Microeconomic Foundations: Financial Markets and Exchange Rates

University of New England

Microeconomic Foundations: Part III

ECON102 Week 5 Prescribed reading: Holden et. al., Chapter 16.une

Learning Objectives Week 5

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What Drives Financial Prices?

Personal Finance International Trade and Global Financial Flows Exchange Rates Supply and Demand of Currencies The Real Exchange Rate and Net Exports The Balance of Paymentsthe

Valuing Stocks

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A The demand curve shows how many stocks investors will buy at each price. B The supply curve describes how many stocks investors will sell at each price. C The equilibrium price is determined where supply equals demand.

Price of Nike stock B Supply Equilibrium price C Equilibrium A Demand Equilibrium quantity Quantity of Nike stockune

Fundamental Analysis

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Fundamental value: The PV of future profits that a company will earn.

How to assess a business's fundamental value:

1. Forecast future profits
2. Discount these profits
3. Add up the sum of those discounted future profits
4. Divide the company's fundamental value by the total number of stocks

A stock is a good deal with its stock price is below its fundamental value. Buy low and sell high!une

Relative Valuation

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Relative valuation: An assessment of the value of an asset by comparing it to similar assets.

Two relative-valuation ratios:

1. Price-to-book ratio: Measures a firm's stock price relative to the book value per share. (Book value is the business's net assets per share.) PB ratio = Price per share Book value per share
2. Price-to-earnings ratio: Measures a firm's stock price, relative to last year's profits, measured as earnings per share. PE ratio = Price per share Earnings per shareune

The Efficient Market Hypothesis

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Efficient market hypothesis: The theory that at any point in time, stock prices reflect all publicly available information. Stock prices represent the collective judgements about a company's fundamental value. It's tough to beat the market. Unless you have information that is not known by other people (insider trading). Financial prices move unpredictably. Forward-looking traders eliminate all predictable stock price changes, so all that's left is the unpredictable changes. . Random walk: When a price follows an unpredictable path. Technical analysis looks for patterns, even where there is none!ine

Gamestop Short Squeeze

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GameStop squeeze returns: How short sellers win or lose money

Story by Madison Reidy . 1mo . @ 3 min read GameStop THINKX333 JINK . A short squeeze happens when many investors bet against a stock and its price shoots up instead. . A short squeeze accelerates a stock's price rise as short sellers bail out to cut their losses. . Contrarian investors try to anticipate a short squeeze and buy stocks that demonstrate a strong short interest. . Both short sellers and contrarians make risky moves. A wise investor has additional reasons for shorting or buying that stock.une

The Value of Expert Advice

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Stock-picking contest pitting a leading wealth manager, a stockbroker, and a fund manager against a cat named Orlando. At the end of the year, Orlando had beaten the pros. Not even experts can beat the market consistently! Past performance is no guarantee of future performance. The efficient markets hypothesis teaches you the value of modesty. The stock market is a leading indicator of the future of the economy.

Percent change in GDP (left scale) and stock prices ASX 200 shown on the right scale) over the past year

5% 50% GDP growth 0% 0% Stock prices -5% -50% 1991 2001 2011 2021 ASX 200 tends to rise in anticipation of a strong economy, but fall in anticipation of an economic downturn. Week 5

Financial Bubbles

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Speculative bubble: When the price of an asset rises above what appears to be its fundamental value. The stock market is like a puppy beauty contest. Greater fool theory: The idea that people buy an investment because they expect other people to buy it from them at a higher price. Not a recommended investment strategy. All bubbles eventually burst, and then you can't find a greater fool.

Even if it's a bubble, it might not be about to burst:

1. It can be hard to spot a speculative bubble.
2. Even if you spot a speculative bubble, it can be hard to bet against it.
3. You don't know when the bubble will burst.une

Tulip Mania

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Dutch Tulip Bulb Market Bubble

['dach 'tü-lap 'balb 'mär-kat 'ba-bal] A famous market bubble and crash in Holland during the 1600s when speculation drove the value of tulip bulbs to extremes. . The Dutch tulip bulb market bubble was one of the most famous asset bubbles and crashes of all time. · Tulips sold for approximately 10,000 guilders at the height of the bubble, equal to the value of a mansion on the Amsterdam Grand Canal. . Tulips were introduced to Holland in 1593. The bubble occurred primarily from 1634 to 1637. . Recent scholarship has questioned the true extent of tulipmania, suggesting that it may have been greatly exaggerated as a parable of greed and excess.une

