Chapter 7

Chapter 7 - 9/22/2010 _.P_i_"i_+._P1_ (1+ke)...

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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“ mesh-n \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-~m-3+...+—;+—~——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's-uni“: 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 “fit-37ft? 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 him-ire? {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 “$43; 6.310 D e L' X —¥:© I a: " i nir‘lr. QCri’iOYMQ-‘l? No Hams “twat” #4513353 grimy W5 {XMLW‘WA Efficient Markets: Application of Rational Expectations Recall The rate of return from holding a security equals the sum of the capital gain on the security, plus any cash payments divided by the initial purchase price of the security. R:B+lmlDI+C B R = the rate of return 011 the security EH 2 price of the security at time t + I, the end of the holding period P; = price of the security at time t, the beginning of the holding period C = cash payment (coupon or dividend) made during the holding period *°\ . 4 , r‘" . ‘1. i ‘ n, 1’3"?” 23:" Hf"? '= x ' 33":- .-— whéfipglffirgg fifliflvlfl (3:532 N\\\ CQRUQQ,» “Ye-t. @W‘fii {1:53. a "finite. arm—a; fire“; 3“. .~ L._ x. 5'; ' girl: i an .-/ —-«-. c , R _ -' ..'. a n A 1 t Pam/‘4‘: ééé‘ elitist}; ,3? at?” M“ is“ i 9/22/2010 Efficient Markets (cont’d) At the beginning of the period,_ we know RP and C. PM is unknown and we must form an expectation of it. Theex ec dret te ‘s Real}ng :9 a" a r“, as Q 2:. “bet J-: P <~ MWW f a w Expectations of future prices are equal to optimal forecasts using all grrent (availab einfo tion so ,3 I a mint}? = W :Pfl 4’: + 1 Supply and Demand analysis states R9 will equal the equilibrium return R *, so Roll: 7 a an it: ~ -, ,‘-. {"1 i“, ’m ‘1," z, ; i - ‘ ’ " n l ,31. "i 7C“ .22» U2: __ \e a ‘ )ih .- .4 ,3 - . x ‘ attractant-32’s; m\\\ \l‘é‘éifié' . t- 3 t\;-' ‘ .ll\fi§: saturates j???) \ ta taxfiist’a‘efSE 1.4 Efficient Markets sait- s pica? :7 #9 t,\'xaxauatt:;. t Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium retu m o In an efficient market, a security’s price fully reflects all available information Rationale R°f>R* :>RT:> Rafi R0f<R* 213$: 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 over-priced 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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Chapter 7 - 9/22/2010 _.P_i_&amp;quot;i_+._P1_ (1+ke)...

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