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

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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

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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

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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

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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

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