Finance notes 3.5 - Sheet1 Behavior of stock market prices...

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Sheet1 Page 1 Behavior of stock market prices information -> stock valuation- investors form belief -> investor reasses asset about discounted cash flow value when new info. Question: Whether prices adjust quickly and correctly when new info. arrives (is market efficient?) Efficient market: prics fully reflect available information Example: AMD been secretly making processor AMD - 2$ NPV per share = 4$, theyare a new chip comes out, making the new value 6$, if the makrets efficient enough, it w immediately until next new chip comes out. In an inefficient market: market takes recognize this new technology or the stock overshoots and then lowers back to 6$ Efficiency: - Unexpected news can affect stock price - changes in stock price should be random and unpredictable Stock prices follow a "Random Walk" - what makes it efficient? * Competition among the investors *the investors study and gather the info. in order to find the mispriced stock -Equilibrium - information becomes costly to find * can not expect to earn excess returns consistently using costless trading strat 3 forms of efficiency: *Strong form Efficiency - price reflects all information (both private and public *Semi-strong form efficiency - price reflects all public information ~Fundamental analysis will not lead to excess returns *Weak form Efficiency - price reflects all information contained in the past pric ~ technical analysis can't lead to excess return Chapter 13 3 Key questions: 1. What is risk? How to measure it. 2. For what kind of risks do investors get rewarded? 3. how to convert risk into discount rate? Investor rationality *Investors are rational - they always want more money than less money if risk is s *Always prefer lower risk if they can get the same reward Expected return: E(R) = n sigma i=1 Pi Ri Stock Probability Stock c Stock t Boom .3 15% 25% Normal .5 10% 20% Recession .2 2% 1%
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Sheet1 Page 2 E(r) Stock C = .15*.3 + .1 * .5 + .02 * .2 = .099 = 9.9% Risk free RoR = 6%, stock C's risk premium = 9.9% - 6% = 3.9% Variance = n sigma i = 1; Pi (Ri - E(r))^2 ~=0.3*(0.15-0.099)^2 + 0.5*(0.1-0.099)^2 + 0.2*(0.02-0.099)^2 = 0.00203 stdev = sqrt(.203) = .045 Portfolio - Collection of assets 2000$ A weight = (2000/15000) E(Ra) 3000$ B weight = (3000/15000) E(Rb) 4000$ C weight = (4000/15000) E(Rc) 6000$ D weight = (6000/15000) E(Rd) E(Rp) = sum of all Wj*E(Rj) j= # stock in portfolio Alternative method: 1) Find porfolio return in each possible state 2) then compute expected return
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This note was uploaded on 09/08/2010 for the course BUS 170 at San Jose State University .

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Finance notes 3.5 - Sheet1 Behavior of stock market prices...

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