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Financial Markets and Institutions (Mishkin, Eakins) (ch.

6-7-8)

Financial Markets and Institutions (Libera Università Internazionale degli Studi Sociali

Guido Carli)

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Financial Markets and Institutions (Mishkin, Eakins) (ch.

6-7-8)

Financial Markets and Institutions (Libera Università Internazionale degli Studi Sociali

Guido Carli)

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CH. 6: Are Financial Markets Eicient?

Eicient market hypothesis: prices of market securiies relect all available informaion.

Is this always true? Are markets really eicient?

Analyse real-life data.

EMH:

Re=Pt+1

e−Pt+C

To analyse the EMH we use the concept of arbitrage, i.e. market paricipants eliminate the unexploited

proit opportuniies (returns that are unjusiied by the nature of the security), so there is no unjusiied

return; two types:

1. Pure arbitrage: eliminaion of unexploited proit involves no risk

2. : risk atached, i.e. there’s some unpredictability in the investment.

In fact,

– Scenario 1: knowing that

Rof >R¿

(i.e. opimal forecast > equilibrium):

Demand increases  current Price increases  returns decrease  unexploited proit disappears!!

– Scenario 2: knowing that

Rof <R¿

(i.e. opimal forecast < equilibrium):

Demand decreases  current price decreases  returns increase  no unexploited proit!!

So, since inancial markets allow to many paricipants to join, not everybody must be well informed for the

mkt to work eiciently (awareness of “smart money” is suicient)!

EMH gives a strong message: all prices are correct and relect market fundamentals (i.e. all factors with

direct impact over future income stream of the securiies).

Implicaions:

1. Prices are correct  all investments are equally good

2. All informaion about intrinsic value is relected in the price

3. Security prices can be used to correctly assess the validity of an investment (and its cost of

capital)

Is EMH credible?

Evidence in favour:

(given the “random walk”: tomorrow’s price will be like today’s + an element of uncertainty)

– It is impossible for assets to outperform the market; also, recommendaions by analysts may be

wrong, because of the uncertainty that dictate the trends;

– Stock prices, on average, relect all publicly available informaion (announcements do not cause

raises in prices in real life, because it is implied that the news was already public)

– Random-walk assumpion (which is equivalent to the EMH)

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There exist two types of test to assess the correctness of this assumpion:

1. Examine stock market records: are past changes useful for making predicions?  technical

analysis tries to idenify trends and cycles through the analysis of past data; there is strong

evidence of the incompaibility of this method with the EMH, meaning it is not (always)

successful.

2. Are available data (apart from past records) useful for predicing changes?

Evidence against:

–small-irm efect: anomaly in the returns of small-irms’ stock, which appear to be abnormally high;

this may be due to the low liquidity of this stock, inappropriate measurement of risk etc.

–January efect: abnormal returns on stocks in the beginning of the year because investors, who are

willing to reduce their tax liabiliies, will sell their stocks in December and repurchase them in

January. Thus, the increase in supply will drive prices down, increasing returns; the repurchases will

be done at lower prices, which will later normalize.

–Market overreacion: market may overreact to big announcements and stocks may normalize only

ater a while; in the meanime, buying and selling aciviies may indeed lead to leverage.

–Excessive volaility: stocks could be subject to unexplainably high luctuaions, because they may

be driven by factors that are not the fundamentals

–Mean reversion: stock returns display mean reversion, meaning that small returns now will

probably lead to higher returns tomorrow. This phenomenon, although controversial, sill violates

the idea of random-walk behaviour.

–Slow incorporaion of informaion: stocks do not immediately adjust to announcements, resuling

in some variaions even in the period ater that.

We can conclude markets are not eicient. So… how to study the behaviour of securiies (price/rate)?

 behavioural inance, which applies concepts from anthropology, psychology etc. to inancial mkt;

Psychology plays an important role:

– “smart money”, who have the power of making markets eicient, are humans and subject to risk

aversion  all those short-term transacions, that could potenially ix prices to levels that are

jusiied by the fundamentals, do not take place under the uncertainty of proit.

–Overconidence in their beliefs lead investors to make a large number of investments that jusify

the trading volume.

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CH. 7: Why Do Financial Insituions Exist?

Facts about inancial markets:

As sources of external inancing in the US, in order of importance we ind:

Loans (from banks and others) > bonds (32%) > stocks (11%)

This is quite surprising since a lot of focus is put on the stock market (and on marketable securiies,

i.e. bonds + stock); most of the inancing is indirect (inancial intermediaries).

Financial system is very strictly regulated; governments intervene to promote the provision of

informaion and the soundness of the system as a whole.

Only large, well-established corporaions have access to the securiies market to inance their

aciviies.

Debt contracts are very complicated documents, both in the case of businesses and of privates:

Restricive covenants: they are provisions present in the contract to impose some rules to

the borrower and restrict the aciviies he can engage in;

Collateral: property that is pledged to the lender in case the borrower is not able to repay

his debt  secured vs. unsecured debt

Financial Intermediaries: the advantages

They allow private (small) savers to take part to the inancial markets by reducing the transacion

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