Personal Finance

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1. Harness the power of compound interest. A small amount of money can grow over time, so start saving early and save your gains.
2. Don't pick individual stocks. Even if the efficient markets hypothesis is not perfectly right, it is mostly right.
3. Diversify your portfolio to reduce risk. Easiest way to diversify your stock holdings is to buy index funds.
4. Past performance is no guarantee of future performance.
5. Minimising paying fees
6. Follow all five rules with low-cost index funds.une

Global Trade Is Growing

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Total world exports (which equals total world imports) as a share of world GDP

n 12% 1970 1980 1990 2000 2010 2020 Globalisation describes the increasing global integration of economies, cultures, politics, and ideas. It rises due to: (1) cheaper air transport; (2) larger cargo ships; and (3) internet.the

Imports and Exports Have Grown Rapidly in Australia

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As a share of GDP

30% Exports 20% Imports 10% 0% 1972 1984 1996 2008 2020 Net exports (trade balance): Spending on exports minus imports. Major Australian exports include natural resources, agricultural products, and services. Major Australian imports include clothes, cars, and lots of raw materials and intermediate goods.une

Australia Trades With Nearly Every Country

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Share of total imports and exports

China 31% Other Countries 37% India 3% United States 9% Singapore 3% United Kingdom 4% Japan 8% Republic of Korea 4% Australia trades a lot with Southeast Asia, China, the US, and Japan.une

Many Countries Import and Export Less Than Australia

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Australia Exports Imports United Kingdom United States South Korea Japan India China 0% 20% 40% The Australian economy is relatively small, so a lot of commerce has to occur across national boundaries. 1111une

Global Financial Flows

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Financial flows are large and include investment in foreign physical assets, financial assets, and loans. Financial linkages are becoming more important over time. Foreign ownership is becoming more common. Financial linkages help diversify risk across the world.University of

Financial Flows

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As a share of GDP*

15% 10% 5% Financial inflows 0% Financial outflows -5% -10% 1995 2008 2021 Investment dollars are also being traded internationally. Investors buying and selling assets in a global capital market. Financial inflows: Investments by foreigners in Australia. Financial outflows: Investments by Australians in foreign countries.une

Foreign Ownership

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As a share of GDP

200% Australian assets owned by foreigners 160% 120% 80% 40% Foreign assets owned by Australians 0% 1949 1980 2016

Financial investment flows take three main forms:

1. Foreign direct investment (FDI)
2. Portfolio investment
3. Deposits and loansUniversity of

Financial Flows Have Risen Sharply

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Reasons for the sharp rise in financial flows:

1. Removal of capital controls and deregulation of the financial sector in both Australia and abroad.
2. Large institutional investors (pension funds and mutual funds) have become more important over time.
3. Technology has made investors more comfortable sending their money overseas.
4. Financial innovation: New ways for investors to diversity and hedge their risks in foreign markets.une

Volatility Spillovers in Stock Markets

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An empirical analysis of the US stock market and output growth volatility spillover effects on three Anglo-Saxon countries Abbas Valadkhani* and George Chen UNE Business School, University of New England, Armidale, Australia (Received 22 May 2013; final version received 1 December 2013) This paper examines the dynamic and switching effects of volatility spillovers arising from US stock market returns and GDP growth on those of Australia, Canada and the UK. For this purpose, we use quarterly data (1961q1-2013q1) and a constant probability Markov regime switching model. We found that the US stock market volatility significantly affects the stock market volatility of all three countries at least in one of the two specified regimes over time. However, the stock market volatilities in none of the three countries are contemporaneously influenced by the US output volatility even after allowing for two distinct regimes. On the other hand, the US stock market volatility exerts significant influences on the output volatilities of both Australia and the UK. Compared with Australia and the UK, Canada and the US show substantial output volatility co-movements, thereby confirming the close association between the two neighbouring economies through the NAFTA (North American Free Trade Agreement). We conclude that shocks emanating from the US stock market have unequivocal flow-on effects on the output and return volatilities of the other economies.