Chapter 14:Learning Objectives

Basics of Stock MarketsExplaining Stock Price Behaviour:

Efficient Markets & Fundamentalists Stock Market VolatilityThe Home-bias in Stock Purchases International Stock Price Linkages

Some Institutional BackgroundSome Institutional Background

Stocks are traded in marketsOTC (over the counter)Exchanges (TSE, CDNX)

Stock performance is measured via indexesTSE300, DJIA, S&P 500

6000

6200

6400

6600

6800

7000

7200

7400

99:01 99:03 99:05 99:07 99:09

TS

E3

00

In

de

x

High-Low and Close in Stock Price Movements

High

Close

Low

Theories of Stock Price DeterminationTheories of Stock Price Determination

Efficient Markets hypothesisweak formsemi-strong formstrong form

Efficient Markets Hypothesis:Weak formEfficient Markets Hypothesis:Weak form

Investors have an “information” set on which “expectations” of future stock prices are formed

E(St+1| St, St-1,…)=St

If the past history of stock prices is known then

E(St+1) = St so that St+1=St+Ut giving rise to the randomwalk of stock prices

The Random Walk of Stock PricesThe Random Walk of Stock Prices

0

1000

2000

3000

4000

5000

6000

7000

8000

1980 1985 1990 1995

TS

E300 (1

975=100)

Year

The Random Walk of Stock PricesThe Random Walk of Stock Prices

-.3

-.2

-.1

.0

.1

.2

1980 1985 1990 1995

Year

Rate

of c

hange in

the T

SE300

Efficient Markets Hypothesis (cont’d) 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, 1976-2002 TSE 300 and the Treasury bill Rate, 1976-2002

0

2000

4000

6000

8000

0 5 10 15 20 25

Treasury bill rate (%)

TS

E 3

00 index (

1975=

100)

Interest Rates and Stock PricesInterest Rates and Stock Prices

Stock Price

RR

LF

LF 2

LF0

LF1 LFs

R S

A Different but Compatible View:The Fundamentalist ApproachA 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 ApproachThe Mathematics of the Fundamentalist Approach

S = [d1/(1+R)] + [d2/(1+R)2] +…..

dn= d1(1+g)n-1

S= d1/(R-g)

Anomalies and Other features of stock price behaviour

Anomalies and Other features of stock price behaviour

Volatility and its MeasurementFigure 14.4

Price-Earnings Ratio January & other calendar effectsBubbles (South Sea, Mississippi,

Tulipmania) International Linkages

What Causes “Noise” in Stock MarketsWhat Causes “Noise” in Stock Markets

Case 1: Market dominatedby Informed Traders

Case 2: Market dominated byUninformed traders

LOW VOLATILITY

HIGH VOLATILITY

InformedTraders

Inf.Traders

NoisyTraders

Noisy Traders

Stock Market VolumeStock Market Volume

0

1000

2000

3000

4000

5000

6000

1976 1980 1984 1988 1992 1996 2000

Vol

ume

of s

hare

s (m

illio

ns)

International Stock Price BehaviourInternational Stock Price Behaviour

0

40

80

120

160

200

240

1970 1975 1980 1985 1990 1995

CANADA GERMANY JAPAN USA UK

Indust

rial S

tock

Index

(1995=100)

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

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

April 1987 September 1987

T-bill=8.08% T-bill=9.35%

TSE300=3902.37 TSE300=2978.323.7%

Dividend=$10.00 g=4%Before S=10/ (8.08-4)=$245.10 After S=10/ (9.35-4)=$186.92

S=23.7%

SummarySummary

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