Question

a. Briefly compare the three forms of Efficient Market Hypothesis (EMH). You observe that the asset price has reflected “rational expectation”, briefly explain what is the meaning of rational expectation and then discuss, based on your observation, which form this market belongs to?

b. Assume that investors form rational expectations, how does monetary policy influence stock prices? [Hint: transmission mechanism]

Answer 1

Though the efficient market hypothesis as a whole theorizes that the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.

The basic efficient market hypothesis posits that the market cannot be beaten because it incorporates all important determining information into current share prices. Therefore, stocks trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued.

The theory determines that the only opportunity investors have to gain higher returns on their investments is through purely speculative investments that pose a substantial risk.

Weak Form

The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.

Semi-Strong Form

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.

Strong Form

The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

Rational Expectations

The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences. It suggests that people’s current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.

• Individuals use their ability to rationalize when making decisions.
• On average, people hold expectations that will be fulfilled.
• Rational expectations are the best guess for the future.
• Although people may be wrong some of the time, on average they are right.
• People learn from past mistakes.
• Values of variables like price, output, and employment are important.
• People behave in ways that seek to maximize their enjoyment of life.
• People behave in ways that seek to maximize their profits.
• Expectations about future inflation influence current buying decisions.
• Individuals create expectations based on all available information.
• Resulting predictions are very close to the market equilibrium.

b.The monetary transmission mechanism is the process by which asset prices and general economic conditions are affected as a result of monetary policy decisions. Such decisions are intended to influence the aggregate demand, interest rates, and amounts of money and credit in order to affect overall economic performance.

Expansionary monetary policy works by improving financial conditions rather than demand. Lowering the cost of money will increase the money supply, which pushes down interest rates and borrowing costs.Low rates prompt companies to buy back shares or issue dividends, which is also bullish for stock prices.

An increase in money supply leads to an increase in stock prices, which in turn, stimulates the stock market and the economy at large, and given that, stock prices are determined by expected dividends and interest rates, any surprises in monetary policy are likely to influence stock.

This work takes a comprehensive look at the monetary policy and stock market dynamics from the African perspective, using five indicators namely; S&P global equity indices, inflation rate, money and quasi growth (M2), real interest rate and GDP growth in a panel VAR model. The panel VAR approach addresses the endogeneity problem by allowing the endogenous interaction between the variables in the system of equations. The study models the dynamic relationship in the system of panel VAR equations with data from 1979:2013, performing cross-sectional dependence, unit-root and cointegration tests, and thus estimated the contemporaneous regression model. The study established that, the stock markets of the 12 African countries are positively affected contemporaneously by their respective monetary policies through the interest rate channel, but could not find evidence to the reverse reaction.

The study then estimated impulse response functions and thus established that both money supply and real interest rate decline in response to positive and negative stock market shocks respectively, whiles inflation responds positively to a negative stock market shock. Using the forecast error variance decompositions (fevds), we establish that between the two monetary policy stances considered (money supply and real interest rate), real interest rate has the greatest influence on the stock market and inflation. Conversely, the stock market turns to exert greater influence on real interest rate than it does on money supply, therefore indicating a reverse relationship between monetary policy and the stock market. Similar reverse relationships among the other variables have been observed.

In conclusion, there are complicated and significant relationships between monetary policy and stock market performance and that the relationship is bidirectional.