VOLATILITY

1. VOLATILITY Chapters 4-8 Richard H. Thaler Advances in Behavioral Science

2. Part II - Volatility • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? • What Moves Stock Prices? • Does the Stock Market Rationally Reflect Fundamental Values? • Stock Prices and Social Dynamics • Stock Return Variances: The Arrival of information and the Reaction of Traders

3. Efficient Market Model • Pt=Et (P*t) • Price of a stock at time t (Pt) equals the optimal forecast at time t (Et) of the net present value of future dividends (P*t) • Since Pt is the optimal forecast of P*t: Pt=P*t+ut where ut is the forecast error • ut must be uncorrelated with Pt • var (P*)=var (u) + var (P) • var (P)<=var (P*)

4. Efficient Market Model • Var (P) is smaller if information is revealed in big lumps occasionally • Variance loses more from long period of time when information is not revealed

5. Should the Efficient Market Model use Dividends or Earnings? • Dividends make the most sense because individuals are concerned with returns (capital gains plus dividends) • However, firms only pay a fraction of earnings in dividends • BUT since the value of the firm in the future is so heavily discounted, most of the current value comes from dividends

6. Does the Efficient Market Model Make Sense Given the Empirical Data? • Stock price volatility is 5-13 times too high to be attributed to new information about future real dividends • One way to save the theory would be to attribute the movements in stock prices to changes in expected real interest rates • The necessary changes in real interest rates are bigger than the changes in nominal rates

7. Part II - Volatility • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? • What Moves Stock Prices? • Does the Stock Market Rationally Reflect Fundamental Values? • Stock Prices and Social Dynamics • Stock Return Variances: The Arrival of information and the Reaction of Traders

8. What Moves Stock Prices? • The standard view suggests that fluctuations in asset prices are attributable to changes in fundamental values. Recent studies (including this study) have challenged the view that stock price movements are a reaction to announcements about significant news.

9. What Moves Stock Prices? • Are the announcements of important news related to the stock price movements?

10. What Moves Stock Prices? • The importance of macroeconomic news on variations in the prices of stocks: • 1926-1985: analysis of monthly stock returns based on two models:  • structured vector autoregression evidence: macroeconomic news explains about one-fifth of the movement in the stock price • unrestricted regression evidence: consistent with earlier studies-substantial fraction of return variation can not be explained by macroeconomic news

11. What Moves Stock Prices? • The importance of macroeconomic news on variations in the prices of stocks: • 1871-1986: analysis of annual stock market returns also based on two models: • structured vector autoregression evidence: conclusions similar to those for the post-1926 period • unrestricted regression evidence: this approach consistent with earlier studies

12. What Moves Stock Prices? • Or are the “big moves” in the stock market related to the “big news”?

13. What Moves Stock Prices? • Non-economic developments and their impact on movements in the stock market • analysis of the S&P Index and major political, military, and economic policy events, 1941-1987: • market fell by 6.62% when President Eisenhower suffers heart attack (September 1955) • market declined by 4.37%: December 1941, after the Japanese attack on Pearl Harbor • market declined by 0.27% when President Reagan was shot (1981)

14. What Moves Stock Prices? • Non-economic developments and their impact on movements in the stock market • analysis of the fifty largest one-day returns on the S&P Index since 1946 and their “causes”: • “stock prices advanced strongly chiefly because they had gone down so long…” (S&P Index rose by 3.44%, 1962) • “further reaction to Truman victory over Dewey” (stock market fell by 4.40%, 1948)

15. What Moves Stock Prices? • In order to better understand asset price movements, two types of research are recommended:  • should model price movements as functions of evolving consensus opinions about the implications of given news regarding fundamental values as investors reexamine existing data or present new arguments. • should develop and test “propagation mechanisms” that can explain why shocks with small effects on discount rates or cash flows may have large effects on prices.

16. Part II - Volatility • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? • What Moves Stock Prices? • Does the Stock Market Rationally Reflect Fundamental Values? • Stock Prices and Social Dynamics • Stock Return Variances: The Arrival of information and the Reaction of Traders

17. Does the Stock Market Rationally Reflect Fundamental Values? • Both the theoretical and empirical foundation of the Efficient Markets Hypothesis have been questioned. The types of statistical tests which have been used to date cannot establish that financial markets are efficient in the sense of rationally reflecting fundamentals. Due to absence of compelling arguments, it has been suggested that large valuation errors are common in speculative markets.

18. Does the Stock Market Rationally Reflect Fundamental Values? • The following conclusions have been drawn as a result of testing the Hypothesis of Market Efficiency: • failure to reject the hypothesis of market efficiency have been taken as evidence that professional portfolio managers can not outperform the market to an important extent by using publicly available information (Merton (1985) further argues that evidence that any individual can outperform the market is weak, thus suggesting that no “hidden models” with market forecasting ability are being used)

19. Does the Stock Market Rationally Reflect Fundamental Values? • The following conclusions have been drawn as a result of testing the Hypothesis of Market Efficiency: • evidence of market efficiency is often viewed as establishing that financial market prices represent rational assessments of fundamental values.

20. Does the Stock Market Rationally Reflect Fundamental Values? • It is difficult to detect certain types of inefficiency in market valuations using standard methods, by looking at observed returns: some studies suggest that market valuations diverge from fundamental values and that much of market volatility is self-generating, leading to valuation errors. • The evidence on the view that market prices represent rational assessments of fundamental values is very weak.

