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CHAPTER 9
Market Efficiency
Learning Objectives
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How all prices of financial instruments are related
How expectations are formed
The difference between rational expectations and adaptive expectations
What the efficient market hypothesis is and how it relates all financial prices
How the sources and uses of funds can integrate financial flows between sectors
Chapter Outline
I.
II.
Stocks Rise 32 Percent While Bonds Fall 10 Percent: Can These Price Movements Be Explained?
How Expected Rates of Return Affect the Prices of Stocks and Bonds
A.
Stocks
B.
Bonds
C.
The Formation of Price Expectations
D.
The Efficient Markets Hypothesis: Rational Expectations Applied to Financial
Markets
E.
The Flow of Funds among Sectors
F.
Pulling it All Together
Answers to Review Questions
Explain why stock and bond prices adjust until investors are
indifferent between stocks and bonds, given varying degrees of
risk and liquidity.
A portfolio generally contains both stocks and bonds. In deciding whether to hold stocks or
bonds, investors compare the expected rates of return on the different types of financial assets,
selecting those with the highest expected return consistent with the risk and liquidity the
investor prefers. The expected return on holding stock is any dividends plus capital gain that
the stock would pay over the holding period. The return on bonds is the coupon rate plus the
expected change in the bond prices over the holding period. If the risk adjusted return on
stocks is greater than the risk adjusted return on bonds, then investo rs will purchase stocks,
driving their prices up and their return down. Likewise, investors will sell bonds, their prices
will fall, and their yield increase. Because of the drive to purchase assets with a higher risk
adjusted return, adjustment would continue until the risk-adjusted return between stocks and
bonds are equalized. In this case, since they pay the same risk adjusted return, the investor is
indifferent between purchasing stocks or bonds.
When full adjustment has occurred, what do differences in returns
on various financial instruments reflect?
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If financial instruments such as stocks and bonds have differences in risk adjusted rates of
return, then investors will purchase those instruments with the highest risk adjusted returns and
sell those with the lower risk adjusted rates of return. This buying and selling in turn causes
financial prices to adjust. When full adjustment has occurred, differences in after -tax returns
on various financial instruments reflect varying degrees of risk and liquidity.
If current and expected earnings rise, what happens to stock
prices?
A growing economy means that sales, production, and incomes increase. As these factors
increase, current and expected earning rise. In general, as current and expected earn ings rise,
stock prices also rise.
Interest rates are going up.
previously issued bonds?
What happens to the prices of
There is an inverse relationship between bond prices and interest rates. Therefore, when
interest rates rise, the prices of previously issued bonds fall.
How do adaptive expectations differ from rational expectations?
Adaptive expectations are expectations formed by looking back at past values of a variable. In
general, more recent past values are given greater weight. Rational expect ations are
expectations formed by looking at the past as well as all additional available information such
as information about expected changes in national income and costs. Rational expectations is
looking both backward and forward.
Why is the actual value of a financial variable different from
the optimal forecast of that variable? Assuming that
expectations are rational, what on average will the difference
between the actual value and the optimal forecast be?
The actual value of a financial variable can be different from the optimal forecast of that
variable because of randomness in financial markets. If expectations are rational, the
difference between the actual value and the optimal forecast will on average be zero. In other
words, sometimes the actual value will be greater than the optimal forecast and sometimes less,
but on average, the differences will cancel each other out. In a given period, it is impossible to
know what this forecast error will be.
Actual values may also turn out to be different from the optimal forecast even when
expectations are rational if there are key additional factors that are relevant but unknown at the
time the forecast is made. This is different from the situation where market participants are
unaware of available information or where the available information is too costly to obtain. In
this case, forecasts are neither accurate or rational.
What is the efficient market hypothesis? How does it differ from
the stronger version of the hypothesis?
The optimal forecast is the best guess possible arrived at by using all of the available
information. The efficient market hypothesis is the theory that the prices of all financial
instruments reflect the optimal forecast of the financial instrument. The stronger versio n of the
hypothesis hypothesizes that the prices of all financial instruments not only reflect the optimal
forecast of the financial instrument but also the true fundamental value of the instrument.
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What is the fundamental value of a financial instrument?
The fundamental value of a financial instrument is the value that
reflects all available information that is accurate, complete,
understood by all and reflects market fundamentals. Market
fundamentals are factors that have a direct effect on future
income streams of the instruments. These factors include the
value of the assets and the expected income streams of those
assets on which the financial instruments represent claims.
What is the rationale behind the efficient market hypothesis?
The rationale behind the efficient market hypothesis is that if current prices do not fully reflect
any changes in expectations then some market participants will earn less than what they other
wise would have. Unexploited opportunities to gain by purchasing those financ ial instruments
that pay a return above equilibrium will exist. The drive for profits will insure that all
opportunities for profits are exploited and that prices of financial instruments adjust to the
equilibrium return that is the optimal forecast.
Explain why the expected return on newly issued and previously
issued bonds is the prevailing interest rate plus any expected
capital gain or loss.
The expected return on bonds is the coupon rate plus the expected percentage change in the
bond’s price over the course of the year. Newly issued and previously issued bonds are
substitutes. If interest rates change on newly issued bonds, prices of previously issued bonds
will change until returns on the newly issued and previously bonds are equalized. When
interest rates change, expected capital loses or gains change on previously issued bonds
change.
