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Unformatted text preview: 9/22/2010 _.P_i_"i_+._P1_
(1+ke) (1+ke) P0 = the current price of the stock » _, Po Div1 = the dividend paid at the end of year 1
k8 = the required return on investment in equity“ meshn \gou E I} m the sale price of the stock at the end of the ﬁrst period  “it: n ‘ ..“\. “ A. m r ; ‘I’,.\‘ 5; _°;“,_, 5.4; = " « “<an 9/22/2010 Generalized Dividend
Valuation Model The value of stock today is the present value of all ﬁiture cash flows D2 D2 DH RI
PO=—l+m~m3+...+—;+—~——h
(1+ke) (1+ke) (1+ke) (1+ke)
If P” is far in the future, it will not affect R, _ m p, ,4 gwum er
0 _ 2 l #— . l: , t _
1:1(1+ke)j HGEVEZ“: ism: The price of the stock is determined only by the present value of
the future dividend stream Renew) ' ﬂ; * “Lip/Ejai‘ .E \___,_. ° (k6 ~g)*“ (kg — g)
Do: the most recent dividend paid g = the expected constant growth rate in dividends
kg = 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 the required return on equity COM 53 e Ne if 27> f”? 3.1
L”. m it"? sag£3
m W'suni“: We; can 90 V‘J'H u: 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 perceived
risk EL; D%_<_§'21 {a :: Stew ﬂ“ ‘tii Cat; .4 Kit=5» J5; r * am
Kg;— iZ 6? a E l l if E"fa’ri—ii Strati Zliiurwl ‘3 “fit37ft? 1 ’ ' is. = 2’30!“ t ,1
K. ‘v m; Vviiﬁla—ga is; wilting 1111'; (Siam:
4; How the Market Sets Prices {View 9/22/2010 1'“ . » i‘uf‘t?‘ (’5 . v; How the Market Sets Prices 0 Information is important for individuals to
value each asset 0 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. Application: The Subprime Financial
Crisis and the Stock Market 0 Financial crisis that started in August 2007
led to one of the worst bear markets in 50
years. 0 Downward revision of growth prospects: 1g. 0 Increased uncertainty: Tke 0 Gordon model predicts a drop in stock
pﬁces. Adaptive Expectations hchthc : Q‘rﬁié "
' s:  Expectations are formed from past experience only. 0 Changes in expectations will occur slowly
over time as data changes. 0 However, people use more than just past
data to form their expectations and
sometimes change their expectations
quickly. (as. .12.“, 9/22/2010 9/22/2010 Theory of Rational
Expectations 0 Expectations wili 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 Formal Statement of the
Theory a: fife
Xe = X01“
X e = expectation of the variable that is being forecast X of = optimal forecast using all available information l» A“ 3,, “or.” ,9 737;“ ,1“: "in K: go m himire?
{JEN{2‘2 0 U’i‘. ‘x iv.) 3 "'i """‘ “‘v‘ 13,412 i . H ' _c i !_ I
— i: =02 axial/i aweé; or:  u 7,. :3
w . _ SUDSE’ECfaﬁ: 9 z 9/22/2010 Implications of
~ expect attend .
o 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) “"3” 2 All? } A”;
win.» 0 The forecast errors of expectations will, on 7
average, be zero and cannot be predicted 6” )5“ ~ Y: : G
ahead of time. Peg; {sweet 03% we”; so Ariel : , , .i . m; em » a; ,« .43
i '3 “.1: i q“ ($3.7? 5:.in in“; z if»: a a. V" V“ a.’ “WP.” . c‘ “are *4 n
arse m set Army“: it knew; t; ‘ gig—EOV.‘} 1 “$43; 6.310
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X —¥:© I a: " i nir‘lr.
QCri’iOYMQ‘l? No Hams “twat” #4513353 grimy W5 {XMLW‘WA Efficient Markets: Application
of Rational Expectations Recall
The rate of return from holding a security equals the sum of the capital
gain on the security, plus any cash payments divided by the
initial purchase price of the security. R:B+lmlDI+C
B R = the rate of return 011 the security
EH 2 price of the security at time t + I, the end of the holding period
P; = price of the security at time t, the beginning of the holding period
C = cash payment (coupon or dividend) made during the holding period
*°\ . 4 , r‘" . ‘1. i ‘ n, 1’3"?” 23:" Hf"? '= x ' 33":
.— whéﬁpglfﬁrgg ﬁﬂiﬂvlfl (3:532 N\\\ CQRUQQ,» “Yet. @W‘ﬁi {1:53. a "finite. arm—a; ﬁre“; 3“. .~ L._ x. 5'; ' girl: i an ./ —«.
c , R _ ' ..'. a n A 1 t
Pam/‘4‘: ééé‘ elitist}; ,3? at?” M“ is“ i 9/22/2010 Efficient Markets (cont’d) At the beginning of the period,_ we know RP and C.
PM is unknown and we must form an expectation of it. Theex ec dret te ‘s
Real}ng :9 a"
a r“, as Q 2:. “bet J:
P <~ MWW f a w Expectations of future prices are equal to optimal forecasts using all grrent (availab einfo tion so ,3 I a
mint}? = W :Pﬂ 4’: + 1
Supply and Demand analysis states R9 will equal the
equilibrium return R *, so Roll: 7 a an it: ~ , ,‘. {"1 i“, ’m ‘1," z, ; i  ‘ ’ "
n l ,31. "i 7C“ .22»
U2: __ \e a ‘ )ih . .4 ,3  . x ‘ attractant32’s; m\\\ \l‘é‘éiﬁé' . t 3 t\;' ‘ .ll\ﬁ§: saturates j???) \ ta taxﬁist’a‘efSE 1.4 Efficient Markets sait s pica? :7 #9 t,\'xaxauatt:;. t Current prices in a financial market will be
set so that the optimal forecast of a
security’s return using all available
information equals the security’s equilibrium retu m o In an efficient market, a security’s price
fully reflects all available information Rationale R°f>R* :>RT:> Rafi
R0f<R* 213$: RM
until
Raf = R,"
In an efﬁcient market, all unexploited proﬁt opportunities Will be eliminated ' Application Investing in the
Stock Market 0 Recommendations from investment advisors
cannot help us outperform the market a A hot tip is probably information already
contained in the price of the stock 0 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 9/22/2010 9/22/2010 Behavioral Finance  The lack of short selling (causing
overpriced stocks) may be explained by
loss aversion o The large trading volume may be explained
by investor overconfidence 0 Stock market bubbles may be explained by
overconfidence and social contagion ...
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 Spring '08
 STAHL
 Economics

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