ECO2023 - Stock Market Essay 4

ECO2023 - Stock Market Essay 4 - What determines the prices...

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What determines the prices of stocks? This answer to this question is complicated. But a simplified answer looks at demand and supply. Demand and supply should be a familiar concept. We know that they determine the prices of goods and services and so, perhaps, their use to determine the price of stocks is not surprising. We also know that there are factors (income, costs, etc.) that shift the demand or supply curves. But in case of stocks, there are essentially only two factors that shift the curves. And these factors shift both curves. Two key questions are: “What are these factors?”, and “How do these factors affect the demand and supply?” Let me tackle these questions in turn. First, what are the relevant factors? One is the expected return from owning the stock. (You can think of the “expected return” as the “expected profit.”) The other is the risk involved in earning this return. The answer to second question about how a change in the expected return or a change in the risk affect the demand and supply hinges on why people buy shares of stock. Unlike most goods and services for which there may be many reasons why people buy them, people buy shares of stock for only reason: To earn a return (that is, make a profit) on their funds. No one can be certain of what the return will be from the stock in particular company, so people have to estimate what they think the return will equal. This estimated return is called the “expected return.” To see the effect of a change in the expected return, let’s suppose that there is some new information which causes many people to revise upward the expected return from owning shares of Merck (a company that makes pharmaceutical drugs). What might this information be? Perhaps Merck announces new research that indicates it has developed a drug to treat a type of cancer. If investors believe that this new drug will be profitable, the demand for Merck stock
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