NOVA SOUTHEASTERN ECN 5050 - Economic Thinking Data Exercise 3

Background:

The stock market is an example of a perfectly competitive market. It has a large number of buyers and sellers (especially for large cap stocks), all common shares of any stock are identical so there is no product differentiation, and there are no barriers to entry preventing buyers or sellers from entering or leaving the market. In a perfectly competitive market, profits cannot exceed the general level in the long run. The mechanism by which this comes about is that any investor in the market who makes excess profits will attract other investors who will copy what the above average investor does. More and more investors will join the bandwagon until the excess profits are competed away.

Stock prices move as new information becomes available about a company’s prospects. Economists believe that stock markets are "informationally" efficient. They gather all publicly available information and make it available to investors. As a result, movements in stock prices reflect new information, that is, they reflect "news". Such news is unpredictable –we do not even know if the next piece of news will be favorable or unfavorable to the stock. As a result the next price of a stock will be equal to the current price of a stock plus a random disturbance. This leads to the random walk model of stock prices:

Pt = δ+ pt-1 + ut pt is the price of the stock at time t ("today) and pt-1 is the price one period earlier ("yesterday"). ut is a random number. For example, you could think of an urn filled with balls with numbers on them (such as the ones

y = 0.9943x + 0.1464

15

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30

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Current Price

Lagged Price

GE Daily Prices

Random Walk Model

used for playing pool). Today’s price is yesterday’s price plus the number on a ball drawn randomly from the urn. The drawing is much like the process of drawing lottery tickets. The numbers on the balls are assumed to have a normal distribution with a mean of 0 and a variance of 1. A normal distribution has most of its values close to the mean. So there may be many balls with -½ or + ½ on them; a little fewer balls will have -1 or +1 on them, and as the numbers move away from zero, the number of balls with each number gets smaller and smaller. The constant δis called a drift factor and prevents the prices from bouncing back and forth around the initial price. It is not a key part of the theory.

The random walk theory suggests that prices are unpredictable, and you cannot use an average of previous values of the price to project the next value of the price. The best prediction of tomorrows price is today’s price.

Assignment:

You are to

 Choose one of the 30 industrial stocks in the Dow Jones Industrial Average. Google Dow Jones Industrial stocks. Note the ticker symbol of the stock you choose. (Do not choose GE)

 Go to Yahoo/Finance and put the ticker symbol in the Get Quote window (on left hand side). Click in Historic prices and change the beginning date to two years before the ending date. Download two years of Historic Prices from Yahoo/Finance into an Excel worksheet.

 Create variables Pt and Pt-1. Pt is the Adj. Close price which adjusts the price for ex-dividend movements and stock splits. Make sure Pt-1is in the column to the left of Pt

 Draw a scatter plot chart with Pt-1 on the horizontal axis and Pt on the vertical axis.

 Insert a linear trend and get the equation. Below is the chart I got for GE prices.

 Select a 5 x 2 array. 5 rows, 2 columns. In the NW corner enter the equal sign and click on the fx function symbol right above your worksheet. Select the statistical category in the category box. Scroll down in the Select a function box until you get to LINEST and select it. A Functions Arguments box opens up. In the Known y’s put the values of Pt and in the known x’s put the values of Pt-1. Skip the constant line and enter TRUE in the stats line. Do not hit OK. Hold the Shift and Ctrl buttons down and hit Enter. The array will fill with a variety of statistics. Select the array, right click and select format cells. Under the Number tab select Number and choose 3 decimal places. They are easier to read.