Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities Chapter Objectives Explain when expectations are rational and when they are irrational. Explain how corporate equities (stocks, shares of a corporation) are valued. Explain what is meant by the term market efficiency. Describe the ways in which financial markets are efficient. Describe the ways in which financial markets are inefficient.

1. The Theory of Rational Expectations Market volatility: Constantly changing prices of financial instruments Rational expectations: An economic theory that posits that, in this case investors, input all available relevant information into the best forecasting model available

Economic fundamentals: Key variables in the pricing of assets – They include expected inflation, interest, default, and earnings rates Investors: Participants in financial markets; purchasers of financial securities 1. The Theory of Rational Expectations

Markets: Observations …expectations, rather than actualities, move prices… People invest based on what they believe the future will bring, not on what the present brings or the past has wrought, though they often look to the present and past (sometimes even the distant past) for clues about the future. That is invest on expectations and trade on realizations.

1. The Theory of Rational Expectations Markets: Rational Expectations Theory …investor expectations will be the best guess of the future using all available information. If everyone’s expectations are rational, then why don’t investors agree on how much assets are worth? Investors have different sets of information available to them (some have inside information, news that is unknown outside a small circle) Investors think differently of common information because their utility functions, their goals and aspirations, differ. Investors use different valuation models, or different theories of how to predict fundamentals and how fundamentals determine securities prices. Investors understand the effect of news more quickly and clearly.

2. Valuing Corporate Equities Ownership means that investors are residual claimants Generally, they are entitled to one vote per share. Exceptions include classified shares May or may not pay Dividends - Cash distributions of corporate earnings to shareholders When valuing corporate equities, what matters is earnings or profits (expected or not??)

2. Valuing Corporate Equities Valuation model: multi-period In the Gordon growth model, a corporate equity is worth the discounted present value of its expected future earnings stream P = E(1 + g)/(k – g) Where, P= price today E = most recent earnings k = required return g = constant growth rate

3. Financial Market Efficiency Efficient Pricing The market’s valuation, given the information available at that moment, is always correct In other words, a good, including a financial security, is worth precisely what the market says it is worth

3. Financial Market Efficiency Efficient Integration Prices of similar securities track each other closely over time Prices of the same security are identical in different markets If not, arbitrage, or the riskless profit opportunity that arises when the same security at the same time has different prices in different markets, would take place. The size of price differences and the speed with which arbitrage opportunities are closed depend on the available technology. Example: making money on B/T

Hedge fund: A type of relatively unregulated mutual fund that engages in sophisticated trading strategies – Only wealthy individuals and institutional investors are allowed to invest directly in such funds 3. Financial Market Efficiency

Portfolio diversification: Entails investing in a relatively large number of issuers within an asset class, such as buying the shares of hundreds of corporations rather than just one or a few in order to reduce return risk – Some of the investments will go sour, others will flourish, and most will fall in between Sectoral asset allocation: Entails investing in a variety of different asset classes consistent with the investor’s goals and lifecycle stage 3. Financial Market Efficiency

4. Evidence of Market Efficiency Securities prices Securities prices in efficient markets are determined by fundamentals: – Interest rates – Inflation – Profit expectations Their direction, up or down, in the next period is random, because relevant news cannot be systematically predicted Securities markets are as efficient as can be, given available information

4. Evidence of Market Efficiency Securities markets Securities markets are as efficient as can be, given available information. Strong Prices reflect all information Semi-Strong Prices reflect all public information Weak Prices reflect past prices

4. Evidence of Market Efficiency Securities markets Some markets are more efficient than others Labor and services markets are the least efficient of all Markets for education, health care, and custom construction services are also highly inefficient, probably due to high levels of asymmetric information

4. Evidence of Market Efficiency Market anomalies The most important example of financial market inefficiencies are so-called asset bubbles or manias, not necessarily irrational, but certainly inefficient: misallocation of resources as prices rise and unexploited profit opportunities as prices fall

4. Evidence of Market Efficiency Market anomalies Thousands of bubbles have arisen throughout human history, typically when assets: 1.Can be purchased with cheap, borrowed money 2.Attract the attention of numerous, inexperienced traders 3.Cannot be easily “sold short” (when nobody can profit from the declining price) 4.Are subject to high levels of moral hazard due to the expectation of a bailout 5.Are subject to high agency costs Agricultural commodities (e.g. tulips) have experienced bubbles most frequently

4. Evidence of Market Efficiency Behavioral Finance Observed less-than-rational behaviors: Loss AversionOverconfidence RepresentativenessConservatism Belief PerseveranceAnchoring Availability BiasAmbiguity Aversion “To the extent that a man is guided by his rational judgment, he acts in accordance with the requirements of his nature and, to that extent, succeeds in achieving a human form of survival and well-being; to the extent that he acts irrationally, he acts as his own destroyer.” -- Ayn Rand, "What Is Capitalism?” Capitalism: The Unknown Ideal

Short selling: Selling a stock or other asset at a high price and buying it back later at a lower price – It is the logical equivalent of buying low and selling high, but many investors don’t attempt it Transparency: In general, the opposite of opacity – In this context, transparency means a relatively low degree of asymmetric information 4. Evidence of Market Efficiency Behavioral Finance