Principles of Finance with Excel (Основы финансов c Excel)

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PFE Chapter 15, Using SML and WACC page 32

the stock reach an “equilibrium” at which it again is perceived as fairly priced?

PFE, Chapter 17, Efficiency page 1

CHAPTER 17: EFFICIENT MARKETS—SOME GENERAL

PRINCIPLES OF SECURITY VALUATION

This version: February 6, 2004

Chapter contents

Overview..............................................................................................................................2

17.1. Efficient Markets Principle 1: Competitive markets have a single price for a single good

..............................................................................................................................................6

17.2. Efficient Markets Principle 2: Bundles are priced additively...................................8

17.3. Additivity is not always instantaneous: The case of Palm and 3Com ....................21

17.4. Efficient Markets Principle 3: Cheap information is worthless..............................28

17.5. Efficient Markets Principle 4: Transactions costs are important............................34

Conclusion .........................................................................................................................36

Exercises ............................................................................................................................38

(benninga@wharton.upenn.edu

PFE, Chapter 17, Efficiency page 2

Overview

Chapters 18 and 19 of Principles of Finance with Excel deal with the valuation of bonds

(Chapter 18) and stocks (Chapter 19). We precede these asset-specific chapters with a

discussion of some general principles of valuation (this chapter).

Finance often requires a lot of calculation, which is why this book concentrates on

solving financial problems with a powerful tool like Excel. But sometimes understanding the

way that financial markets work requires only wisdom and very little calculation. This chapter

discusses some general principles of valuation which can save you from a lot of nonsense and in

many cases require almost no calculation.

Here’s an example of the kind of nonsense that you’ll learn to avoid by reading and

understanding this chapter: Your college roommate Clarence has just given you a “hot tip” on

Federated Underwear (FU) stock : Clarence is sure that you should immediately buy the stock.

“It’s going to go up. I know it,” he says excitedly. “My pop says that FU has been

fluctuating between $15 and $25 for the past year. Every time it gets close to $15, it goes up,

and when it gets close to $25, it goes down again. Yesterday FU closed at $15.05. Buy it and

wait—the stock is sure to go up, and then you’ll sell it at $25 and make a killing.”

After reading this chapter, you’ll know to tell Clarence: “My friend, your advice is a

perfect example of a technical trading rule. And Chapter 17 of my college finance textbook,

Principles of Finance with Excel, explains that these rules are a clear violation of the principle of

weak-form market efficiency, which almost always holds. If you want to bet your money on

such foolishness, go ahead. I’m going to spend my hard-earned cash on a night out at the

Efficient Markets Disco.”

PFE, Chapter 17, Efficiency page 3

In the broadest sense the general principles discussed in this chapter all deal with the role

of information in determining asset prices. When translated into simple language, these

principles sound pretty dumb. They say things like: “Information is important.” “Transactions

costs matter.” “One plus two equals three.” When applied to asset markets the valuation

principles discussed in this chapter often enable you to make surprising statements about what

things are worth.

Here are four basic principles of valuation discussed in this chapter:

Efficient Markets Principle 1. Single price for a single good. In financial markets equivalent

financial assets have the same price. Section 17.1 uses cross-listed stocks—stocks that trade in

two financial, like IBM stock on the New York Stock Exchange and IBM stock on the Pacific

Stock Exchange—as a non-trivial example of this principle.

Efficient Markets Principle 2. Price additivity: The price of a bundle of securities should be

the sum of the prices of each of the securities. It is difficult to overestimate the importance of

this principle. One of its predictions is that there are no “money machines”—it costs money to

make money. Another prediction is that knowing the prices of the components of a financial

asset will help you price the whole asset.

Efficient Markets Principle 3. Information is critical. Finding out previously-unknown

information can be a very profitable exercise. Conversely, it is difficult to make money from

facts that everyone knows. The more widely information is known, the less you can make

money from the information. Principle 3 is usually split into three parts:

PFE, Chapter 17, Efficiency page 4

• The principle of weak-form efficiency: Market prices incorporate all current and past

price information. If this principle holds (and almost all economists believe that it does),

then it is not possible to make money based on the pattern of past prices of a traded

security. This means that “money making” rules which are based on price patterns—

“buy a stock if it’s gone up three days in a row, sell it if it’s gone down 3 days

running”—are futile. The weak-form version of the efficient markets hypothesis should

make you skeptical about a lot of investment strategies. An example is investment

advisors who claim to be able to tell market trends from price patterns. These so-called

“technical traders” are giving advice which violates the weak-form efficient markets

hypothesis, and this advice should be ignored.

