Chapter 14: Learning Objectives  Basics of Stock Markets  Explaining Stock Price Behaviour: Efficient Markets & Fundamentalists  Stock Market Volatility  The Home-bias in Stock Purchases  International Stock Price Linkages

Some Institutional Background  Stocks are traded in markets OTC (over the counter) Exchanges (TSE, CDNX)  Stock performance is measured via indexes TSE300, DJIA, S&P 500

Theories of Stock Price Determination  Efficient Markets hypothesis weak form semi-strong form strong form

Efficient Markets Hypothesis: Weak form Investors have an “information” set on which “expectations” of future stock prices are formed E(S t+1 | S t, S t-1,…)=S t If the past history of stock prices is known then E(S t+1 ) = S t so that S t+1 =S t +U t giving rise to the random walk of stock prices

The Random Walk of Stock Prices

Efficient Markets Hypothesis (cont’d)  Semi-strong form expands the Information set to include other fundamental macroeconomic variables such as interest rates, inflation, money growth,….)  The strong form would incorporate private or insider information. This would most severely limit the profitable opportunities from changes in stock price behaviour

TSE 300 and the Treasury bill Rate,

Interest Rates and Stock Prices Stock Price RR LF LF 2 LF0 LF1 LF s R  S 

A Different but Compatible View: The Fundamentalist Approach  Stock prices should reflect expectations about the flow of future dividends  Assume that dividends reflect profits of the firm  Assume a constant opportunity cost of holding money  Assume a constant growth rate of dividends  Assume that dividends paid out forever

The Mathematics of the Fundamentalist Approach S = [d 1 /(1+R)] + [d 2 /(1+R )2 ] +….. d n = d 1 (1+g) n-1 S= d 1 /(R-g)

Anomalies and Other features of stock price behaviour  Volatility and its Measurement Figure 14.4  Price-Earnings Ratio  January & other calendar effects  Bubbles (South Sea, Mississippi, Tulipmania )  International Linkages

What Causes “Noise” in Stock Markets Case 1: Market dominated by Informed Traders Case 2: Market dominated by Uninformed traders  LOW VOLATILITY  HIGH VOLATILITY Informed Traders Inf. Traders Noisy Traders Noisy Traders

Stock Market Volume

International Stock Price Behaviour

The “Crash” of 1987: An Illustration of the Fundamentalist Approach from Financial Focus 14.2

Summary  Stock market behaviour is governed by the efficient markets hypothesis which comes in the weak, semi- strong and strong forms  The Fundamentalist approach explains the determination of stock prices according to the flow of dividends generated by a stock  Stock price behaviour is also subject to a number of anomalies and there are a number of other interesting aspects about stock prices