164 P A R T I I Financial Markets
market fundamentals, this does not mean that rational expectations do not hold. As long as stock market crashes are unpredictable, the basic lessons of the theory of rational expectations hold.
Some economists have come up with theories of what they call rational bubbles to explain stock market crashes. A bubble is a situation in which the price of an asset differs from its fundamental market value. In a rational bubble, investors can have rational expectations that a bubble is occurring because the asset price is above its fundamental value but continue to hold the asset anyway. They might do this because they believe that someone else will buy the asset for a higher price in the future. In a rational bubble, asset prices can therefore deviate from their fundamental value for a long time because the bursting of the bubble cannot be predicted and so there are no unexploited profit opportunities.
However, other economists believe that the Black Monday crash of 1987 and the tech crash of 2000 suggest that there may be unexploited profit opportunities and that the theory of rational expectations and the efficient market hypothesis might be fundamentally flawed. The controversy over whether capital markets are efficient or expectations are rational continues.
Summary
1.Stocks are valued as the present value of future dividends. Unfortunately, we do not know very precisely what these dividends will be. This introduces a great deal of error to the valuation process. The Gordon growth model is a simplified method of computing stock value that depends on the assumption that the dividends are growing at a constant rate forever. Given our uncertainty regarding future dividends, this assumption is often the best we can do.
2.The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader that values the security the most (either because of less uncertainty about the cash flows or because of greater estimated cash flows) will be willing to pay the most. As new information is released, investors will revise their estimates of the true value of the security and will either buy or sell it depending upon how the market price compares to their estimated valuation. Because small changes in estimated growth rates or required return result in large changes in price, it is not surprising that the markets are often volatile.
3.The efficient market hypothesis states that current security prices will fully reflect all available information, because in an efficient market, all unexploited profit
opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a financial market to be efficient does not require that all market participants be well informed.
4.The evidence on the efficient market hypothesis is quite mixed. Early evidence on the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, and the success of so-called technical analysis was quite favorable to the efficient market hypothesis. However, in recent years, evidence on the small-firm effect, the January effect, market overreaction, excessive volatility, mean reversion, and new information is not always incorporated into stock prices, suggesting that the hypothesis may not always be entirely correct. The evidence seems to suggest that the efficient market hypothesis may be a reasonable starting point for evaluating behavior in financial markets but may not be generalizable to all behavior in financial markets.
5.The efficient market hypothesis indicates that hot tips, investment advisersÕ published recommendations, and technical analysis cannot help an investor out-perform the market. The prescription for investors is to pursue a
C H A P T E R 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 165
buy-and-hold strategyÑpurchase stocks and hold them for long periods of time. Empirical evidence generally supports these implications of the efficient market hypothesis in the stock market.
6.The stock market crash of 1987 and the tech crash of 2000 have convinced many financial economists that the stronger version of the efficient market hypothesis, which states that asset prices reflect the true
fundamental (intrinsic) value of securities, is not correct. It is less clear that these crashes shows that the weaker version of the efficient market hypothesis is wrong. Even if the stock market was driven by factors other than fundamentals, these crashes do not clearly demonstrate that many of the basic lessons of the efficient market hypothesis are no longer valid, as long as these crashes could not have been predicted.
adaptive expectations, p. 147 |
Gordon growth model, p. 143 |
bubble, p. 164 |
January effect, p. 156 |
cash flows, p. 141 |
market fundamentals, p. 152 |
dividends, p. 142 |
mean reversion, p. 157 |
efficient market hypothesis, p. 149 |
optimal forecast, p. 148 |
generalized dividend model, p. 143 |
random walk, p. 154 |
rational expectations, p. 147
residual claimant, p. 141
stockholders, p. 141
theory of efficient capital markets, p. 149
unexploited profit opportunity, p. 152
QUIZ Questions and Problems
Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó
1.What basic principle of finance can be applied to the valuation of any investment asset?
*2. Identify the cash flows available to an investor in stock. How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to estimating bond cash flows. Which security would you predict to be more volatile?
3.Compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able to sell in one year for $20, assuming you require a 15% return.
*4. After careful analysis, you have determined that a firmÕs dividends should grow at 7% on average in the foreseeable future. Its last dividend was $3. Compute the current price of this stock, assuming the required return is 18%.
5.Some economists think that the central banks should try to prick bubbles in the stock market before they
get out of hand and cause later damage when they burst. How can monetary policy be used to prick a bubble? Explain how it can do this using the Gordon growth model.
*6. ÒForecastersÕ predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be rational.Ó Is this statement true, false, or uncertain? Explain your answer.
7.ÒWhenever it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. Otherwise, his expectations of the driving time are perfectly accurate. Considering that it snows only once every ten years where Joe lives, JoeÕs expectations are almost always perfectly accurate.Ó Are JoeÕs expectations rational? Why or why not?
*8. If a forecaster spends hours every day studying data to forecast interest rates but his expectations are not as accurate as predicting that tomorrowÕs interest rates will be identical to todayÕs interest rate, are his expectations rational?