• The principle of semi-strong-form efficiency: Market prices incorporate all publicly-

known information. Financial markets are awash in publicly-available information. Can

you make money by carefully reading the financial statements of IBM? Probably not—

IBM has many shareholders and is followed by hundreds of stock analysts. If the

analysts are doing their job even moderately well, the information which can be gleaned

from the IBM financial statements is already incorporated in the company’s stock price.

Most economists believe that markets are more-or-less semi-strong efficient (as you’ll

see in this chapter, it depends on how difficult it is to derive the information).

• The principle of strong-form efficiency: Market prices incorporate all information which

exists (public or private) about a security. In addition to IBM’s publicly-available

financial statements and the analyses of stock analysts, there’s also lots of private

information about the company. For example, people working for the company know a

lot about the sales, production, and costs of their individual units. Is this information also

PFE, Chapter 17, Efficiency page 5

incorporated in IBM’s stock price? Almost no economists believe this. Meaning:

Knowing privately-available information can provide you with profits.

Markets are not

strong-form efficient.

Efficient Markets Principle 4. Transactions costs are important and can screw up everything.

This is an important truth about markets. Transactions costs—by this we mean not just the costs

of buying and selling securities, but also the cost of ferreting out information—make it more

difficult to trade. And it’s trade—the buying and selling of financial assets like stocks and

bonds—which makes market prices reflect the true value of assets.

Finance concepts discussed in this chapter

• Efficiency

• Additivity

• Short sales

• Open-end and closed-end mutual funds

Excel functions used

• This chapter has some Excel, but nothing sophisticated

Beware: Stock trading on the basis of insider information is also illegal.

PFE, Chapter 17, Efficiency page 6

17.1. Efficient Markets Principle 1: Competitive markets have a single price

for a single good

A competitive market is a market with a large number of buyers and sellers, none of

whom can influence the price of the goods bought and sold in the market. Financial markets are

good examples of competitive markets: There are a large number of buyers and sellers for most

stocks sold on major stock exchanges, there are many banks competing for your bank accounts

and for your mortgage, and so on.

The principle that competitive markets have a single price for a single good is basic to

economics and is drilled home in most introductory economics courses. Under some

circumstances, this principle seems to be ridiculously obvious. For example: In the Asheville,

North Carolina, farmer’s market (the author’s home town), there are many stands selling apples.

Many of the vendors sell Granny Smith (GS) apples. The GS apples sold by the vendors are of

approximately the same size and quality. The result: the price of apples of the same type is

approximately the same at all the stands. Why? Suppose one vendor deviates from the

equilibrium price of GS apples by selling below the price of the other vendors. Then he’ll attract

a lot of buyers. Being competitive, he will raise his price and the other GS vendors (also

competitive) will lower their prices until, equilibrium being restored, the market price for GS

apples is the same at all GS stands.

Cross-listed stocks—an application of the one-price principle

The one-good one-price principle also has applications in stock markets. Here’s an

example: IBM stock is traded both on the New York Stock Exchange (NYSE) and on the Pacific

Stock Exchange (PSE). When both exchanges are open, the prices of IBM stock are basically

PFE, Chapter 17, Efficiency page 7

the same in both exchanges. This isn’t surprising: If the price of IBM in New York is $120 and

its price is $118 in San Francisco, brokers would obviously try to arbitrage (that is: make

money from unreasonable differences in prices) by buying IBM stock in San Francisco and

selling it in New York. Since transactions costs are very low and since trade in stocks is

instantaneous, this will drive the prices together.

