Transcript Document
Chapter 7
The Stock Market, The Theory of Rational Expectations, and the Efficient Market Hypothesis
Computing the Price of Common Stock • Basic Principle of Finance
Value of Investment = Present Value of Future Cash Flows
• One-Period Valuation Model
P
0 (1
Div
1
k e
) (1
P
1
k e
) (1) © 2004 Pearson Addison-Wesley. All rights reserved
7-2
Generalized Dividend Valuation Model
P
0 (1
D
1
k e
) 1 (1
D
2
k e
) 2 (1
D n k e
)
n
(1
P n k e
)
n
(2) • Since last term of the equation is small, Equation 2 can be written as
P
0
t
1 (1
D t k e
)
t
(3) © 2004 Pearson Addison-Wesley. All rights reserved
7-3
Gordon Growth Model
• Assuming dividend growth is constant, Equation 3 can be written as
P
0
D
0 (1
k e
) 1
g
) 1
D
0 (1
g k e
) 2 ) 2
D
0 (1
g k e
) ) (4) • Assuming the growth rate is less than the required return on equity, Equation 4 can be written as
P
0
D
0 (
k e
g
)
g
) (
k e D
1
g
) (5) © 2004 Pearson Addison-Wesley. All rights reserved
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How the Market Sets Prices
• The price is set by the buyer willing to pay the highest price • The market price will be set by the buyer who can take best advantage of the asset • Superior information about an asset can increase its value by reducing its perceived risk © 2004 Pearson Addison-Wesley. All rights reserved
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How the Market Sets Prices
• Information is important for individuals to value each asset.
• When new information is released about a firm, expectations and prices change.
• Market participants constantly receive information and revise their expectations, so stock prices change frequently.
© 2004 Pearson Addison-Wesley. All rights reserved
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Adaptive Expectations
• Expectations are formed from past experience only.
• Changes in expectations will occur slowly over time as data changes.
• However, people use more than just past data to form their expectations and sometimes change their expectations quickly.
© 2004 Pearson Addison-Wesley. All rights reserved
7-7
Theory of Rational Expectations
• Expectations will be identical to optimal forecasts using all available information • Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate – It takes too much effort to make the expectation the best guess possible – Best guess will not be accurate because predictor is unaware of some relevant information © 2004 Pearson Addison-Wesley. All rights reserved
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Implications
• If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well – Changes in the conduct of monetary policy (e.g. target the federal funds rate) • The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time. © 2004 Pearson Addison-Wesley. All rights reserved
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Efficient Markets
• Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return • In an efficient market, a security’s price fully reflects all available information © 2004 Pearson Addison-Wesley. All rights reserved
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Evidence on Efficient Markets Hypothesis
Favorable Evidence
1. Stock prices reflect publicly available information: anticipated announcements don’t affect stock price 2. Stock prices and exchange rates close to random walk If predictions of
P
big,
R of
>
R*
predictions of
P
small
Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns 2. January effect: high returns in January 3. Market overreaction 4. New information is not always immediately incorporated into stock prices
Overview
Reasonable starting point but not whole story © 2004 Pearson Addison-Wesley. All rights reserved
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Application Investing in the Stock Market
• Recommendations from investment advisors cannot help us outperform the market • A hot tip is probably information already contained in the price of the stock • Stock prices respond to announcements only when the information is new and unexpected • A “buy and hold” strategy is the most sensible strategy for the small investor © 2004 Pearson Addison-Wesley. All rights reserved
7-12
Behavioral Finance
• The lack of short selling (causing over-priced stocks) may be explained by loss aversion • The large trading volume may be explained by investor overconfidence • Stock market bubbles may be explained by overconfidence and social contagion © 2004 Pearson Addison-Wesley. All rights reserved
7-13