C h a p t e r |
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8 |
An Economic Analysis |
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of Financial Structure |
A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities. But how does the financial system make sure that your hard-earned savings get channeled to Paula the Productive Investor rather than to Benny the Bum?
This chapter answers that question by providing an economic analysis of how our financial structure is designed to promote economic efficiency. The analysis focuses on a few simple but powerful economic concepts that enable us to explain features of our financial system, such as why financial contracts are written as they are and why financial intermediaries are more important than securities markets for getting funds to borrowers. The analysis also demonstrates the important link between the financial system and the performance of the aggregate economy, which is the subject of Part V of the book. The economic analysis of financial structure explains how the performance of the financial sector affects economic growth and why financial crises occur and have such severe consequences for aggregate economic activity.
Basic Puzzles About Financial Structure Throughout the World
The financial system is complex in structure and function throughout the world. It includes many different types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so onÑall of which are regulated by government. The financial system channels billions of dollars per year from savers to people with productive investment opportunities. If we take a close look at financial structure all over the world, we find eight basic puzzles that we need to solve in order to understand how the financial system works.
The pie chart in Figure 1 indicates how American businesses financed their activities using external funds (those obtained from outside the business itself) in the period 1970Ð1996. The Bank Loans category is made up primarily of bank loans; Nonbank Loans is composed primarily of loans by other financial intermediaries; the Bonds category includes marketable debt securities such as corporate bonds and commercial paper; and Stock consists of new issues of new equity (stock market shares). Figure 2 uses the same classifications as Figure 1 and compares the U.S. data to those of Germany and Japan.
170 P A R T I I I Financial Institutions
F I G U R E 1 Sources of External
Funds for Nonfinancial Businesses in
the United States
Source: Reinhard H. Schmidt, ÒDifferences Between Financial Systems in European Countries: Consequences for EMU,Ó in Deutsche Bundesbank, ed., The Monetary Transmission Process: Recent Developments and Lessons for Europe (Hampshire: Palgrave Publishers, 2001), p. 222.
Bank Loans
40.2%
Nonbank |
Bonds |
Loans |
35.5% |
15.1% |
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Stock |
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9.2% |
Now let us explore the eight puzzles.
1.Stocks are not the most important source of external financing for businesses. Because so much attention in the media is focused on the stock market, many people have the impression that stocks are the most important sources of financing for American corporations. However, as we can see from the pie chart in Figure 1, the stock market accounted for only a small fraction of the external financing of American businesses in the 1970Ð1996 period: 9.2%.1 (In fact, in the midto late 1980s, American corporations generally stopped issuing shares to finance their activities; instead they purchased large numbers of shares, meaning that the stock market was actually a negative source of corporate finance in those years.) Similarly small figures apply in the other countries presented in Figure 2 as well. Why is the stock market less important than other sources of financing in the United States and other countries?
2.Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Figure 1 shows that bonds are a far more important source of financing than stocks in the United States (35.5% versus 9.2%). However, stocks and bonds combined (44.7%), which make up the total share of marketable securities, still supply less than one-half of the external funds corporations need to finance their activities. The fact that issuing marketable securities is not the most important source of financing is true elsewhere in the world as well. Indeed, as
1The 9.2% figure for the percentage of external financing provided by stocks is based on the flows of external funds to corporations. However, this flow figure is somewhat misleading, because when a share of stock is issued, it raises funds permanently; whereas when a bond is issued, it raises funds only temporarily until they are paid back at maturity. To see this, suppose that a firm raises $1,000 by selling a share of stock and another $1,000 by selling a $1,000 one-year bond. In the case of the stock issue, the firm can hold on to the $1,000 it raised this way, but to hold on to the $1,000 it raised through debt, it has to issue a new $1,000 bond every year. If we look at the flow of funds to corporations over a 26-year period, as in Figure 1, the firm will have raised $1,000 with a stock issue only once in the 26-year period, while it will have raised $1,000 with debt 26 times, once in each of the 26 years. Thus it will look as though debt is 26 times more important than stocks in raising funds, even though our example indicates that they are actually equally important for the firm.
C H A P T E R 8 An Economic Analysis of Financial Structure 171
%
100
United States
90 |
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Germany |
80 |
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Japan |
70 |
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60 |
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50 |
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40 |
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30 |
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20 |
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10 |
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0 |
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Bank Loans |
Nonbank Loans |
Bonds |
Stock |
F I G U R E 2 Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany and Japan
The categories of external funds are the same as in Figure 1 and the data are for the period 1970Ð1996.
Source: Reinhard H. Schmidt, ÒDifferences Between Financial Systems in European Countries: Consequences for EMU,Ó in Deutsche Bundesbank, ed., The Monetary Transmission Process: Recent Developments and Lessons for Europe (Hampshire: Palgrave Publishers, 2001), p. 222.
we see in Figure 2, other countries have a much smaller share of external financing supplied by marketable securities than the United States. Why donÕt businesses use marketable securities more extensively to finance their activities?
