Chapter 6
Are Financial Markets Efficient?
The Efficient Market Hypothesis Rationale Behind the Hypothesis Stronger Version of Efficient Markets Theory Evidence on the Efficient Market Hypothesis Evidence in Favor of Market Efficiency Mini-Case Box: An Exception That Proves the Rule: Ivan Boesky Case: Should Foreign Exchange Rates Follow a Random Walk? Evidence Against Market Efficiency Overview of the Evidence on Efficient Markets Theory The Practicing Manager: Practical Guide to Investing in the Stock Market How Valuable are Published Reports by Investment Advisors? Mini-Case Box: Should You Hire and Ape as Your Investment Adviser? Should You Be Skeptical of Hot Tips? Do Stock Prices Always Rise When There is Good News? Efficient Markets Prescription for the Investor Case: What Does the Stock Market Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis? Behavioral Finance
Overview and Teaching Tips
To fully understand how asset prices are determined, students need to be exposed to efficient markets hypothesis which describes how information is reflected in the asset prices. The discussion of the evidence on the efficient markets illustrates how much controversy there is in this theory. Students also particularly enjoy the Practicing Manager application which uses efficient markets theory to provide a practical guide to investing in the stock market. This application captures the attention of even the most disinterested student because all of us are interested in how to get rich (or, at least, in how to keep from getting poor). This application also gives students practice using the reasoning that they learned earlier in the chapter. In addition, the theory is confronted with evidence that shows the student important implications for the real world.
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Mishkin/Eakins Financial Markets and Institutions, Sixth Edition
Answers to End-of-Chapters Questions
1. False. Expectations can be highly inaccurate and still be rational because optimal forecasts are not necessarily accurate: A forecast is optimal if it is the best possible even if the forecast errors are large. 2. Although Joes expectations are typically quite accurate, they could still be improved by his taking account of a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations. 3. No, because he could improve the accuracy of his forecasts by predicting that tomorrows interest rates will be identical to todays. His forecasts are therefore not optimal, and he does not have rational expectations. 4. True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable, however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist. 5. No, you shouldnt buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices. Hence you cannot expect to earn more than the equilibrium return on stocks by acting on the money supply information. 6. No, because this is publicly available information and is already reflected in stock prices. The optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from selling your stocks. 7. Probably not. Although your broker has done well in the past, efficient markets theory suggests that she has probably been lucky. Unless you believe that your broker has better information than the rest of the market, efficient markets theory indicates that you cannot expect the broker to beat the market in the future. 8. No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on IBM stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the persons expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market. 9. False. All that is required for the market to be efficient so that prices reflect information on the monetary aggregates is that some market participants eliminate unexploited profit opportunities. Not everyone in a market has to be knowledgeable for the market to be efficient. 10. False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information. 11. Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and as we learned in Chapter 7, long-term interest rates would fall. The decline in long-term interest rates implies that long-term bond prices would rise.
Chapter 6
Are Financial Markets Efficient?
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12. True in principle. Foreign exchange rates are a random walk over a short interval such as a week because changes in the exchange rate are unpredictable. If a change were predictable, large unexploited profit opportunities would exist in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist and so the foreign exchange rate will approximately follow a random walk. 13. No, because this expected change in the value of the dollar would imply that there is a huge unexploited profit opportunity (over a 100% expected return at an annual rate). Since rational expectations rules out unexploited profit opportunities, such a big expected change in the exchange rate could not exist. 14. False. Although human fear may be the source of stock market crashes, that does not imply that there are unexploited profit opportunities in the market. Nothing in rational expectations theory rules out large changes in stock prices as a result of fears on the part of the investing public.
Quantitative Problems
1. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding. Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split? If the actual market price immediately following the split is $17.00/share, what does this tell us about market efficiency? Solution: Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split conveys no new information, the market value of the company does not change, remaining at $5 billion. But, with the split, every share becomes three shares, so 300 million shares are outstanding. The new price/share is $5 billion/300 million, or $16.67/share. If the actual price is $17.00/share, the price appears too high. This can be viewed two ways. One possibility is that markets are inefficientsome type of anomaly has occurred, and its not clear if the market will correct itself. Another possibility is that the stock split actually conveyed information about the company. Investors may believe (possibly incorrectly) that the price/share is expected to increase significantly, and that why the firm implemented the stock split. 2. If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced? Solution: The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.
