Noise and the State of Long-Term Expectations - Admission/Application Essay Example

Noise and the of Long-Term Expectations of the Number: Paper: Noise and the of Long Term Expectations Introduction The essay highlights the comments of Fisher Black in his article, “Noise” and John M. Keynes in his article, “The state of long-term expectation” in context of Efficient Market Hypothesis. In the process, assumptions of Capital Asset Pricing Model are also elaborated. The assumptions are compared with ideas proposed by Keynes and Black. According to Fisher Black, noise is required in financial markets, but makes the market imperfect at the same time. The trade declines, if there are no noise trading. If there is absence of noise trading, then investors will not invest in the market and as a result, will hold back their assets. They are reluctant to take any risk, which is associated with different types of trade. According to John M. Keynes, it is unwise to attach expectation to something, which is uncertain in future. He stated that it is prudent to gain information regarding the issue and then feel confident to invest therein. So, it is not advisable to make long-term expectation without evaluating the results in details. It is observed that individuals consider the current situation for predicting the future. This is very risky as they can lose a considerable amount if the actual situation is not equivalent to the expected one. In this context, the Capital Asset Pricing model (CAPM) is introduced to elaborate the risk factor associated with the individuals. Hence, the essay explains relevance of the comments provided by the two great personalities by way of drawing connections with efficient market hypothesis. Capital Asset Pricing model (CAPM) CAPM assists the investors to determine rate of returns of the assets they are possessing in an efficient capital market. The model is the extension of the Markowitz Portfolio Theory and is developed by Sharpe (1964) and Mossin (1966 cited in Lintner 13-20). It is constructed after considering the unsystematic risk, which can be diversified in the market. The model aims at explaining that the investor should bear the systematic risk in order to receive a considerable return from their investment. Assumptions of CAPM The following are the assumptions of CAPM: 1) The security markets are seen as perfectly competitive and there many investors who participate in trade in the financial market. This particular market is characterized by small and large investors and they are explained as the price takers. 2) The financial market is regarded as frictionless. Tax and other charges are not applied in this market. 3) The investors believe in short time investment and have only one holding period as they fear to lose in long-term. 4) The investors have the opportunity to make unlimited lending at risk free rate. 5) The investors are rational and use Markowitz model for selecting any portfolio. 6) All the investors have access to the same information and they are observed to analyze the information in similar manners. 7) All the investors seek estimation of the expected returns in the same way (Lintner 13-20). The above mentioned assumptions are applied in an efficient market, which is why it is important to describe the efficient market hypothesis. Efficient Market Hypothesis (EMH) The hypothesis states that stock market prices follow a random path. This refers to the fact that there are daily variations in the stock prices, which follow a random walk. The empirical evidence depends on three arguments that are regarded as weak assumptions. Firstly, the investors in financial markets are expected to be rational and that is the reason for them to randomly select securities. Secondly, if investors are not rational during their investment decision, then they try to balance the prices. Thirdly, if investors are irrational and are encountering rational arbitrageurs in market, then arbitrageurs desire to eliminate the prices (Black “Noise” 10-12). It is observed that the investors give fundamental value to each security. This value is recognized as the net present value of future cash flows or discounted cash flow after considering risk characteristics of each security. The model elaborates that investor acquire adequate information regarding the fundamental value of securities. Thereafter, they respond to the information through trade, in case of favorable news in the stock market (Lintner 13-20). However, if the market is competitive and there exists risk-neutral investors, then the return on securities are unpredictable. Hence, it can be identified that price of the securities follows a random walk. The price of the securities is efficient for risk-averse investors as it considers the risk associated over time. It is observed that when the investors are not rational, the market is considered to be efficient (Sharpe 427-430). Therefore, the model states that irrational investors cannot trade randomly in efficient market. In the concerned market, trading volume is huge owing to these irrational buyers’ trade securities. In this case, price of the stock is close to the fundamental value. This particular information relies on the fact that there is lack of correlation between trading strategies and irrationality of the investors (Sharpe 