There’s more to this than meets the eye: The NYSE opens before the PSE, but the PSE

stays open later. This means that information about IBM which arrives late in the day will be

incorporated in the PSE stock price but will hit the NYSE price only the next morning. In some

cases this phenomenon is even more extreme—for example, there’s a large group of Israeli

shares which is traded both in Tel-Aviv and on the Nasdaq in the United States. The trading

overlap between the two markets is only 1 hour per day (between 9:30 and 10:30 am Eastern

time, both Nasdaq and Tel-Aviv are open—after this Tel-Aviv closes and all trading in the dual-

listing stocks is on the Nasdaq ). During this trading overlap, cross-listed stocks have the same

price in both markets, but when only one market is open, this need not be so.

Notice how we’ve already slipped in the importance of transactions costs (“Principle 4: Transactions costs can

mess everything up”). This sentence suggests that transactions costs may include not only the direct cost of buying

and selling (commissions, computer time, etc.), but also the time involved in transporting a good from one market to

another. Luckily for this example, stock markets have pretty low transactions costs, especially for brokers and

dealers.

PFE, Chapter 17, Efficiency page 8

17.2. Efficient Markets Principle 2: Bundles are priced additively

Prices are additive when the market price of A+B is equal to the market price of A plus

the price of B. This sounds so obvious that it’s hard to believe that it could be interesting (and,

indeed, once you understand it, it’s pretty boring!).

For an initial example, we go back to the Asheville farmer’s market. Our previous

example dealt with Granny Smith (GS) apples, but some of the vendors also sell Red Delicious

(RD) apples. As we speak, the price of GS apples is $2 per pound and the price of RD apples is

$3 per pound. Simon, a somewhat peculiar vendor, sells bags of apples containing both GS and

RD apples: Each bag weighs 2 pounds and contains 1 pound of GS and 1 pound of RD apples.

How should he price these bags? Obviously at $5 per bag.

Why? Not so trivial, actually. Suppose Simon prices the bags at $4.50. Then anyone

wanting 1 pound of GS and 1 pound of RD will obviously buy with Simon. If Simon is sensitive

to supply and demand, he’ll notice the demand for his mixed bags of apples and raise the price;

at the same time, other apple stands—seeing their demand weaken—will lower the prices of their

apples.

Furthermore, if Simon persists in selling his bags of apples at $4.50, Sharon—a sharp

cookie (or should we say “sharp apple”?)—will buy bags of apples from Simon. She’ll then take

the apples out of the bag and sell them at her apple stand for the market price of $2 for GS and

$3 for RD. In the language of finance—Sharon is arbitraging the price. In the language of her

grandmother, Sharon is buying cheap and selling dear.

On the other hand, suppose Simon prices the bags at $5.50. People will probably stop

buying with him, even if they want bags with equal combinations of GS and RD—they can buy

them cheaper elsewhere. Eventually Simon will have to lower his price. If, contrary to

PFE, Chapter 17, Efficiency page 9

expectations, it turns out that Simon does a brisk business in the apple bags for $5.50, then other

smart apple stand owners will start selling their own bags of apples; since they can put together a

bag for less than what Simon charges, the price of the mixed bags will go back down.

There might actually be room for Simon to sell his apple bags for $5.05, since he’s saving

his customers the trouble of going to 2 apple stands. In the language of finance, he’s saving

them the transactions cost of buying the apples separately. They ought to be willing to pay him

for this service.

The principle of price additivity is often summed up by the statement that there are no

money machines in financial markets: You cannot simply make money by buying a complex

financial asset (like Simon’s bags of apples), taking it apart (separate bags of GS and RD), and

selling the separate bags. The converse is also true: The “money machine” of combining GS

and RD apples into one bag won’t work.

Now that you understand the principle of additivity as applied to the Asheville farmer’s

market, here are some non-trivial finance applications:

Additivity, example 1: The term structure prices bonds

The principle of bundle pricing is often applied to the pricing of bonds. A bond gives

you a series of payments over time. Each of these payments is a separate financial package. If

we can price each financial package, then we should be able to price the bond. For the moment

we confine ourselves to a simple bond example, saving more complicated ones for the next

chapter.

In a broader sense, all of the efficient markets principles in this chapter say that there are no easy ways to make

money on financial markets. If you want to make money, you’ll have to do some meaningful work.