Finance 4000

Money and Capital Markets

Sixth class

• What makes for an efficient asset market?

  
  
  

  • Answer common in profession

    
    
    

    • Price changes are unpredictable

      
      
      

    • The random walk theory of stock prices

      
      
      

  • A better answer

    
    
    

    • An efficient asset market transfers ownership of the assets at the lowest cost among the alternatives available

      
      
      

    • This is more consistent with the usual economic meaning of efficiency

      
      
      

      • The economic definition of efficiency: given the resources available, the maximum amount of each good or service is being produced given the amounts of the other goods and services

        
        
        

      • Note: many different combinations of goods and services can be efficient

        
        
        

• One part of an efficient asset market is that the prices reflect the "correct" things

  
  
  

  • whatever economic theory would suggest

    
    
    

• Rational expectations

  
  
  

  • Expectations that are not predictably wrong given the information available to the person or firm

    
    
    

  • Expectations that are consistent with the relevant economic theory given the information available to the person or firm

    
    
    

  • Expectations that are consistent with the relevant economic theory including the costs and benefits of acquiring information

    
    
    

  • Comments
    • Rational expectations have nothing to do with "rationality" versus "irrationality"

      
      
      

    • Rational expectations can be quite inaccurate
      • Landfall of hurricanes 4 days in advance
      • Interest rate on 90-day Treasury bills tomorrow

• What does this imply for prices of assets?

  
  
  

  • 

    
    
    

  • Let a superscript "e" mean that the variable is the "expected" or "anticipated" value

    
    
    

    • is the expected price at t+1

      
      
      

    • is the expected cash payment at t+1

      
      
      

    • 

      
      
      

  • Where does this expected value come from and why does it matter?

    
    
    

    • Any theory about portfolio choice concerns expected returns

      
      
      

    • Rational expectations -- expected value is the one consistent with the relevant economic theory

      
      
      
      
      

• Related but not the same

  
  
  

  • Fundamentals theories of prices

    
    
    

    • Stock price is present value of "dividends" -- payments to shareholders
    • 

      
      
      

  • "Bubbles" theories of prices

    
    
    

    • Castles in the air

      
      
      

    • Can be consistent with a thorough-going choice-based economic theory

      
      
      

    • Can also be consistent with a "greater fool" theory

      
      
      

  • What about failing to take advantage of profit opportunities?

    
    
    

    • For example, "people predictably over-react" to certain things

      
      
      
      
      
      
      

• Sometimes, fundamental theories are interpreted as implying that stock prices should be a random walk. Why?

  
  
  

  • Suppose that dividends are perfectly predictable

    
    
    

  • Suppose that expected holding-period returns are constant.

    
    
    

  • Then the difference between the actual holding-period return and the expected holding-period return is

    
    
    

    • 

      
      
      

    • This is all the variation in the actual holding-period return since the expected holding-period return is constant

      
      
      

      • Variation in the holding-period return is unpredictable

        
        
        

      • Changes in prices are unpredictable
      • In short, a random walk

        
        
        

• No predictable changes in prices is not consistent with the data

  
  
  

  • Even including dividends and other payments

    
    
    
    
    

• Basic implication of idea

  
  
  

  • Current stock price for a firm reflects expectations that are consistent with operation of the firm and the market for stock

    
    
    

    • A minus 30 percent return must be unexpected (a surprise)

      
      
      

  • Implications for buying individual stocks and betting that other traders are wrong

    
    
    

  • Implications for personal trading

    
    
    

    • Recommended
    • A Random Walk Down Wall Street by Burton Malkiel
    • Stocks for the Long Run by Jeremy J. Siegel
    • Not recommended
    • Seize the Day by David Nassar