Money & Banking Week 1 1/24/2006.

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Presentation transcript:

Money & Banking Week 1 1/24/2006

Function of Financial Markets ...

Direct Finance: Financial Markets & Instruments Debt (Fixed Income Securities) Fixed cash flows (interest). Principal to be repaid. Default leads to bankruptcy. Equity Cash flows tied to profits (dividends). No principal to be repaid. Investors are residual claimants.

Financial engineering leads to … Derivatives Securities whose value derives from the value of an underlying asset, index, currency or commodity. Asset-backed securities Securities that are constructed from cash flows from assets such as mortgages. A type of fixed income security.

Equity Markets Exchanges NYSE AMEX Over-the-counter NASDAQ

Primary vs. secondary markets

Brokers vs. dealers

Dividend Valuation Model

Gordon Growth Model

Rational Expectations Optimal forecasts (the best guess of the future) using all available information. Application to inflationary expectations. Relation to adaptive expectations.

Efficient Markets Hypothesis “You can’t beat the market.”

Weak Form of EMH There are no repeating patterns in stock prices. Technical analysis does not work.

Strong Form of EMH All publicly available information is immediately incorporated into the price of the stock. Fundamental analysis does not work.

Evidence in Favor of EMH Performance of investment analysts and mutual funds. Earnings announcements have no effect on stock prices. Stock prices follow a “random walk.”

Evidence Against EMH “Anomalies” Small-Firm Effect January Effect Market Overreaction Excessive Volatility Mean Reversion New Information Slow to be Absorbed