427-430). The above mentioned hypothesis considers that markets are efficient and are divided into three levels described as follows: Weak Form EMH This type of EMH reflects that the market is efficient, which have the ability to highlight all the information. The hypothesis predicts that rates of return in the market are independent i.e. past rates have no connection with the future rates. Consequently, the concept stating that one trader sells or buys only one stock is not valid (Black “Noise” 530-531). Semi-Strong EMH This type of EMH indicates that the market is efficient and information is publicly available. The hypothesis depicts that the stocks adapt to new information that are available in the market. This type of hypothesis also incorporates weak form of hypothesis. The investors concentrate on purchasing stocks only after acquiring sufficient information regarding the stock prices (Black “Noise” 530-531). Strong - Form EMH This hypothesis also implies that the market is efficient and information is available both privately and publicly. It also incorporates weak form EMH and semi-strong EMH. The investors will not earn profit above the average price level, even if he/she is acquainted with new information (Black “Noise” 530-531). Noise According to Black (1986 cited Shleifer 36-56), noise makes trading possible in a financial marker and also allows investors to follow the asset prices. Noise has the ability to make a market inefficient and also prevents the investors to take advantage of inefficiencies prevailing in the market. Noise creates expectation among the individuals and does not follow any rational rules. It is very difficult to identify the fundamental value of securities as there are constant fluctuations that occur due to several factors such as, exchange rate (Black, Jensen and Schloes 530-540). Hence, the stock market is defined by risk that is associated with incessant fluctuations in the stock prices. According to Black (1986 cited in Black “Noise” 530-533), the arbitrageurs utilize these additional risks for extracting profit. Nonetheless, Shleifer (2000) had identified that the noise trader risk had become prominent in market and have posed challenges on way of becoming efficient. The noise trader risk is the one that is undertaken by a trader while purchasing securities in the rising markets and selling them when market is declining. This particular process restricts degree of arbitrage that is expected for lowering the prices to a rational level, despite presence of noticeable risk in the market (Shleifer 36-56). The professional arbitrageurs are not ready to sell a stock in short since they believe that trading the stock at twice the fundamental value is less profitable, compared to trading the same security to one who is deceived into paying thrice the same value (Shleifer 36-56). When there are a number of noise traders in the market, the payment for information is high. The noise traders pay high charges when information is costly and of high importance. The noise traders lose money when information is already acquired by the investors and as a result, the investors wisely avoid them. When the amount of noise trading increases, it is advantageous to trade on information. This is possible only when the prices are noisier. The increase in the trading of information does not reflect that prices are efficient in the market, rather it is implied that the information will acquire greater position and traders will invest more accordingly (Vuolteenaho 235-245). Noise traders must trade to reflect their influence. As information traders trade mostly with noise traders, cutting back on noise trading also reduces information trading. As a consequence, prices will not move considerably when the market is closed as they move when the market is open. The relevant market refers to the market where the noise traders trade. These noise traders prefers to high priced stocks than low priced stocks for selling and vice versa for purchasing. The splits between the two will lead to increase in both liquidity and volatility of stock in daily life. Low-priced stocks will be less efficiently priced than high-priced stocks. The price of a stock will be a noisy estimate of its value. The earnings of a firm (multiplied by a suitable price-earnings ratio) will give another estimate of value of the firms stock. This estimate will be noisy too. As long as noise traders do not always look at earnings for deciding upon ways to trade, the estimate from earnings will give information that is new to the estimate from price (Vuolteenaho 235-245). The State of long-term expectation According to Black, Jensen and Schloes (1972) there is no need to attach excessive expectation to uncertainties of the future. They stated that there should be adequate information regarding the fact, which will build confidence in the individual. The long-term expectation made by the individuals are not correct until and unless he/she have required confidence on their investment. The long-term expectations are not solely dependent on the probable forecast, but also on confidence with which the investors forecasts. In the stock markets, long-term expectation is quite obvious for investors as they are investing their assets on it. The expectations are dependent on conditions of