?
The optimal forecast is the best guess possible arrived at by using all of the available information. The efficient market hypothesis is the theory that the prices of all financial instruments reflect the optimal forecast of the financial instrument. The stronger version of the hypothesis hypothesizes that the prices of all financial instruments not only reflect the optimal forecast of the financial instrument but also the true fundamental value of the instrument.
8. What is the fundamental value of a financial instrument?
The fundamental value of a financial instrument is the value that reflects all available information that is accurate, complete, understood by all and reflects market fundamentals. Market fundamentals are factors that have a direct effect on future income streams of the instruments. These factors include the value of the assets and the expected income streams of those assets on which the financial instruments represent claims.
9. What is the rationale behind the efficient market hypothesis?
The rationale behind the efficient market hypothesis is that if current prices do not fully reflect any changes in expectations then some market participants will earn less than what they other wise would have. Unexploited opportunities to gain by purchasing those financial instruments that pay a return above equilibrium will exist. The drive for profits will insure that all opportunities for profits are exploited and that prices of financial instruments adjust to the equilibrium return that is the optimal forecast.
10. Explain why the expected return on newly issued and previously issued bonds is the prevailing interest rate plus any expected capital gain or loss.
The expected return on bonds is the coupon rate plus the expected percentage change in the bond’s price over the course of the year. Newly issued and previously issued bonds are substitutes. If interest rates change on newly issued bonds, prices of previously issued bonds will change until returns on the newly issued and previously bonds are equalized. When interest rates change, expected capital loses or gains change on previously issued bonds change.
11. Using the flow-of-funds framework, explain why the combined deficits of the deficit sectors must equal the combined surpluses of the surplus sectors.
The flow of funds framework is a social accounting system that divides the economy into a number of sectors and monitors the financial flows of funds among sectors. The four main sectors are the household, business, government and rest-of-the-world sectors. Any sector is composed of both surplus spending units (SSUs) and deficit spending units (DSUs). For any sector, the combined surpluses of the SSUs may be greater than the combined deficits of the DSUs. In this case, the sector would be a surplus sector. If the combined deficits of the DSUs are greater than the combined surpluses of the SSUs, then the sector is a deficit sector.
For all sectors combined, borrowing (the issuance of financial claims) must be equal to lending (the acquisition of financial assets). This is so because each financial claim, in turn, implies the existence of a complementary financial asset. However, in each individual sector, it is highly unlikely that the combined surpluses just equal the combined deficits. Thus, the economy is usually composed of surplus and deficit sectors where the combined surpluses of the surplus sectors is equal to the combined deficits of the deficit sectors for the economy as a whole.
12. Must all market participants know the optimal forecast of a financial instrument for the price of the financial instrument to be driven to the optimal forecast?
It is not necessary for all market participants to know the optimal forecast. All that is necessary is for a few participants to know the optimal forecast. The few who are savvy will keep buying and selling financial instruments as long as there are unexploited opportunities to profit based on the optimal forecast. In this way, the price will be driven to the optimal forecast even if all market participants do not know it.
13. What is a “bubble” in a financial market? Can financial prices ever overshoot or undershoot optimal values?
A bubble is an extraordinary run-up of stock or bond prices, that does not seem to be related to market fundamentals. Such run-ups have occurred in Japan in the late 1980s and more recently in the United States in the late 1990s. Prices can overshoot or undershoot optimal values in either stock market bubbles or crashes. It can be rational to buy a share of stock at a price above its optimal value, if it is thought that there will be other investors in the future who would be willing to pay inflated prices (prices that exceed those based on market fundamentals) for the stock. This phenomenon is sometimes called “the greater fool” theory. Likewise, it may be rational not to buy a stock that is trading below its optimal value if it was believed that market psychology was such that the stock’s price could go down further.
Other economists suspect that financial market prices may overreact before reaching equilibrium when there is a change in either supply or demand. That is, prices may rise or fall more than market fundamentals would justify before settling down to the price based on fundamentals.
14. If the household, business, and government sectors are all deficit sectors, what does this imply about the rest-of-the-world sector?
If the household, business, and government sectors are all deficit sectors, then the rest-of-the-world sector must be a surplus sector and the surplus must be equal to the combined deficits of the other three sectors.
Answers to Analytical Questions
2. Assume the equilibrium return on a financial instrument is 10 percent and the instrument pays no dividends or interest. If the current price is $100 and the expected future price one year from not just increased from $110 to $120, what will happen to the current price?
Assuming the equilibrium return does not change, the current price will increase to $109.09. We found this by solving for the expected price one year from now by substituting into the following formula:
R = (Pt+1 - Pt + D)/Pt where
R = percentage return over the time period (the equilibrium return)
Pt+1 = price of the stock at the end of the time period
Pt = price of the stock at the beginning of the time period
D = dividend payments made during the time period
In this case, we know R, Pt+1, and D and can solve for Pt from the following formula: (10 percent = ($120 - Pt + $0)/Pt) and 1.1 Pt = $120. Therefore, Pt = $109.09.
16. Assume the equilibrium return on a financial instrument is 10 percent. If the current price is $100 and the instrument does not pay interest or dividend, what is the price expected one year from now when the market is in equilibrium? If the equilibrium return on the instrument increases to 15 percent because the instrument is perceived as more risky, what happens to the current price, assuming the expected price one year from now does not change?
We can solve for the expected price one year from now by substituting into the following formula:
R = (Pt+1 - Pt + D)/Pt where
R = percentage return over the time period (the equilibrium return)
Pt+1 = price of the stock at the end of the time period
Pt = price of the stock at the beginning of the time period
D = dividend payments made during the time period
In this case, we know R, Pt, and D. Therefore, Pt+1 equals $110 (10 percent = (Pt+1 - $100 + $0)/$100).
If R increases to 15 percent and the expected future price ($110) does not change, then the price of the stock falls to $95.65. This was found by substituting for R and Pt+1 in the above equation and solving for Pt (15 percent = ($110 – Pt + 0)/Pt: therefore, Pt = $95.65.
17. News comes out that leaves investors to believe that there is more risk involved with owning financial instrument A. What will happen to its equilibrium return?
The equilibrium return on a financial instrument is based on its risk and return compared to other financial instruments. Assuming the risk and return of other financial instruments do not change, then the equilibrium return of owning financial instrument A will increase as it becomes more risky. Investors must be compensated with a higher return because of the greater risk involved with holding instrument A.
18. Assume that in 2002 through 2005, the government and household sectors run significant surpluses. What does this imply about the other sectors?
The government and household sectors can run significant surpluses only if other sectors such as the business and rest-of-the-world sectors run significant deficits, equal to the combined surpluses of the government and household sectors.