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Chapter 6 - Efficient market hypothesis

# Chapter 6 - Efficient market hypothesis - Chapter 6 The...

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Chapter 6 The stock market, the theory of rational expectations, and the efficient market hypothesis We begin by discussing the fundamental theories that underlie the valuation of stocks. These theories are critical to understanding the forces that cause the value of stocks to rise and fall minute by minute and day by day. Once we have learned the methods for stock valuation, we need to explore how expectations about the market affect its behavior. We do so by examining the theory of rational expectations. When this theory is applied to financial market, the outcome is the efficient market hypothesis. A. Computing the price of common stock Basic principle of Finance Value of Investment = Present value of future cash flows The one-period valuation model ) 1 ( 1 1 0 k P D P + + = Where 0 P : the current price of the stock. The zero subscript refers to time period zero, or the present. 1 D : the dividend paid at the end of Year 1 1 P : the price at end of the first period; the assumed sales price of the stock. k : the required return on investments in equity The generalized dividend valuation model Using the same concept, the one-period dividend valuation model can be extended to any number of periods: The value of stock is the present value of all future cash flows. The only cash flows that an investor will receive are dividends and a final sales price when the stock is ultimately sold in period n. the generalized multi-period formula for stock valuation can be written as: 6-1

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n n n k P D k D k D P ) 1 ( ) 1 ( ) 1 ( 2 2 1 0 + + + + + + + = Since n P is far in the future, it will not affect 0 P . The generalized dividend model could be rewritten with the final sales price: + + + + = 2 2 1 0 ) 1 ( ) 1 ( k D k D P = + = 1 0 ) 1 ( t t t k D P The Gordon Growth Model The generalized dividend valuation model required that we compute the present value of an infinite stream of dividends, a process that could be difficult. Thus simplified models have been developed to make the calculations easier. One such model is the Gordon growth model, which assumes constant dividend growth. g k D g k g D P - = - + = 1 0 0 ) 1 ( Where g : the expected constant growth rate in dividends B. How the market sets security prices The players in the market, bidding against each other, establish the market price. When new information is released about a firm, expectations change and with them, prices change. New information can cause changes in
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Chapter 6 - Efficient market hypothesis - Chapter 6 The...

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