the market as well as sales movement of the companies who are issuing their stocks. The investors gain confidence only when they have acquired adequate information regarding the stock prices. The historical price of the stock are observed and tracked so as to get an idea of future stock price movement. This stock price movement is difficult to predict as it is dependent on performance of the company (Black "Banking and Interest Rates in a World without Money: The Effects of Uncontrolled Banking” 9-12). The performance of a certain stock relies upon sales and profit of a company. In an efficient market, fluctuations of the stock prices are obvious and the investors are accordingly conscious about their performance in future. The long-term expectation becomes very risky. With passage of time, there has been a gradual rise in proportion of equity in the aggregate capital investment of the community. The people, who owned large proportion of equity, lacked adequate knowledge about its performance. Thus, it can be stated that there has been a decline in the number of investors who have adequate knowledge regarding the stock before investment. The huge fluctuation in profit of the companies has influenced performance of the market to a great extent. This fluctuation in the profit has resulted in fluctuation of the share prices. It is observed that conventional valuation of stocks is dependent on psychology of the mass; if the individuals change their mind abruptly then there will be no equity investment. As a consequence, the share price market will come down with sudden change of opinion among the mass. The market has to encounter a series of optimistic and pessimistic sentiments, which cannot be reasoned (Black "Banking and Interest Rates in a World without Money: The Effects of Uncontrolled Banking” 9-12). Contrast of the assumptions of CAPM with comments of Keynes and Black in the context of EMH According to Fisher Black, noise trader’s help in rendering a market efficient and are important in an economy. They are the risk takers and earn adequate profit from the risks as the market favors their expectation. Hence, expectation also plays an important role in the efficient market. The first assumption of CAPM can be compared with this view. According to CAPM, the investors can also be the price takers. They gather knowledge regarding the stock price movement and then invest their money in that stock. There are small as well as large investors who do not only rely on the market information, but also takes part in market arbitraging. They are rational buyers and aim at taking the best decision possible for the investment (Pastor and Stambaugh 67-121). In an efficient market, abnormal profit is gained by adjusting the trading rules that are publicly or privately available. The investors in a weak form of efficient market do not employ past information about the stock price for achieving excess return, rather they develop trading rule randomly. So, the prices are chosen at a random. It implies that the investors will encounter risk in gaining profit. As a result, the long-term expectations of these investors are high as they take greater risk. The risk-return trade off, in this case, becomes high. According to John M. Keynes, long-term expectations are favorable only when the investor has adequate information regarding the stock price movement. If psychology of the mass changes to a great extent, then market is affected, thereby dragging down the stock prices (Pastor and Stambaugh 67-121). In efficient markets, the stock price fluctuations are higher, which is why the investors gather adequate knowledge and analyze its future trends through forecast. When the investors are trading in semi-strong EMH, they are able to earn abnormal profit by applying trading policies, which are publicly available in annual reports in form of announcements. As a consequence, the traders can access the information more efficiently and thus can predict the performance of the stock prices more accurately. The information enables investors to gain confidence regarding the stock investment. According to Fischer Black, noise traders are expected to behave in three different ways. Firstly, the noise traders can act as technicians who are skilful with the capability to exploit information in order to earn considerable profit from the efficient market. Secondly, the noise traders provide liquidity to the market by offering liquidity services, which increases risk bearing capacity of the market. Thirdly, the noise traders can behave irrationally with the ability to act as if no information is available (Pastor and Stambaugh 67-121). They employ a number of trading rules or models for selecting the perfect portfolio of securities. Such type of traders increases their trading volume by investing in bulk with the expectation of gaining in long run, without analyzing present and future performance of the stock prices. The skilful traders believe in performing technical analysis, which portrays the past performance of the stock. They aim at investigating slight sluggishness in price movement of the stock. The noise traders are observed to lose money when value of the stock rises to a great extent and they are not able to sell it to investors (Lakonishok, Shleifer and Vishny 1542-1550). The noise