21. Are abnormal returns possible using only publicly available information? • A case study: is it surprising that “senators’ stocks beat the market by 12 percent”. What does it suggest? (Financial Times, February 24, 2004). • US senators' personal stock portfolios outperformed the market by an average of 12 per cent a year in the five years to 1998, according to a new study • first time senators did especially well, with their stocks outperforming the market by 20% a year, on average, outperforming many professional fund managers and senior executives

22. Are abnormal returns possible using only publicly available information? • A case study: is it surprising that “senators’ stocks beat the market by 12 percent”. What does it suggest? (Financial Times, February 24, 2004). • on the contrary, a separate study in 2000 showed that the average household’s portfolio underperformed the market by 1.44 % a year, on average.

23. Part II - Volatility • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? • What Moves Stock Prices? • Does the Stock Market Rationally Reflect Fundamental Values? • Stock Prices and Social Dynamics • Stock Return Variances: The Arrival of information and the Reaction of Traders

24. Stock Prices and Social Dynamics • Most people who buy and sell stocks take it for granted that social dynamics affect stock prices • Never the less, most finance academics have not accepted this theory • Questionable Logic Defending Efficient Market Model • Because returns cannot be forecasted, the real price of the stock must be close to its intrinsic value

25. There is no reason that fashion should not impact financial markets • Psychology is present in virtually every part of life • The financial market is not as professionalized as one might think • Individuals held 65% of all NYSE stocks in 1980 • As long as the percentage of smart investors is small, returns will not be affected • The ambiguity of Stock value lends itself to being influenced by fads

26. There is no reason that fashion should not impact financial markets • Investors’ opinions are influenced by a variety of media • i.e. mass media, family, friends, coworkers • Post WWII upward trend can likely be attributed to increased optimism • Percentage of people participating in stock market increases from 4 to 15 in the 18 years up to 1970

27. An Alternative Model to the Efficient Market Model • Relies upon the existence of “smart money investors” • States that the real price of stock is affected by the discounted value of expected future dividends and the expected future demand of ordinary investors

28. An Alternative Model to the Efficient Market Model • Different views on what causes the demand of stock by ordinary investors • Affected only by what is fashionable; Independent of dividends • Responds to past returns • Responds to current and lagged dividends

29. Over-Reaction to Dividends?? • Over time, stock prices are highly correlated with dividends • HOWEVER, stock prices are much more volatile than dividends • Prices tend to be relatively high when dividends are relatively high • “It is as if the optimism of investors is too volatile, influenced by departures from trends rather then trends themselves” • A high dividend-price ratio predicts high returns

30. Over-Reaction to Dividends?? • Shiller hypothesizes that the overreaction to dividends is more pronounced in the demand of ordinary investors • The presence of smart money investors lessens the effect on prices

31. Part II - Volatility • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? • What Moves Stock Prices? • Does the Stock Market Rationally Reflect Fundamental Values? • Stock Prices and Social Dynamics • Stock Return Variances: The Arrival of information and the Reaction of Traders

32. Observation: • Equity Returns are more volatile during exchange trading hours than during non-trading hours • On an hourly basis the variance when the exchanges are open is between 13 and 100 times larger

33. Hypotheses: • More public information arrives during normal business hours • Higher volatility is caused by the abundance of public announcements such as tender offers, buyouts, and judicial decisions during normal business

34. Hypotheses: • Private information • Volatility is caused by the use of private information. This information only affects prices through the trading of informed investors • Assumption: If informed investors are more likely to trade when the exchanges are open, return variances will be higher during this period • Question: Is this a reasonable assumption? Why not use other options such as ADRs etc.?

35. Hypotheses: • Trading introduces noise into stock returns • Investors overreact to each other’s trades • Trading noise would increase return variances when the exchanges are open since more people trade on the exchanges

36. Results: • Results are consistent with both the private information hypothesis and the trading noise hypothesis. • However, mispricing causes only 4%-12% of daily return variance • Even if all of mispricing occurs during the trading day, the effect is small • Conclusion: Variance is caused by differences in the arrival and incorporation of information during trading and non-trading periods. • Question: Why not the first hypothesis?

37. Possible explanations: • Private information • Examples: Analyst reports, original research, insider trading • Private information only affects prices through trading • Information is produced by investors and security analysts • Most private information is incorporated into prices during trading hours

38. Possible explanations: • Private information • Production of private information is more common when the exchanges are open • Security analysts are more likely to work at this time • Benefits of producing private information are larger when the exchanges are open and information can be acted on quickly and conveniently

39. Possible explanations: • Private information • Even if information is produced at a constant rate during both trading and non-trading periods only when the information is used in trading can prices be affected • Informed investors trade on their information for more than one day • Question: Why would investors trade on their information for more than one day?

40. Possible explanations: • Noise • The process of trading introduces noise into stock returns • The cause is divided into two parts: • An information component that reflects a rational assessment of the information arriving that day • Independent or positively correlated error component • Some noise is not corrected during the trading day in which it occurs • Question: Why does noise take so long to correct?

41. Case study: Exchange Holiday • Exchange holidays reduce the value of private information • Informed investors both must delay acting on their info and run the risk that someone else will discover it • Or they must find a less convenient way to trade • Therefore less private information will be produced

42. Case study: Exchange Holiday • If less information is produced on exchange holidays: • More will be produced on succeeding days • With more information available to produce the cost of generating any amount should fall • Some of the information that is not produced privately because the exchanges are closed might become publicly observable after a few days

43. Case study: Exchange Holiday • If huge trading return variances are caused by trading noise the variance should fall when exchanges are closed and the variance that is lost should not be recovered

44. The End