Transcript Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Markets Hypothesis Copyright  2011 Pearson Canada Inc. 7- 1

Chapter 7
The Stock Market, the Theory of Rational
Expectations, and the
Efficient Markets Hypothesis
Copyright  2011 Pearson Canada Inc.
7- 1
Common Stock
• Common stock is the principal way that
corporations raise equity capital.
• Stockholders have the right to vote and be the
residual claimants of all funds flowing to the
firm.
• Dividends are payments made periodically,
usually every quarter, to stockholders.
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One-Period Valuation Model
DIV1
P1
P0 

(1  k e ) (1  k e )
PO = the current price of the stock
DIV1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the
first period
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Generalized Dividend Valuation Model
The value of stock today is the present value of all future cash
flows
D1
D2
Dn
Pn
Po 

 ... 

1
2
n
(1  k e ) (1  k e )
(1  k e ) (1  k e )n
If Pn is far in the future, it will not affect P0

Dt
P0  
t
t 1 (1  k e )
The price of the stock is determined only by the present
value of the future dividend stream
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Gordon Growth Model
D0 (1  g)
D1
P0 

ke  g
ke  g
D0 = the most recent dividend paid
g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate
forever.
The growth rate is assumed to be less than required return on
equity
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Price Earnings Valuation Method I
The price earnings ratio (PE) represents how
much the market is willing to pay for $1 of
earnings from the firm.
1. A higher than average PE may mean the
market expects earnings to rise in the future.
2. A high PE may also mean the market feels
the firm’s earnings are very low risk.
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Price Earnings Valuation Method II
• The PE ratio can be used to estimate the
value of a firm’s stock.
• The product of the PE ratio times the
expected earnings is the firm’s stock price.
• (P/E) x E = P
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How the Market Sets Stock Prices I
• 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 risk.
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How the Market Sets Stock Prices II
Investor Discount Rate
Stock Price
You
15%
$16.67
Jennifer 12%
Bud
10%
$22.22
$28.57
•Each investor has a different required return leading to
differing valuations of the stock.
•New information leads to changes in expectations and
therefore changes in price.
•Stock prices are constantly changing.
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Monetary Policy and Stock Prices
• Monetary policy is an important determinant
of stock prices
• Gordon Growth model shows two ways in
which monetary policy affects stock prices
• ↓i lowers the return on bonds and this leads
to a ↓ in ke which leads to an ↑ stock prices
• ↓i stimulates economy leading to an ↑g
leads to an ↑ stock prices
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Adaptive Expectations
• 1950s and 1960s economists believed in adaptive
expectations.
• Adaptive expectations means that expectations were
formed from past experience only
• Changes in expectations occur slowly over time.
• Mathematical formation of hypothesis shows that
expected value at time t is a weighted average of
current and past values
• The smaller the weights the longer that past events
affect current expectations
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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.
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Formal Statement of the Theory
Xe = Xof
Xe = expectation of the variable that is being forecast
Xof = optimal forecast using all available information
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Implications of the Theory
• 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.
• The forecast errors of expectations will, on
average, be zero and cannot be predicted
ahead of time.
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Efficient Markets: Rational Expectations in
Financial Markets I
Recall: The rate of return from holding a security equals the
sum of the capital gain on the security plus any cash payments
divided by the initial purchase price of the security
Pt 1  Pt  C
R
Pt
R = the rate of return on the security
Pt+1 = price of the security at time t+1, the end of the holding
period
Pt = price of the security at time t, the beginning of the holding
period
C = cash payment (coupon or dividend) made during the holding
period
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Efficient Markets: Rational Expectations in
Financial Markets II
At the beginning of the holding period, we know Pt and C
Pt+1 is unknown and we must form an expectation of it.
The expected return then is:
e
P
e
t 1  Pt  C
R 
Pt
Expectations of future prices are equal to optimal forecasts using all
currently available information so
Pte1  Ptof1  Re  Rof
Supply and demand analysis states Re will equal the equilibrium
return R* so Rof = R*
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Efficient Markets: Rational Expectations in
Financial Markets III
• 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 and all profit opportunities
will be eliminated.
• Caveat: Not everyone in an financial market must be
well informed about a security or have rational
expectations for the efficient market condition to
hold.
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Rationale Behind the Theory
Rof  R*  Pt   Rof 
R  R*  Pt   R 
of
of
until
Rof = R*
In an efficient market all unexploited profit opportunities will be
eliminated
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Stronger Version of the Efficient Market
Hypothesis
• Efficient markets are rational (optimal
forecasts using all available information)
• Also requires prices to reflect true
fundamental (intrinsic) value of the securities.
• In an efficient market prices are always correct
and reflect market fundamentals
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Application: Practical Guide to 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.
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Behavioural 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.
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