traders rely on their own decision and do not depend on information that is available to them. According to them, they are making a sound investment decision when they are following the noise market. The trades that they execute are not based on any fundamental data and they are very abrupt in taking investment decision when they realize that noise is prevalent in the market, guiding it to a particular direction. It is often observed that they make a poor decision by reacting to news of the market and thus, loses a considerable amount of money. The noise traders are often concerned with short term effect of the market and avoid long-term perspective of the same (Lakonishok, Shleifer and Vishny 1542-1550). The continuous buying and selling procedure in the market increases the price volatility. If the time horizon of stock increases, the impact of noise trading declines. Hence, it can be stated that investment for long horizon helps the investors to beat the market in a better manner compared to the noise traders (Roll 130-145). The assumption pertaining to the transaction cost and tax deduction from values of the securities are explained by linking with comments of the great personalities. According to Fisher Black, the transaction cost reduces trade volume of the stock, which affects profit of the company who issues the share. On the other hand, tax deduction lowers activity of the noise traders. It does not change the bid-ask spread or have any effect on liquidity of the stock price. Nevertheless according to CAPM, there is no deduction for transaction cost or tax pertaining to the security markets. As a result, a contrast between the two concepts can be clearly identified (Lakonishok, Shleifer and Vishny 1542-1550). It is observed that CAPM consider time period of one year and validity of the model can only be justified if time period is expanded to multiple years. So, the model explains whether the market returns are stable or not. The changing market conditions and cost structure of companies also indicate the fact that beta of security market does not remain constant for years. Here, beta is defined as the risk associated with stock returns. The beta estimation is subject to statistical variability. The betas related to industry are more reliable than individual betas of the company. Therefore, it is difficult to justify the assumptions of CAPM, as they are based on one year time period. It is suggested that the model is not a perfect one to deal with changes in the real world. The model does provide a reasonable model of risk-return trade–off, but overlooks all changing aspects of the business environment as well as long-term expectation of traders and the market as a whole (Lakonishok, Shleifer and Vishny 1542-1550). Conclusion Noise trading and long-term expectations are very important topics in financial market. The financial market is the place where entities buy and sell securities at low transaction cost. The price of these securities is dependent on conditions of market and performance of individual companies. These prices are affected by the psychology of mass as their opinions may increase and lower price of the stock. These prices are affected by noise trading. A rise in noise trading leads to a similar hike in volume of trade; but lessens the probability to profit from the investment. From the above discussions, it can be concluded that expectations of the investors heightens when the stock performs well. When the stock prices increase, traders sell the stock and vice-versa. This process of purchase and sale of securities provides many opportunities as well challenges to the market. This trading process allows noise traders as well as traders to gain profit from the market. With a greater time horizon, noise trading is observed to decline. This leads to fall in trading volume. This chain reaction helps the market to balance the trade and make profit accordingly. Works Cited Black, Fischer, Michael, Jensen and Myron, Schloes. “The Capital Asset Pricing Model: Some Empirical Tests.” Studies in The Theory Of Capital Markets (1972). Web. 17 June 2014. Black, Fischer. "Banking and Interest Rates in a World Without Money: The Effects of Uncontrolled Banking." Journal of Bank Research 1(1970): 8-20. Web. 17 June 2014. Black, Fischer. “Noise.” Journal of Finance 41(1986): 529 – 543. Web. 17 June 2014. Lakonishok, Josef, Andrei, Shleifer and Robert, Vishny. Contrarian Investment, Extrapolation and Risk. Journal of Finance 49(1994): 1541-1578. Print. Lintner, John. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics 47 (1965): 13-37. Web. 17 June 2014. Print. Pastor, Lubos and Robert, Stambaugh. Costs of Equity Capital and Model Mispricing. Journal of Finance 54 (1999): 67-121. Print. Roll, Richard. A Critique of the Asset Pricing Theorys Tests Part I: On Past and Potential Testability of the Theory. Journal of Financial Economics 4(1997): 129-176. Print. Sharpe, William F. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance 19(1964): 425- 442. Web. 17 June 2014. Shleifer, Andrei. Inefficient markets: An introduction to behavioural finance. New York: Oxford University Press. 2000. Print. Vuolteenaho, Tuomo. “What Drives Firm Level Stock Returns?” Journal of Finance 57(2002): 233–264. 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