Using the flow-of-funds framework, explain why the combined
deficits of the deficit sectors must equal the combined
surpluses of the surplus sectors.
The flow of funds framework is a social accounting system that
divides the economy into a number of sectors and monitors the
financial flows of funds among sectors. The four main sectors
are the household, business, government and rest-of-the-world
sectors. Any sector is composed of both surplus spending units
(SSUs) and deficit spending units (DSUs). For any sector, the
combined surpluses of the SSUs may be greater than the combined
deficits of the DSUs. In this case, the sector would be a
surplus sector. If the combined deficits of the DSUs are greater
than the combined surpluses of the SSUs, then the sector is a
deficit sector.
For all sectors combined, borrowing (the issuance of financial claims) must be equal to lending
(the acquisition of financial assets). This is so because each financial claim, in turn, implies
the existence of a complementary financial asset. However, in each individual sector, it is
highly unlikely that the combined surpluses just equal the combined deficits. Thus, the
economy is usually composed of surplus and deficit sectors where the combined surpluses of
the surplus sectors is equal to the combined deficits of the deficit sectors for the economy as a
whole.
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Must all market participants know the optimal forecast of a
financial instrument for the price of the financial instrument
to be driven to the optimal forecast?
It is not necessary for all market participants to know the optimal forecast. All that is
necessary is for a few participants to know the optimal forecast. The few who are savvy will
keep buying and selling financial instruments as long as there are unexploited opportunities to
profit based on the optimal forecast. In this way, the price will be driven to the optimal
forecast even if all market participants do not know it.
What is a “bubble” in a financial market? Can financial prices
ever overshoot or undershoot optimal values?
A bubble is an extraordinary run-up of stock or bond prices, that
does not seem to be related to market fundamentals. Such run-ups
have occurred in Japan in the late 1980s and more recently in the
United States in the late 1990s. Prices can overshoot or
undershoot optimal values in either stock market bubbles or
crashes. It can be rational to buy a share of stock at a price
above its optimal value, if it is thought that there will be
other investors in the future who would be willing to pay
inflated prices (prices that exceed those based on market
fundamentals) for the stock. This phenomenon is sometimes called
“the greater fool” theory. Likewise, it may be rational not to
buy a stock that is trading below its optimal value if it was
believed that market psychology was such that the stock’s price
could go down further.
Other economists suspect that financial market prices may overreact before reaching
equilibrium when there is a change in either supply or demand. That is , prices may rise or fall
more than market fundamentals would justify before settling down to the price based on
fundamentals.
If the household, business, and government sectors are all
deficit sectors, what does this imply about the rest-of-theworld sector?
If the household, business, and government sectors are all deficit sectors, then the rest -of-theworld sector must be a surplus sector and the surplus must be equal to the combined deficits of
the other three sectors.
Answers to Analytical Questions
Assume the equilibrium return on a financial instrument is 10
percent and the instrument pays no dividends or interest. If
the current price is $100 and the expected future price one
Market Efficiency
year from not just increased from $110 to $120, what will
happen to the current price?
Assuming the equilibrium return does not change, the current price will increase to $109.09.
We found this by solving for the expected price one year from now by substituting into the
following formula:
R = (P t+1 - P t + D)/P t where
R = percentage return over the time period (the equilibrium return)
P t+1 = price of the stock at the end of the time period
P t = price of the stock at the beginning of the time per iod
D = dividend payments made during the time period
In this case, we know R, P t+1 , and D and can solve for P t from the following formula: (10
percent = ($120 - Pt + $0)/Pt) and 1.1 P t = $120. Therefore, P t = $109.09.
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Assume the equilibrium return on a financial instrument is 10
percent. If the current price is $100 and the instrument does
not pay interest or dividend, what is the price expected one
year from now when the market is in equilibrium? If the
equilibrium return on the instrument increases to 15 percent
because the instrument is perceived as more risky, what
happens to the current price, assuming the expected price one
year from now does not change?
We can solve for the expected price one year from now by substituting into the following
formula:
R = (P t+1 - P t + D)/P t where
R = percentage return over the time period (the equilibrium
return)
P t+1 = price of the stock at the end of the time period
P t = price of the stock at the beginning of the time period
D = dividend payments made during the time period
In this case, we know R, P t , and D. Therefore, P t+1 equals $110 (10 percent = (Pt+1 - $100 +
$0)/$100).
If R increases to 15 percent and the expected future price ($110) does not change, then the
price of the stock falls to $95.65. This was found by substituting for R a nd P t+1 in the above
equation and solving for P t (15 percent = ($110 – P t + 0)/P t : therefore, P t = $95.65.
News comes out that leaves investors to believe that there is
more risk involved with owning financial instrument A. What
will happen to its equilibrium return?
The equilibrium return on a financial instrument is based on its risk and return compared to
other financial instruments. Assuming the risk and return of other financial instruments do not
change, then the equilibrium return of owning fina ncial instrument A will increase as it
becomes more risky. Investors must be compensated with a higher return because of the
greater risk involved with holding instrument A.
Assume that in 2002 through 2005, the government and household
sectors run significant surpluses. What does this imply about
the other sectors?
The government and household sectors can run significant surpluses only if other sectors such
as the business and rest-of-the-world sectors run significant deficits, equal to the combined
surpluses of the government and household sectors.