# Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 20
RISK AND VALUE OF STOCKS
Stocks
Risk and the Value of Stocks
Theory of Efficient Markets
Investing in Stocks for Long Run
Stock Markets' Role in the Economy
Financial Intermediation
Role of Financial Intermediaries
Risk and value of stocks
The dividend-discount model must be adjusted to include compensation for a stock's risk
- Ptoday
D next
P  next
_ year
_ year
+
Ptoday
Ptoday
Since the ultimate future sale price is unknown the stock is risky,
The investor will require compensation in the form of a risk premium
Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp)
The risk-free rate can be thought of as the interest rate on a treasury security with a maturity of
several months
Our dividend discount model becomes:
D today
=
P  today
rf + rp - g
Risk and value of stocks
Stock Prices are high when
Current dividends are high (Dtoday is high)
Dividends are expected to grow quickly (g is high)
The risk-free rate is low (rf is low)
The risk premium on equity is low (rp is low)
The S&P 500 index finished the year 2003 at just over 1,100. was this level warranted by
fundamentals?
Risk free real interest rate is about 2% or rf = 0.02
Risk premium is assumed to be 4% or rp = 0.04
Dividend growth rate is around 2% or g = 0.02
The owner of a \$1,000 portfolio would have received \$30 in dividends during 2003
Substituting the information in our adjusted dividend discount model:
\$30
Ptoday =
= \$750
0.02 + 0.04 - 0.02
But the actual stock prices were substantially higher than this calculated figure
This may be due to wrong assumption on risk premium.  The investors may have been
demanding lower risk premium in 2003.
To compute it, we use the same equation
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Money & Banking ­ MGT411
VU
\$30
1,10 =
-  0.02
(0.02+rp)
The Theory of Efficient Markets
The basis for the theory of efficient markets is the notion that the prices of all financial
instruments, including stocks, reflect all available information
As a result, markets adjust immediately and continuously to changes in fundamental values
When markets are efficient, the prices at which stocks currently trade reflect all available
information, so that future price movements are unpredictable.
If the theory is correct then no one can consistently beat the market average; active portfolio
management will not yield a return that is higher than that of a broad stock-market index
If managers claim to exceed the market average year after year, it may be because
They must be taking on risk,
They are lucky,
They have private information (which is illegal), or
Markets are not efficient
Investing in Stocks for the Long Run
Stocks appear to be risky, and yet many people hold substantial proportions of their wealth in
the form of stock
This is due to the difference between the short term and the long term;
Investing in stocks is risky only if you hold them for a short time
In fact, when held for the long term, stocks are less risky than bonds.
Figure: S&P 1-Year Stock Returns, 1871 to 2003(Returns are Real, Adjusted for Inflation using
the CPI)
60
40
20
0
-20
-40
-60
1895 1907
1919
1931 1943 1955
1871
1967
1883
197
1991
200
Years
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Money & Banking ­ MGT411
VU
Figure: S&P Long-Run Stock Returns, 1871 to 2003(Returns are Real, adjusted for inflation
using the CPI)
60
40
20
0
-20
-40
-60
1895 1907
1919
1931 1943 1955
1871 11883
1967
197
1991
200
____1-Year Returns
____25 year Returns
The Stock Market's Role in the Economy
The stock market plays a crucial role in every modern capitalist economy.
The prices determined there tell us the market value of companies, which determines the
allocation of resources.
Firms with a high stock market value are the ones investors' prize, so they have an easier time
garnering the resources they need to grow.
In contrast, firms whose stock value is low have difficulty financing their operations
So long as stock prices accurately reflect fundamental values, this resource allocation
mechanism works well.
At times, however, stock prices deviate significantly from the fundamentals and prices move in
ways that are difficult to attribute to changes in the real interest rate, the risk premium, or the
growth rate of future dividends.
The Stock Market's Role in the Economy
Shifts in investor psychology may distort prices; both euphoria and depression are contagious
When investors become unjustifiably exuberant about the market's future prospects, prices rise
regardless of the fundamentals, and such mass enthusiasm creates bubbles.
Bubbles
Bubbles are persistent and expanding gaps between actual stock prices and those warranted by
the fundamentals.
These bubbles inevitably burst, creating crashes.
They affect all of us because they distort the economic decisions companies and consumers
make
If bubbles result in real investment that is both excessive and inefficiently distributed, crashes
do the opposite; the shift to excessive pessimism causes a collapse in investment and economic
growth
When bubbles grow large enough and result in crashes the stock market can destabilize the real
economy
Financial Intermediation
Economic well-being is essentially tied to the health of the financial intermediaries that make up
the financial system.
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Money & Banking ­ MGT411
VU
We know that financial intermediaries are the businesses whose assets and liabilities are
primarily financial instruments.
Various sorts of banks, brokerage firms, investment companies, insurance companies, and
pension funds all fall into this category.
These are the institutions that pool funds from people and firms who save and lend them to
people and firms who need to borrow
Financial intermediaries funnel savers' surplus resources into home mortgages, business loans,
and investments.
They are involved in both
Direct finance--in which borrowers sell securities directly to lenders in the financial markets
Indirect finance--in which a third party stands between those who provide funds and those who
use them
Intermediaries investigate the financial condition of the individuals and firms who want
financing to figure out which have the best investment opportunities.
As providers of indirect finance, banks want to make loans only to the highest-quality
borrowers.
When they do their job correctly, financial intermediaries increase investment and economic
growth at the same time that they reduce investment risk and economic volatility
Role of Financial Intermediaries
As a general rule, indirect finance through financial intermediaries is much more important than
direct finance through the stock and bond markets
In virtually every country for which we have comprehensive data, credit extended by financial
intermediaries is larger as a percentage of GDP than stocks and bonds combined
Around the world, firms and individuals draw their financing primarily from banks and other
financial intermediaries
The reason for this is information;
Just think of an online store
You can buy virtually EVERYTHING ­ from \$5 dinner plates to \$300,000 sports car
But you will notice an absence of financial products, like student loans, car loans, credit cards
or home mortgages
You can not bonds on which issuer is still making payments, nor can you have the services of
checking account.
Why such online store does not deal in mortgages?
Suppose a company needs a mortgage of \$100,000 and the store can (if at all) establish a system
in which 100 people sign up to lend \$1,000 each to the company
But the store has to do more
Collecting the payments
Figuring out how to repay the lenders
Writing legal contracts
Evaluating the creditworthiness of the company and feasibility of the mortgaged project
Can it do it all?
Financial intermediaries exist so that individual lenders don't have to worry about getting
answers to all of the important questions concerning a loan and a borrower
Lending and borrowing involve transactions costs and information costs, and financial
intermediaries exist to reduce these costs
Financial intermediaries perform five functions:
1. They pool the resources of small savers;
2. They provide safekeeping and accounting services as well as access to the payments
system;
3. They supply liquidity;
4. They provide ways to diversify risk; and
5. They collect and process information in ways that reduce information costs
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