Ec 1723 Section Notes

October 20, 2011

Review (Last Week)

Market Eciency a.k.a. Informational Eciency
General idea: in an ecient market, asset prices properly incorporate relevant information. Loosely speaking, we can think of this as price = fundamental value There are three important types market eciency that rely on different notions of relevant information Weak-form eciency (past trading information) Semi-strong form eciency (all publicly available information) Strong-form eciency (all information) Testing market eciencyreturns Unpredictable risk-adjusted returns imply market eciency (i.e., efciency in prices) Joint-hypothesis problem: abnormal risk-adjusted returns could either indicate market ineciency, or improper risk-adjustment Even if risk-adjusted returns are almost unpredictable, this need not imply that prices are anywhere close to fundamental value (Shiller) Strong-form market eciency is theoretically implausible Grossman-Stiglitz paradox: if prices revealed all information, then there would be no incentive for anybody to gather information. If nobody is gathering information, where does the information supposedly revealed from the market come from? Resolution to G-S paradox: prices only partially reveal private information, so private information delivers abnormal returns that cover the marginal cost of gathering that information Nonetheless, event studies that measure how prices react to new information suggest that prices generally incorporate new information fairly rapidly 1

Prices and Returns

The price of an asset can be dened as the sum of its discounted future cash-ows, for some choice of risk-adjusted, possibly time-varying, discount rate Baseline super-simple case: consider an innitely lived asset that pays a constant dividend D in each period, and suppose that there is a constant gross discount rate of 1 + R. Pt P0 1 (D + Pt+1 ) 1+R 2 3 1 1 1 = D+ D+ D + ... 1+R 1+R 1+R 1 t = D 1+R t=1 t 1 = D 1+R t=1 = = D R

If we maintain the constant gross return 1 + R from the super-simple baseline case, but now allow the dividend to vary over time (denote the dividend at date t by Dt ), similar calculations to those above yield the Dividend Discount Model (DDM): Pt P0 1 Et [Dt+1 + Pt+1 ] 1+R 2 3 1 1 1 = E0 D1 + D2 + D3 + ... 1+R 1+R 1+R t 1 = E0 Dt 1+R t=1 1 t = E0 [Dt ] 1+R t=1 =

Now, still holding the return constant, suppose that dividends are expected i to grow at the constant rate G, so that Et [Dt+1+i ] = (1 + G) Et [Dt+1 ]. Then, by the now-familiar calculations, we get the Gordon Growth Model: 2 3 1 1 1 P0 = E0 D1 + D2 + D3 + ... 1+R 1+R 1+R t 1 = E0 Dt 1+R t=1 2

= =

t 1 t1 (1 + G) E0 [D1 ] 1+R t=1 t1 1 1 t1 = (1 + G) E0 [D1 ] 1 + R t=1 1 + R s 1 1+G E0 [D1 ] = 1 + R s=0 1 + R s 1 1+G = E0 [D1 ] 1 + R s=0 1 + R = E0 [D1 ] RG

t=1

1 1+R

E0 [Dt ]

A mathematical result known as Jensens inequality implies that if G is a random variable, then 1 1 E > RG R E [G] Uncertainty about growth rates has been proposed as a possible explanation for the high prices of tech stocks in the 1990s (personally, I take a very dim view of this explanation, but you should be aware of it for exam purposes)

New Material (This Week)

Earnings, Investment, Dividends, and Growth
We want to characterize the growth rate in the Gordon model in terms of more fundamental quantities. Roughly speaking, growth comes from investment, so G depends on 1) the amount of money a rm invests, and 2) how much the rm earns on those investments. Assume that dividends (D) are a constant fraction of earnings (E): D = (1 B) E The quantity B is known as the plowback or retention rate; it is the fraction of earnings that the rm retains and reinvests We can write the growth rate of earnings as G = B ROE, where ROE denotes return on equitythe rate of return that the rm earns on money that it invests.

If dividends are constant (say D), and the discount rate is R, then the Gordon growth model gives the price of the rm as P = D RG

We can use the formulas above to replace D and G in this equation, to obtain P P E (1 B) E R B ROE 1B = R B ROE E = (1 B) + B ROE P =

or R

The last line means that the rate of return, R, is a weighted average of a rms earnings yield and investment protability. Basically, we expect this relationship to hold because prot-maximizing rms will allocate their earnings to the best available investment prospects, and therefore increase B up to the point where ROE = R.

Short-Selling Constraints, Belief Dierences, and Overvaluation

Suppose that dierent investors have dierent beliefs about the true value of some asset In general, heterogeneous beliefs need not cause the market-clearing price of an asset to diverge from the average believed value Investors who believe that the true value is greater than the current price optimistswill want to buy the asset Investors who believe that the true value is less than the current price pessimistswill want to sell the asset The pessimists will typically sell to the optimists, both types of investors will be happy, but the price need not change. Intuitively, the market-clearing price reects the beliefs of both types of investors If short-sales are prohibited, then only the beliefs of investors who want to buy the asset (i.e., optimists) are reected in the market-clearing price The countervailing inuence of the pessimists beliefs are not incorporated into prices More generally, we can think of the market-clearing price of an asset as a weighted average of the beliefs of the investors who trade it, where the weights correspond to the relative amounts of money that the dierent investors invest 4

 In this context, a prohibition on short-selling is analogous assigning a weight of zero to the beliefs of pessimists This context also illustrates why the overvaluation eect can be exacerbated by leverage: when leverage is available, the most optimistic investors will borrow in order to buy the asset, so the market-clearing price will weight more heavily the beliefs of the most optimistic investors.

Fixed Income
Yield to Maturity (YTM) YTM is just a convenient mechanism for thinking about bond prices. YTM on a bond is dened as the discount rate which equates the present value of the bonds payments to its price For an mperiod zero-coupon bond with date-t price Pmt , the YTM (call it Ymt ) is dened as the solution to m 1 Pmt = 1 + Ymt In logarithms, dening pmt := log (Pmt ) and ymt := log (1 + Ymt ), the equation above becomes pmt = mymt Note that YTM and price are inversely related to one another! Holding period return: the return on a bond held for one year Suppose we buy an m-period bond today, and sell it next period (when its maturity is m 1). The holding period return is 1 + Rm,t+1 = Pm1,t+1 Pmt

Comparing the YTM of two bonds of dierent maturities isnt meaningful, but comparing their holding period returns is meaningful An important special case: perpetuities A perpetuity is a coupon bond with an innite maturity The yield on a perpetuity with price P and coupon C is Y =
C P

cf. Gordon growth model, or equivalently, the sum of an innite geometric series

Duration Duration is a weighted average of the times at which a bond produces payments The time at which a payment occurs is weighted by the fraction of the bonds present value that the payment represents Duration allows us to characterize the sensitivity of the price of a coupon bond to changes in interest rates. Modied duration, D := Duration , is commonly used by practition1+Y ers. It measures the proportional change in price caused by a given small change in YTM Modied duration is only a linear approximation to price-sensitivity Convexity is a measure of the curvature (i.e., non-linearity) of bond price sensitivity