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
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 7400
High-Low and Close in Stock Price Movements

7200 High

7000

T SE3 00 Index
Close
6800
Low
6600

6400

6200

6000
99:01 99:03 99:05 99:07 99:09
Theories of Stock Price Determination

 Efficient Markets hypothesis

 weak form
 semi-strong form
 strong form
Efficient Markets Hypothesis:
Weak form

Investors have an “information” set on which

“expectations” of future stock prices are formed

E(St+1| St, St-1,…)=St

If the past history of stock prices is known then

E(St+1) = St so that St+1=St+Ut giving rise to the random

walk of stock prices
The Random Walk of Stock Prices

8000

7000

6000
TSE300 (1975=100)

5000

4000

3000

2000

1000

0
1980 1985 1990 1995

Year
The Random Walk of Stock Prices

.2
Rate of change in the TSE300

.1

.0

-.1

-.2

-.3
1980 1985 1990 1995

Year
Efficient Markets Hypothesis (cont’d)

 Semi-strong form expands the Information

set to include other fundamental
macroeconomic variables such as interest
rates, inflation, money growth,….)
 The strong form would incorporate private or
insider information. This would most severely
limit the profitable opportunities from
changes in stock price behaviour
TSE 300 and the Treasury bill Rate, 1976-2002
T S E 3 0 0 in d e x ( 1 9 7 5 = 1 0 0 ) 8000

6000

4000

2000

0
0 5 10 15 20 25

Treasury bill rate (%)

Interest Rates and Stock Prices

R R

LF1 LFs

R S

LF0
LF 2
Stock Price
LF
A Different but Compatible View:
The Fundamentalist Approach

 Stock prices should reflect expectations about

the flow of future dividends
 Assume that dividends reflect profits of the
firm
 Assume a constant opportunity cost of
holding money
 Assume a constant growth rate of dividends
 Assume that dividends paid out forever
The Mathematics of the Fundamentalist
Approach

S = [d1/(1+R)] + [d2/(1+R)2] +…..

dn= d1(1+g)n-1

S= d1/(R-g)
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)
 International Linkages
What Causes “Noise” in Stock Markets

Case 1: Market dominated

by Informed Traders Noisy
Traders
 LOW VOLATILITY
Inf.
Noisy Traders Traders

Informed
Case 2: Market dominated by
Traders Uninformed traders

HIGH VOLATILITY
Stock Market Volume

6000

5000
Volume of shares (millions)

4000

3000

2000

1000

0
1976 1980 1984 1988 1992 1996 2000
International Stock Price Behaviour

240
Industrial Stock Index (1995=100)

200

160

120

80

40

0
1970 1975 1980 1985 1990 1995

CANADA GERMANY JAPAN USA UK

The “Crash” of 1987: An Illustration of the
Fundamentalist Approach
from Financial Focus 14.2

April 1987 September 1987

T-bill= 8.08% T-bill= 9.35%
TSE300=3902.37 TSE300=2978.323.7%
Dividend= $10.00 g= 4%
Before S= 10/ (8.08-4)= $245.10 A fter S= 10/ (9.35-4)= $186.92

S= 23.7%
Summary

 Stock market behaviour is governed by the

efficient markets hypothesis which comes
in the weak, semi-strong and strong forms
 The Fundamentalist approach explains the
determination of stock prices according to the
flow of dividends generated by a stock
 Stock price behaviour is also subject to a
number of anomalies and there are a number
of other interesting aspects about stock prices