RISK AND VALUE OF STOCKS:The Theory of Efficient Markets

<< VALUING STOCKS:Fundamental Value and the Dividend-Discount Model

ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings >>

Money & Banking MGT411

Lesson 20

RISK AND VALUE OF STOCKS

Stocks

Risk and the Value of Stocks

Theory of Efficient Markets

Investing in Stocks for Long Run

Stock Markets' Role in the Economy

Financial Intermediation

Role of Financial Intermediaries

Risk and value of stocks

The dividend-discount model must be adjusted to include compensation for a stock's risk

Return to Holding Stock for One Year =

- Ptoday

D next

P next

_ year

Ptoday

Since the ultimate future sale price is unknown the stock is risky,

The investor will require compensation in the form of a risk premium

Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp)

The risk-free rate can be thought of as the interest rate on a treasury security with a maturity of

several months

Our dividend discount model becomes:

D today

P today

rf + rp - g

Risk and value of stocks

Stock Prices are high when

Current dividends are high (Dtoday is high)

Dividends are expected to grow quickly (g is high)

The risk-free rate is low (rf is low)

The risk premium on equity is low (rp is low)

The S&P 500 index finished the year 2003 at just over 1,100. was this level warranted by

fundamentals?

Risk free real interest rate is about 2% or rf = 0.02

Risk premium is assumed to be 4% or rp = 0.04

Dividend growth rate is around 2% or g = 0.02

The owner of a $1,000 portfolio would have received $30 in dividends during 2003

Substituting the information in our adjusted dividend discount model:

$30

Ptoday =

= $750

0.02 + 0.04 - 0.02

But the actual stock prices were substantially higher than this calculated figure

This may be due to wrong assumption on risk premium. The investors may have been

demanding lower risk premium in 2003.

To compute it, we use the same equation

Money & Banking MGT411

$30

1,10 =

- 0.02

(0.02+rp)

The answer is approximately 2.75%

The Theory of Efficient Markets

The basis for the theory of efficient markets is the notion that the prices of all financial

instruments, including stocks, reflect all available information

As a result, markets adjust immediately and continuously to changes in fundamental values

When markets are efficient, the prices at which stocks currently trade reflect all available

information, so that future price movements are unpredictable.

If the theory is correct then no one can consistently beat the market average; active portfolio

management will not yield a return that is higher than that of a broad stock-market index

If managers claim to exceed the market average year after year, it may be because

They must be taking on risk,

They are lucky,

They have private information (which is illegal), or

Markets are not efficient

Investing in Stocks for the Long Run

Stocks appear to be risky, and yet many people hold substantial proportions of their wealth in

the form of stock

This is due to the difference between the short term and the long term;

Investing in stocks is risky only if you hold them for a short time

In fact, when held for the long term, stocks are less risky than bonds.

Figure: S&P 1-Year Stock Returns, 1871 to 2003(Returns are Real, Adjusted for Inflation using

the CPI)

-20

-40

-60

1895 1907

1919

1931 1943 1955

1871

1967

1883

197

1991

200

Years

Money & Banking MGT411

Figure: S&P Long-Run Stock Returns, 1871 to 2003(Returns are Real, adjusted for inflation

using the CPI)

-20

-40

-60

1895 1907

1919

1931 1943 1955

1871 11883

1967

197

1991

200

____1-Year Returns

____25 year Returns

The Stock Market's Role in the Economy

The stock market plays a crucial role in every modern capitalist economy.

The prices determined there tell us the market value of companies, which determines the

allocation of resources.

Firms with a high stock market value are the ones investors' prize, so they have an easier time

garnering the resources they need to grow.

In contrast, firms whose stock value is low have difficulty financing their operations

So long as stock prices accurately reflect fundamental values, this resource allocation

mechanism works well.

At times, however, stock prices deviate significantly from the fundamentals and prices move in

ways that are difficult to attribute to changes in the real interest rate, the risk premium, or the

growth rate of future dividends.

The Stock Market's Role in the Economy

Shifts in investor psychology may distort prices; both euphoria and depression are contagious

When investors become unjustifiably exuberant about the market's future prospects, prices rise

regardless of the fundamentals, and such mass enthusiasm creates bubbles.

Bubbles

Bubbles are persistent and expanding gaps between actual stock prices and those warranted by

the fundamentals.

These bubbles inevitably burst, creating crashes.

They affect all of us because they distort the economic decisions companies and consumers

make

If bubbles result in real investment that is both excessive and inefficiently distributed, crashes

do the opposite; the shift to excessive pessimism causes a collapse in investment and economic

growth

When bubbles grow large enough and result in crashes the stock market can destabilize the real

economy

Financial Intermediation

Economic well-being is essentially tied to the health of the financial intermediaries that make up

the financial system.

Money & Banking MGT411

We know that financial intermediaries are the businesses whose assets and liabilities are

primarily financial instruments.

Various sorts of banks, brokerage firms, investment companies, insurance companies, and

pension funds all fall into this category.

These are the institutions that pool funds from people and firms who save and lend them to

people and firms who need to borrow

Financial intermediaries funnel savers' surplus resources into home mortgages, business loans,

and investments.

They are involved in both

Direct finance--in which borrowers sell securities directly to lenders in the financial markets

Indirect finance--in which a third party stands between those who provide funds and those who

use them

Intermediaries investigate the financial condition of the individuals and firms who want

financing to figure out which have the best investment opportunities.

As providers of indirect finance, banks want to make loans only to the highest-quality

borrowers.

When they do their job correctly, financial intermediaries increase investment and economic

growth at the same time that they reduce investment risk and economic volatility

Role of Financial Intermediaries

As a general rule, indirect finance through financial intermediaries is much more important than

direct finance through the stock and bond markets

In virtually every country for which we have comprehensive data, credit extended by financial

intermediaries is larger as a percentage of GDP than stocks and bonds combined

Around the world, firms and individuals draw their financing primarily from banks and other

financial intermediaries

The reason for this is information;

Just think of an online store

You can buy virtually EVERYTHING from $5 dinner plates to $300,000 sports car

But you will notice an absence of financial products, like student loans, car loans, credit cards

or home mortgages

You can not bonds on which issuer is still making payments, nor can you have the services of

checking account.

Why such online store does not deal in mortgages?

Suppose a company needs a mortgage of $100,000 and the store can (if at all) establish a system

in which 100 people sign up to lend $1,000 each to the company

But the store has to do more

Collecting the payments

Figuring out how to repay the lenders

Writing legal contracts

Evaluating the creditworthiness of the company and feasibility of the mortgaged project

Can it do it all?

Financial intermediaries exist so that individual lenders don't have to worry about getting

answers to all of the important questions concerning a loan and a borrower

Lending and borrowing involve transactions costs and information costs, and financial

intermediaries exist to reduce these costs

Financial intermediaries perform five functions:

1. They pool the resources of small savers;

2. They provide safekeeping and accounting services as well as access to the payments

system;

3. They supply liquidity;

4. They provide ways to diversify risk; and

5. They collect and process information in ways that reduce information costs

Table of Contents: