Finance 622

1.

A. The efficient markets theory says that the only thing affecting stock prices is news.  Since news is inherently unpredictable, so are stock prices and returns.  This suggests that models predicting returns (like P/E ratios) are irrelevant.

B. The Shiller P/E ratio eliminates the business cycle variation in profit margins and uses the mean returns over the past 10 years as a baseline.  However, since at any given time it is improbable the ratio will reflect the exact mean, returns will vary.  The percentages reflect market variation, 50% to 150%, which is multiplied by the Shiller ratio.  A higher Shiller ratio will offset loses caused by market variation.

C. It suggests that forecasting is imprecise. Actual returns can vary significantly from the predicted Shiller ratio. It also suggests that it will eventually fall back towards the mean, 16.5.

D. It is probably more informative than the regular P/E ratio, which doesn’t consider that price and earnings may be simultaneously low due to recession.  However, as the efficient markets hypothesis says, the only thing that really affects the price of a stock is news, and news is not predictable.  The Shiller P/E ratio does a decent job of approximating actual returns but, as indicated in Implied Return v Actual Return graph, there is much room for error.

2.

A. When expectations of inflation are low, there is less expected risk with nominal.  A lower risk premium means lower yields, and an increase in demand increases prices.

B. If all bonds are inflation protected, then there is no change in yield or prices when inflation decreases.

C. No.  Investors choose TIPS over nominal bonds to reduce the risk of inflation.  If there is low risk of high inflation, investors will choose nominal bonds.  With low inflation nominal bonds are in higher demand.  Yields are nominal bonds are low, high on TIPS.