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Chapter 14:Learning Objectives

Basics of Stock Markets

Explaining Stock Price Behaviour:

Efficient Markets & Fundamentalists

Stock Market Volatility

The Home-bias in Stock Purchases

International Stock Price Linkages

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Some Institutional Background

Stocks are traded in markets

OTC (over the counter)

Exchanges (TSE, CDNX)

Stock performance is measured via indexes

TSE300, DJIA, S&P 500

6000

6200

6400

6600

6800

7000

7200

7400

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

TSE300

Index

High-Low and Close in Stock Price Movements

High

Close

Low

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Theories of Stock Price Determination

Efficient Markets hypothesis

weak form

semi-strong form strong form

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The Random Walk of Stock Prices

0

1000

2000

3000

4000

5000

6000

7000

8000

1980 1985 1990 1995

TSE300(1975

100)

Year

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The Random Walk of Stock Prices

-.3

-.2

-.1

.0

.1

.2

1980 1985 1990 1995

Year

Rate

ofchangeintheTSE300

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Efficient Markets Hypothesis (contd)

Semi-strong form expands the Informationsetto include other fundamentalmacroeconomic variables such as interest

rates, inflation, money growth,.) The strong form would incorporate private or

insider information. This would most severelylimit the profitable opportunities from

changes in stock price behaviour

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TSE 300 and the Treasury bill Rate, 1976-2002

0

2000

4000

6000

8000

0 5 10 15 20 25

Tr sury bill r t (%)

T

00i

(19

75=100)

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Interest Rates and Stock Prices

St ck ricF

F 2

LF0

LF1 LFs

R S

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A Different but Compatible View:

The Fundamentalist Approach

Stock prices should reflect expectations aboutthe flow of future dividends

Assume that dividends reflect profits of thefirm

Assume a constant opportunity cost ofholding money

Assume a constant growth rate of dividends

Assume that dividends paid out forever

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The Mathematics of the Fundamentalist

Approach

S= [ 1

/(

1+ )] + [ 2

/(

1+

)2

] +..

= 1(1+ )-1

S= 1/( - )

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Anomalies and Other features of

stock price behaviour

Volatility and its Measurement

Figure 14.4

Price-Earnings Ratio January & other calendar effects

Bubbles (South Sea, Mississippi, Tulipmania)

I

nternational Linkages

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What Causes Noise in Stock Markets

Cas 1: ark t i at

by I f r Tr aders

Case2: arket domi ated by

U i formed traders

LOW VOLATILITY

HIGH VOLATILITY

InformedTraders

Inf.

Traders

Noisy

Traders

Noisy Traders

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Stock Market Volume

0

1000

2000

3000

4000

5000

6000

1976 1980 1984 1988 1992 1996 2000

Volumeofs

ares(millions)

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International Stock Price Behaviour

0

40

80

120

160

200

240

1970 1975 1980 1985 1990 1995

C AN AD A G E R MAN Y JAP AN S A K

In

d

strialStockIndex(1

995

100)

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The Crash of 1987: An Illustration of the

FundamentalistApproach

from Financial Focus 14.2

April 1987 September 1987

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

TSE300=3902.37 TSE300=2978.323.7%

D ividend=$10.00 g=4%

BeforeS=10/(8.08-4)=$245.10 AfterS=10/(9.35-4)=$186.92

(S=23.7%

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Summary

Stock market behaviour is governed by theefficient markets hypothesis which comesin the weak, semi-strong and strong forms

The Fundamentalist approach explains thedetermination of stock prices according to theflow of dividends generated by a stock

Stock price behaviour is also subject to a

number of anomalies and there are a numberof other interesting aspects about stock prices