3.Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct finance involves the sale to households of marketable securities such as stocks and bonds. The 44.7% share of stocks and bonds as a source of external financing for American businesses actually greatly overstates the importance of direct finance in our financial system. Since 1970, less than 5% of newly issued corporate bonds and commercial paper and around 50% of stocks have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries such as insurance companies, pension funds, and mutual funds. These figures indicate that direct finance is used in less than 10% of the external funding of American business. Because in most countries marketable securities are an even less important source of finance than in the United States, direct finance is also far less important than indirect finance in the rest of the world. Why are financial intermediaries and indirect finance so important in financial markets? In recent years, indirect finance has been declining in importance. Why is this happening?
4.Banks are the most important source of external funds used to finance businesses. As we can see in Figures 1 and 2, the primary sources of external funds for
172 P A R T I I I |
Financial Institutions |
businesses throughout the world are loans (55.3% in the United States). Most of these loans are bank loans, so the data suggest that banks have the most important role in financing business activities. An extraordinary fact that surprises most people is that in an average year in the United States, more than four times more funds are raised with bank loans than with stocks. Banks are even more important in countries such as Germany and Japan than they are in the United States, and in developing countries banks play an even more important role in the financial system than they do in the industrialized countries. What makes banks so important to the workings of the financial system? Although banks remain important, their share of external funds for businesses has been declining in recent years. What is driving their decline?
5.The financial system is among the most heavily regulated sectors of the economy. You learned in Chapter 2 that the financial system is heavily regulated, not only in the United States but in all other developed countries as well. Governments regulate financial markets primarily to promote the provision of information, in part, to protect consumers, and to ensure the soundness (stability) of the financial system. Why are financial markets so extensively regulated throughout the world?
6.Only large, well-established corporations have easy access to securities markets to finance their activities. Individuals and smaller businesses that are not well established are less likely to raise funds by issuing marketable securities. Instead, they most often obtain their financing from banks. Why do only large, well-known corporations find it easier to raise funds in securities markets?
7.Collateral is a prevalent feature of debt contracts for both households and businesses. Collateral is property that is pledged to the lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well. The majority of household debt in the United States consists of collateralized loans: Your automobile is collateral for your auto loan, and your house is collateral for your mortgage. Commercial and farm mortgages, for which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial businesses; corporate bonds and other bank loans also often involve pledges of collateral. Why is collateral such an important feature of debt contracts?
8.Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. Many students think of a debt contract as a simple IOU that can be written on a single piece of paper. The reality of debt contracts is far different, however. In all countries, bond or loan contracts typically are long legal documents with provisions (called restrictive covenants) that restrict and specify certain activities that the borrower can engage in. Restrictive covenants are not just a feature of debt contracts for businesses; for example, personal automobile loan and home mortgage contracts have covenants that require the borrower to maintain sufficient insurance on the automobile or house purchased with the loan. Why are debt contracts so complex and restrictive?
As you may recall from Chapter 2, an important feature of financial markets is that they have substantial transaction and information costs. An economic analysis of how these costs affect financial markets provides us with solutions to the eight puzzles, which in turn provide us with a much deeper understanding of how our financial system works. In the next section, we examine the impact of transaction costs on the structure of our financial system. Then we turn to the effect of information costs on financial structure.
C H A P T E R 8 An Economic Analysis of Financial Structure 173
Transaction Costs
How Transaction
Costs Influence
Financial
Structure
How Financial
Intermediaries
Reduce
Transaction Costs
Transaction costs are a major problem in financial markets. An example will make this clear.
Say you have $5,000 you would like to invest, and you think about investing in the stock market. Because you have only $5,000, you can buy only a small number of shares. The stockbroker tells you that your purchase is so small that the brokerage commission for buying the stock you picked will be a large percentage of the purchase price of the shares. If instead you decide to buy a bond, the problem is even worse, because the smallest denomination for some bonds you might want to buy is as much as $10,000, and you do not have that much to invest. Indeed, the broker may not be interested in your business at all, because the small size of your account doesnÕt make spending time on it worthwhile. You are disappointed and realize that you will not be able to use financial markets to earn a return on your hard-earned savings. You can take some consolation, however, in the fact that you are not alone in being stymied by high transaction costs. This is a fact of life for many of us: Only around one-half of American households own any securities.
You also face another problem because of transaction costs. Because you have only a small amount of funds available, you can make only a restricted number of investments. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk.
This example of the problems posed by transaction costs and the example outlined in Chapter 2 when legal costs kept you from making a loan to Carl the Carpenter illustrate that small savers like you are frozen out of financial markets and are unable to benefit from them. Fortunately, financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets.
Economies of Scale. One solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. By bundling investorsÕ funds together, transaction costs for each individual investor are far smaller. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. For example, the cost of arranging a purchase of 10,000 shares of stock is not much greater than the cost of arranging a purchase of 50 shares of stock.
The presence of economies of scale in financial markets helps explain why financial intermediaries developed and have become such an important part of our financial structure. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings are then passed on to individual investors after the mutual fund has taken its cut in the form of management fees for administering their accounts. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification for individual investors reduces their risk, making them better off.
